Fixing the financial sector-economy disconnect

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 Fixing the financial sector-economy disconnect

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• The disconnect: Economy looks set to experience a huge contraction but stocks have kept afloat. When the pandemic struck the market was at 40,000, in late-March it was less than 26,000 and now it’s again approaching the 40000 mark. Current stock-price valuations indicate expectations of an unusual rise in sales and profits. This seems highly improbable. 
• The repercussions: Economy and market have had to be looked at in isolation before as well, but significant climb in the middle of a recession is worrying. The impact of a collapse will be felt in several other sectors in many ways. For instance, it can cause currency depreciation and affect the balance sheets of companies that have borrowed abroad. Many other possibilities including investors turning bankrupt exist.
• Intervention is required: We cannot afford to wait for self-correction. However, the government has its fiscal situation to deal with. RBI, so far, has only purchased volumes of foreign currency assets as insurance against a sudden change in foreign investment. 
• Probable cause: As RBI has also pointed out, a plausible explanation for the disconnect could be liquidity injection in developed countries some of which got invested in the Indian stock market. Such speculative investment can affect Indian financial sector and economy enormously, and must be reduced drastically. 
• Sensex and net cumulative foreign institutional investor (FII) inflow: Rise in FII investment between August 2019 and March 2020 kept the Sensex high even as the economy deteriorated. During the outbreak FII investment declined and so did the sensex but with liquidity injection the fall in sensex reversed. 
• FII investment in debt and equity: Liquidity injection did not cause a reversal in investment in debt instruments. Cumulative outflow of FII investment in debt instruments increased since debt investment is risky when probability of default is high during recessions. Cumulative outflow of FII investment in equity did not decrease since in a market driven by expectations of revival, rising stock prices tend to real-ize the expectations.
• Cumulative FII inflows in emerging Asian markets: Cumulative FII inflows for Thailand, Malaysia, and Indonesia were negative for the year ending August 2021 but were positive for India and have increased further recently. A reason for this is that government has not discouraged speculative inflows. In September 2019 when the economy was declining, India had announced a reduction in corporate tax rates. Expectations of more such concessions drove the disconnect between economy and market when liquidity was injected in markets. 
• Stock markets in emerging Asian countries: Indian stock market performed better than the rest before the pandemic, fell as sharply as in other markets when Covid happened, but revived and performed better than Thai and Malaysian markets. 
• Summary: Indian market trends differ from other markets and the reasons are not purely external, as stated by RBI. RBI governor has stated the bank will ensure stability when a correction happens. But RBI should not avoid taking action, it must take steps to control speculative FII inflows.

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