The Hindu Business Line : Asset price inflation and impact on economy

ASSET price inflation basically refers to increases in the prices of stocks and housing. Contrary to the impression prevailing in some quarters, there is absolutely no reason to include asset price inflation in consumer price indices.

On the contrary, asset price inflation helps relieve the pressure of excess liquidity on consumer prices.

The problem with asset price inflation is, rather, that if and when a bubble bursts, it can have serious effects on the real economy, because of the disruption of financial markets, as lenders are suddenly left with insufficient collateral.

It is because of this that there has been a great deal of concern about asset price inflation; not because of its possible effect on consumer prices.

The problem is that there is no way to determine the extent to which `irrational exuberance' is providing a boost to asset prices; or the extent to which increasing asset prices are only a reflection of 'strong fundamentals'. Not even post facto; after a bubble has burst. For the simple reason that the bursting of bubbles, too, could be, and usually is, caused by `irrational' factors.

This leaves market regulators with the serious problem of whether or not, and when, to take an attitude of `benign neglect' to increasing asset prices.

Asset price bubbles have been and will be for many years to come a serious issue for policy-makers in India, thanks to the fact that the new government, too, seems to have adopted a policy of encouraging investments in shares by banks, pension funds, life insurance companies and so on. The Government has been encouraging investments in the stock market for two main reasons. One reason is that a `wealth effect' can prove beneficial to the real economy, to the extent that it increases expenditure and, therefore, income.

The other reason is the effect of a buoyant stock market on the resources that can be raked in by offloading of shares of public sector companies.

It is worth noting in this connection that in his Budget Speech, the Finance Minister, Mr P. Chidambaram, stated clearly that he proposed to use disinvestment as an important source for raising extra-budgetary resources; among other things because disinvestment would reduce the need for budgetary support to companies owned by it.

The trouble is that the larger the amount of public and private funds that are `diverted' to the stock market, by reducing rates of interest on safe investments, and by increasing the flow of public funds, the greater the stakes in market stability; and the greater the risk of being unable to follow a policy of benign neglect.

To take a recent example, in the wake of the large and sudden fall in the share market, the Reserve Bank of India quickly reduced the margins on loans to brokers intended for on-lending to their clients. But for this, like the banks themselves, the brokers too would have found themselves in a serious quandary, because of the sudden fall in the value of the collateral.

This could clearly have set off a further stampede. The point is that the government's increased and increasing interest in the stock market has already quite clearly vitiated its ability to follow prudent banking policies.

This problem is sure to become increasingly problematic in the years to come. The same problem, of course, arises with respect to the housing component of asset price inflation as well.

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