What’s driving up this frothy market?

Alok Ray | Updated on July 15, 2021

Covid stimulus, FPI inflows and cost-cutting by firms have lifted the stock market, even as the real economy is languishing

People wonder why, despite the real economy experiencing negative growth following the Covid outbreak, the stock market in India is doing so well. In fact, the Bombay Stock Exchange Sensitive Index (Sensex) has doubled in less than a year precisely when the real economy was tumbling down. Several explanations can be provided to explain this paradox.

The most general one is that the stock market is always ‘forward-looking’, meaning it reflects what the market thinks will happen in future, instead of what is happening right now to production, employment, etc. So, there is no necessary conflict between an economy having negative growth and stock market booming at the same time if the market believes that the economy is going to have high growth and high profits in the foreseeable future.

Then, there are other explanations that are more specific to the current context.

First, though GDP has been falling, the profits earned by many firms, specially the big ones in sectors like IT, pharma, online retail, oil and gas and metals have been rising. This is because some firms have been able to cut costs, by resorting to work from home, laying off workers and repaying debts (and hence reducing interest costs), more than the fall in sales revenues. Also, sales revenues have gone up for some companies due to rising global prices of commodities like metals, oil and gas.

Big cuts in corporate tax rates have further helped to boost net-of-tax profits. At the same time, because of the government credit guarantee and debt and interest moratorium during the Covid period and more robust supply chain logistics, some firms in the organised sector have been able to increase production and sales at the expense of smaller unorganised sector firms. Remember that though the decline in the small firms has adversely affected the GDP and employment numbers, these firms are unrepresented in the Sensex and Nifty.

Low interest rates

Second, a related explanation runs in terms of artificially low interest rates (both short and long term), specially in the developed world. This makes investment in equities more attractive than in the bond market. Also note that the price of equities is inversely related to the interest rate. The price of a company share today is determined as the sum of expected returns (dividends plus capital gains) over the lifetime of the asset, discounted at the relevant interest rate at that point in time in future.

So, if the interest rate is low, the discounted sum (or, present value) will be high and so would the current price of the asset. This explains why a falling interest rate regime keeps the prices of financial assets and stock indexes (like Dow Jones in the US and Sensex in India) rising. Alternatively, if the interest rate is low, other assets like stocks, gold and real estate attract more investment funds which push up their prices.

Third, the world economy is currently flush with liquidity as a result of the continuing bond buying by the Fed and other major central banks of the world for many years, and recently further accentuated by the need to finance the massive Covid stimulus packages. This excess money supply is looking for investment alternatives all over the world which is pushing up asset (stocks, gold, real estate) prices in many parts of the globe, including India.

This year up to mid-June (according to Bloomberg Data), Foreign Portfolio Investors (FPIs) have invested $8.1 billion in India, which is next only to Brazil among the emerging market economies. Note that during the same period, there has been a capital outflow to the tune of $16.6 billion from South Korea and $4.6 billion from China.

This shows that FPIs of the world believe that India offers attractive returns on equity in the foreseeable future, relative to even manufacturing powerhouses like Korea and China. This is particularly true for the post-Covid world when the rest of the world wants to reduce its over-dependence on China and diversify its investment basket and sources of supply. It is an established fact that the movement in the Indian stock market is highly correlated with the flows of FPI money in and out of India.

Fourth, even the recent FDI inflows have mostly gone into existing ‘brownfield’ projects like the $25 billion mega stake sale deal between Reliance Retail and Amazon, following an earlier $16 billion stock acquisition of Indian e-commerce firm Flipkart by Walmart. Though such deals have jacked up our foreign exchange reserves and stock indexes, the real economy is yet to feel any significant impact, except for showing a tendency towards greater monopolisation of business.

Regarding consequences, a few points are worth noting. One, the booming stock prices, together with big falls in employment and incomes of workers and owners of small enterprises, is further worsening the already highly unequal distribution of income and wealth. Stocks in India are predominantly held by the high-income group. Though middle class professionals are gradually moving towards holding some equities through the SIP and mutual fund routes, the low-income segment is virtually absent in equity markets and depend solely on wage income which is getting squeezed.

Aggregate demand

Two, the resulting income and wealth effect is depressing the aggregate demand in the economy and hence GDP growth since the rich have a lower propensity to spend. Alongside, the demand pattern, and, consequently, the production and employment mix, is also changing from mass consumer goods to luxury products. It is not surprising, therefore, that amidst the misery of the unemployed, there is no dearth of demand for super luxury imported cars and mansions. Given the excess capacity in many sectors, more cash in the hands of rich shareholders are not being invested in capacity expansion and is being used to buy more assets like stocks in the secondary market, gold, jewellery and real estate, creating ‘asset bubbles’, which do not help boost the real economy.

There is one positive impact, though. The high profits and stock market boom have enabled the government garner more than ₹26,000 crore as dividend from 23 listed PSUs in 2020-21, a 124 per cent increase over the previous year. This bonanza has helped the government to somewhat contain the fiscal deficit and, thereby, maintain a higher level of expenditure than would otherwise have been possible.

The writer is a former professor of economics at IIM Calcutta, and Cornell University

Published on July 15, 2021

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