Soda, chilly powder and a buoyant equity market


In the mid-1970s, there was a ­Kerala restaurant in Delhi where you could eat as much as you wanted for only two rupees. It was a haven for impecunious bachelors like me. The economics of this restaurant worked, I later discovered, because they added soda to the rice and generous amounts of red chilly powder to the sambhar.

When you drank water to quench the flames of the sambhar, the soda in the rice made your stomach bloat and you didn’t eat very much after that. The demand-supply equilibrium was thus artificially achieved by soda and chilly powder.

TCA Srinivasa Raghavan
TCA Srinivasa Raghavan

I was reminded of this because a friend recently asked me to explain why the stock market is booming when the real economy, which produces actual goods and services, is not growing by very much.

My answer to her: the soda in the market is the availability of a very large number of scrips for trading and the chilly is the cash in the pockets of a very large number of big and small investors. The water is the relaxed trading norms which make it easy for everyone with a laptop to trade. No longer is trading restricted to the brokers; anyone with a mobile device and a demat account can do it. More money and more traders mean that the stock market is bloated beyond levels warranted by the real economy.

Lest you think this is odd, this disconnect is neither new nor confined to India. The same thing had happened in Europe too between 2001 and 2008. Real output was growing at just about two per cent while the turnover in the stock markets had almost tripled. When a deputy governor of the RBI pointed this out to the Europeans during a conference, they had no answer.

By the end of 2008, the stock market in Europe had collapsed because the easy credit from the banks and transfer payments to citizens by the government dried up. No money, no boom.

The FII dollars

This could happen in India too but at present the chances are remote because of the foreign institutional investors. For every rupee an Indian invests they can, and do, invest a hundred rupees. Also, they enjoy a tax advantage, at least until March 31, 2017, in that they don’t have to pay capital gains on short term trading profits. This to ensure that they keep on buying and selling and the market stays buoyant.

Another aspect of the FIIs is that in their own countries they earn very low net returns, less than one percent. So India, where the returns tend to be between 2 and 5 per cent, is a very attractive destination. This also ensures that they keep investing in India.

Then there is the vested interest that the government has in keeping to market fizzing because that is the only way the FIIs with their dollars will stay invested in the Indian market. With exports badly down, India is in dire need of these FII dollars.

That is why the LIC, which is the main instrument that the government employs to keep the market high, will keep buying whenever there is a downturn, as indeed there was after Brexit.

Thus, neither the number of traders nor liquidity is a problem. This means the market will stay up regardless of what is happening in the real sector.

Developed countries scenario

This does not happen in developed countries where large investors keep a close watch on the performance of the real sector. If it is doing badly, it means profits and dividends will be low. That depresses the demand for stocks and moves the money into debt.

This does not — or is not allowed to — happen in India and other ­emerging markets. That is why they are ­outperforming the markets in the developed countries.

Of course, other bad news — such as a massive defeat for the BJP in UP, Punjab, Gujarat and Goa, or riots, or war with someone like Pakistan or China — could take the fizz out of the market. But that too will not happen till 2017.

For both these reasons of capital gains taxation, and/or adverse electoral outcomes, 2017 is the year when the Indian market will come in sync with the real sector. Or, if the LIC is ordered to prop it up regardless of how much it costs, even that may not happen.

Net-net, the soda is having its effect and bloating the stomach for stocks, regardless of the appetite for them.

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