Stock market shocks

Written by Shashanka Bhide | Shashanka Bhide | Updated: Jan 28 2008, 04:08am hrs
Financial market volatility is back again. This time too, it is not scandals but real market risks that have led to market turbulence. The stock price rollercoaster has again shown that things cannot be taken for granted for too long. While the latest episode will dampen interest in equity investment among retail investors for a while, a market recovery will erase memories once more. The point, therefore, is to look for a way to minimise the cost of such volatility. Growth-and-slowdown cycles are not unexpected. What would be of interest is the likely direction that policy might take in that context.

Does market turbulence have policy implications India's financial markets, even in the absence of capital account liberalisation, are not immune to global market conditions. The frenetic global development of new financial products and tech applications has meant that nothing is immune to world shocks, especially from developed markets. Much of the capital flow into developing countries comes from the developed world. For us in India, while accelerated economic growth is a necessary condition for solving many of our problems, any shock is a cause for anxiety. Whether it is the widening of interest rate spreads between Indian and international markets, oil price shock or global tightening of grain markets, the repercussions are inescapable.

However, are these shocks now more bearable than earlier Clearly, at the aggregate level, India's capacity to bear risks has risen. Our markets are bigger and more diverse than ever before. The sizable forex and foodgrain reserves, coupled with a stronger fiscal position, offer a good cushion.

An important point often made in this context is the external shock-absorber provided by the relatively large size of the domestic economy. Internal sources of demand are expected to keep overall demand growth intact even if external markets soften. Measured in terms of trade in goods and services, we are not as integrated with world markets as China is. A large part of the capital inflows into India has led to the creation of production capacity to meet domestic demand. And capacity creation has been accelerating, as shown by the increasing ratio of capital formation to GDP. However, a significant portion of this investment is in housing and construction, a sector sensitive to volatility in global capital flows. It is capital formation by way of plant & machinery that has been in response to growing domestic demand. This is one of the fundamentals of the Indian economy said to be especially strong, granting the country a vital aspect of its much talked about resilience to global turmoil.

It is, however, unrealistic to expect domestic demand to entirely offset a drop in demand from international markets in case of a slowdown in the West. The key determinant of India's ability to sustain its growth momentum would be how long the slump in international demand is likely to last. Would this be an opportunity to put in place mechanisms to improve long-term productivity in various sectors

Business incentives operate in such a way that input accumulation, capital formation and production have an obvious element of dependency on the general sense of exuberance in international markets and perception of unlimited demand. It would be interesting to examine what is likely to happen in a more cautious climate of demand. Would this be used to encourage innovation and productivity improvements Would this be used to establish foundations for longer-term growth through investments in human capital There will be obvious pressures for increased public expenditure.

It is premature to pass judgment on the likely impact of the huge stock market swings experienced last week not only here but also in other markets around the globe. Still, it is an opportunity to assess the implications of programmes that define directions of the economy through incentives. These are incentives set not only by government policies, but also by markets themselves.

In the public policy arena, two areas which have received much attention in the context of accelerating economic growth are infrastructure and agriculture. In the context of a slower global growth, initiatives for expansion of infrastructure are likely to be sustained. However, there are strong complementarities in the development of rural infrastructure and agriculture. It is reasonable to expect attention to be focused on the rejuvenation of the rural economy, where it is not so much international but domestic economy linkages that are critical for such a revival.

What are the private sector, or for that matter public sector enterprise, initiatives likely to be International market conditions would be more demanding in terms of prices, which would translate into a greater need for efficiency. While this in itself may increase the attractiveness of the domestic economy, the key test of the longer term impact of the private sector response would be the attention that is paid to productivity. Rural markets should begin to play their due role as sources of demand, which would also require improving production efficiency.

The author is senior research counsellor, NCAER. These are his personal views