Businesses are prone to the forces of the economy and business cycles are unavoidable. However, as our understanding of economics improves the severity of business cycles has been reduced by taking steps to counter the downturn in the economy. Of the many steps taken the one that is of the most interest to the stock markets is the change in monetary policy. In this article we look at the impact of the change in money supply (as a proxy for change in monetary policy) on the stock markets.
But first a few basics.
The central bank’s job in a country is to ensure the stability of the currency and ensure the right kind of an environment for economic growth. For example, the Reserve Bank of India’s objective is:
"…to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."
Source: RBI website
The Federal Reserve Bank’s (central bank in the US) objectives are to facilitate economic growth in line with the economy’s growth potential, ensure a high level of employment, stable prices and moderate long-term interest rates.
Households keep their saving with a bank and this money is made available to the industry through a banking system of a country, with the central bank at the helm. Thus, the banks act as financial intermediaries. A part of the money that is deposited has to be kept as a reserve with the central bank, RBI in India’s case. The remaining part is given out as loans or is parked in other financial instruments.
The central bank using the reserves as input prints currency notes i.e. supplies money. The process of creation of money using the deposits is known as multiple expansion of bank deposits. Suppose an investor deposits Rs 100 in a savings account. Of this Rs 10 (10%) has to be kept as reserve with the central bank and the remaining Rs 90 can be given out as loans. The bank loans the amount to a company wanting to start an industrial venture. The company receiving the loan puts the money into another bank account. The second bank has to keep Rs 9 as reserve and give out Rs 91. This process continues. Thus, we find that at a reserve requirement of 10% every rupee deposited can support demand deposits of Rs 10. The ratio of the new deposit to the increase in reserve is known as the money supply multiplier. The central banks print currency accordingly. If a deposit creates money, withdrawal of deposits has the reverse effect that is to remove money from the system.
The central banks control the flow of money in the financial system through the monetary policy. The tools used for implementing the monetary policy are:
- Open market operations
- Interest rates
- Reserve ratio
The higher the reserve ratio, higher amount of money, the commercial banks will have to hold with the central bank and thus, the money available to the industry will be lower. Also, the central bank buys and sells government securities (G-secs), which is known as the open market operations. If the central bank sells G-secs, deposits will be withdrawn from the banking system to buy these instruments and this will in turn reduce the liquidity. On the other hand, if it buys back G-secs, it will increase the liquidity in the system. Finally the banks borrow from the central bank when they face shortage of reserves. By altering the rate at which the central banks lends out the liquidity in the systems can be controlled.
If banks can borrow at lower rates then they can lend out to industries at lower rates also. Thus, the cost of capital becomes cheaper. Depending on the economic environment central banks follow tight money or cheap money policy. When the economy is growing a multiplier effect comes into play. Expectations of future growth propel investments, which in turn drive employment and higher employment results into increased spending. However, increased spending could cause the risk of inflation. Thus, by limiting the availability of money or making it dearer, the central bank steers the economy away from inflation.
In 1979, when the US economy had high levels of inflation the Federal Reserve under the chairmanship of Paul Volcker undertook the monetarist experiment. It reigned in the growth in bank deposits and reserves. Consequently, the inflation declined sharply between 1979 and 1982. The slow money growth caused interest rates to soar. This impacted investments adversely and the economy stagnated. The unemployment rose from about 6% to about 10% in 1982. On the other hand, to counter the slowdown in the US economy the Fed has reduced rates from 6.5% beginning January 2001 to 1.75% on December 2001.
Thus, the central bank of a country tries to counter the weak economy by reducing the cost of one of the most important inputs for business - money. By effectively increasing the money supply into a country’s financial system, the availability of capital is made cheaper with the hope that investments in business becomes more lucrative and investments begin to take place.
Lower interest rates are good for the stock markets. This is due to the fact that lower interest rates make the other asset classes that compete with equities like fixed deposits become relatively less attractive. Also, lower interest rates mean that the interest burden on corporates that have a raised a significant part of their capital through debt reduces. Consequently, earnings tend to grow at a faster pace and therefore, stock markets are again benefited in the long run.
Thus, growth in money supply should result to better performance for the stock markets. While there seems to be not much of a correlation, the stock market indices seem to mirror the growth in money supply with a lag effect. Higher growth rates have been followed by stock market indices gaining significantly in subsequent years. However, more prominent is the fact that a lower growth rate in money supply has caused index to decline more often than not. This has been seen for both the Indian the US markets. It is very difficult to come to a definite conclusion especially for the Indian markets since scams distort the data significantly. Also, stock markets are not purely driven by fundamentals.
Since October 2001 the RBI cut the cash reserve ratio by 2.5% to 5%. Further the bank rate has also been lowered by 0.5% to 6.5%. This effectively means more than Rs 80 bn has been added in the system. But this has not been reflected by the stock markets. Of course bond markets have rallied since, indicating that part of the money has found its way into debt. It leaves us to wonder how long before the money comes into equities.