Stock markets are a barometer of any economy. If the markets are doing well it is a reflection that the economy is doing well too. They are also a channel to invest one's savings. Lastly, for stock markets to prosper foreign investments are critical. Most of us would agree with the above statements. However, recently we came across an interesting article in First Post which came out with sound contradicting logic stating why this may not necessarily be true.
Here we just try and see the reasons behind that logic and also present our view on it.
Statement 1: Stock Markets are a barometer of corporate sector and thus Indian economy.
When we say that stock markets are a barometer of our economy we see the performance of BSE-Sensex or NSE-Nifty vis-a-vis the performance of the economy. However, it may be noted that both these indices encompass 30 and 50 stocks respectively. But at the same time there are more than 5,000 odd companies that are listed on the exchanges. So, in effect a performance of handful companies out of the entire universe is being used to project the performance of the economy.
Our View: Now, on the face of it, it may appear discomforting. However, it may be noted that rest of the companies (out of the other sectoral indices) are miniature in size. Also, if market cap of Sensex or Nifty companies is viewed as a proportion of total market cap of all the listed companies, the index companies would garner a decent share (we have not done the exact math) in it. Thus, they represent a fair size of the overall market. Hence, it would not be completely wrong to say that markets are a barometer of Indian economy.
Statement 2: Stock markets help channel savings
While stock markets do offer an option as another investment avenue, their share as a percentage of total financial savings is limited. As per the First Post article, it was highest at about 5% in 2009/10. Thus, going by the figure it may seem that while stock markets do offer an investment option but it is hardly meaningful in channelizing the savings of an Indian household.
Our View: We feel this is the case because of conservative nature of the Indian household. As such, most of their savings are invested in insurance, public provident funds , banks, post offices etc. And in order to increase the share of equities one needs to educate them about the risk and return characteristics of the asset class per se. Also, over time once people get more informed and the economy recovers the share of equities in overall savings would increase.
Statement 3: Foreign investments are critical to India's growth
Apart from fundamentals, markets move on liquidity. Thus, in a sense foreign capital is critical to India's growth. But considering that India's savings rate is in the range of 30-35% imagine what could happen if majority of these savings are channelized into stock markets. If it does happen, India will no longer be reliant on foreign capital that much.
Our View: While it is true that foreign capital is necessary for growth, we need to understand why such a situation has come up in the first place. With high savings rate why should we seek outside foreign capital? Also, it may be noted that the foreign capital that is coming in is pumped into the system out of the liquidity exercise undertaken by the central banks around the world. Since that money is not finding its way into their domestic asset classes for lack of growth prospects it is chasing India. But it may be noted that this capital is short term in nature. It can flee at the slightest uncertainty and expose our economy to currency shocks. Hence, instead trying to woo foreign investors the government should create an environment where the domestic people are able to benefit out of the economic boom. If not, we are at a risk of cheap liquidity contagion of foreign markets.