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Home  » Business » Aftereffects of stock market crash

Aftereffects of stock market crash

By T N Ninan
June 17, 2006 14:04 IST
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The key question to be asked is what effect the gyrations on the stock market will have on the real economy. Will the sharp drop in share prices mean that the real economy too will slow down? That is easy, and the answer is "Yes".

The tricky part is figuring out by how much. To take the macro picture first, a net outflow of portfolio investment means that the dollar inflow, which helped pay for the large deficit on trade in goods and services (more than $20 billion a year), is no longer there.

This puts pressure on the rupee, as the deficit has to be paid for. As rupees get sucked out of the system to buy the dollars, money supply tightens, and its price (interest rates) goes up. That is usually a signal for a general economic slowdown, as people borrow less for spending and investment. This is elementary. So it is no surprise that the Reserve Bank has already raised interest rates, even as the rupee has dipped. A lower rupee means costlier imports (of items like oil), and benefit for exporting firms like Infosys. Expect therefore a shift in favour of exporting sectors.

The numbers tell us that investors are poorer by about Rs 10 lakh crore (or a quarter of GDP!). But that means little. The vast majority of Indian stocks are held by foreign institutional investors, company promoters and by domestic institutions and mutual funds-most of which will either not sell (because they are long-term players, so temporary value fluctuations are treated as notional), or whose losses do not directly impact the domestic economy.

Also, the losses relate to the peak of the stock market index a month ago; investors are no poorer today than they were a few months ago when the Sensex first crossed 10,000-and no investor then felt he was doing badly.

 Sensex Rise and Fall: Complete Coverage

Still, the psychology of investing suggests that people (especially late-comers to the party) will benchmark against the peak, so the virus of a negative wealth effect will certainly spread through the system.

One impact is on other asset prices, like real estate. This may be a good thing, as prices had climbed far too rapidly over the past couple of years and many people were getting priced out-which is not good for real estate activity. If prices now become more reasonable, and more people offload empty housing stock because it no longer makes sense to hold it as investment, the net impact might well be positive (though house-owners will feel the negative wealth effect).

More important than all this is the change in expectations, which plays a vital part in the business cycle of boom and bust. The psychology of the bull run has been broken. People don't expect to be able to make easy money any more. Companies will watch sales graphs nervously, especially when it comes to non-essentials or impulse purchases (that extra shirt or pair of shoes can wait a while).  Pay hikes will be more measured, and people will want to hold on to cash just that little bit more than before.

Companies that were planning to borrow money in order to invest in new capacity will check the risk factors again: How much might interest rates climb? And what if demand falls short? And of course, there will be fewer share issues because today's prices in an uncertain market are not such an attractive sell-and the investment that would have been fuelled by the IPOs will consequently be delayed.

Higher interest rates, costlier imports, lower asset prices, fewer IPOs, less borrowing, uncertain demand-all of that signals a slowdown. For a fundamentally healthy economy, a year of 7 per cent growth (as opposed to 8 per cent) will not mean such a lot. But at the micro-level, the impact will be felt more forcefully. And the way these things work, slower corporate growth will impact profit projections, and in turn make current valuations look stretched. My net take: the ground has just shifted under our feet.
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T N Ninan
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