Booming stock market and ailing economy

In India, the stock market prices are surging to new highs, while the economy is not doing very well. Why? Even though stocks ought to represent the present value of future corporate profits, it has been observed repeatedly that the current profits, and profits in the near future, tend to be overemphasised. Currently such profits are high. A part of this is simply cyclical. But there is also another important part. 

In 2019, the corporate tax rates were cut substantially. The effect of this hardly showed up in 2020 due to Covid-19, but the profits have gone up in 2021. Furthermore, over the last year, the production-linked incentives (PLI) scheme has been introduced. This is benefiting a part of the corporate sector.

Thanks to Covid-19, and some earlier policies related to the goods and services tax (GST) and the Real Estate (Regulation and Development) Act (RERA), the market share of the corporate sector in business has increased. Subsequently, a few policy announcements that were supposed to benefit businesses in general have disproportionately affected the corporate sector. These policy measures are as follows.  

The Reserve Bank of India (RBI) lowered the real interest rates by at least 3 percentage points. This has had a big effect on profits. Also, the RBI is accepting inflation at the maximum permissible 6 per cent rate rather than the mandated 4 per cent. A big jump in the inflation rate, at least initially, can benefit businesses. Furthermore, the Customs duties have been increased gradually by at least 5 percentage points. This increases the profitability for the domestic businesses. Finally, the RBI has been increasing its reserves substantially by buying foreign currencies, thereby increasing their prices. This has helped exporters. 

Individually, any of the above policies may not mean too much but the aggregate effect is significant. It is an important reason for the surge in corporate profits (the cost cutting is not very widespread and deep). 

Let us now move from the corporate sector to the economy more generally. It is interesting that many of the above policies have aggravated the difficulties for much of the economy. Because the corporate tax rate was cut substantially and the PLI was brought in, the oil tax has had to be high. This regressive tax has hurt the economy. GST, RERA, etc had already hurt many small businesses. The very low interest rate policy has made the real interest income negative for savers. Both the rise in import tariffs and the rise in the price of dollar have hurt the Indian consumer. And, the jump in inflation rate has hit the public hard. 
 

It follows that a part of the rise in corporate profits and the stock prices in India is at the expense of the economy more generally. So, not only is there no contradiction between the booming stock market and the ailing economy, in fact the two are somewhat going together currently. 

Of course, besides the rise in corporate profits, there are other important reasons for the stock market boom. First, the interest rates are very low, making stocks attractive. Second, we have irrational exuberance lifting prices higher and higher. However, let us take a closer look. 

Very low interest rates are not market determined; these are policy induced. And, the irrational exuberance is not entirely exogenous; it is partly an exaggeration of the quantitative effect of the jump in profits (and strengthened balance sheets) on the worth of stocks. This brings us back to why the profits are high now. We have seen already that a part of this is due to various government policies. So, why such policies in the first place? 

The thinking seems to be that the corporate sector is important in the developed countries and we should fast replicate this in India. So, it needs to be incentivised — more so as it is at a disadvantage in India. What is wrong with the entire argument?

Corporations are not the only ones disadvantaged in India. In any case, in developed economies the large corporate sector is, by and large, a result of a long evolutionary process, and the invisible hand of the market. Competition, ease of entering a business in general and not just in a business related to the technology sector, and creative destruction have all played an important role. Though the governments enabled businesses there, attempts were made to “save capitalism from capitalists”, and the tax-GDP ratio was raised substantially over time. All this is not the case in India. 

It is very good that the public authorities are interested in economic growth but the approach needs to change. Then we may not get into “puzzling” situations like an ailing economy and a booming stock market.

The writer is visiting faculty, Indian Statistical Institute, Delhi Centre