It's the markets, stupid

Business Standard, 19 May 2004

When the NDA seemed to be coasting to victory, Nifty was at 1900. On Monday, Nifty closed at 1400. This was an astonishing loss of 26%, or over Rs.3 trillion of market capitalisation. The losses were sharpest with PSUs, including PSU banks.

There are some who think this the stock market is irrelevant. But it helps to think carefully about what we now face. The Congress manifesto itself betrays fairly bad economic policy. In addition, there are signs that a resurgent left may have an impact on economic policy.

After a difficult first year, the NDA had conquered their demons of the SJM and the RSS in terms of economic policy. Will Sonia be able to bring the left under heel, the way Vajpayee was able to silence his band? Will Sonia be able to match Vajpayee's economic policies? The markets think not.

However, even putting the problems of a soft-headed Congress and a rather over vocal left together, is it reasonable to think that the companies of India are now worth 26% less than they were two months ago, when the NDA was in charge? It does seem like an unusually large adjustment. The markets seem to have a lot of faith in the ability of the left to do damage.

Manmohan Singh once famously commented that he did not worry about the ups and downs of the market. The left has now tried to dismiss the markets as being irrelevant. This may have been okay fifteen years ago, when the markets were much smaller. Today, the equity market capitalisation is in the same league as total bank deposits, and the financial markets are the veritable commanding heights of the economy.

This drop in stock prices has real consequences. Two major channels of influence can be identified. The first is the "wealth effect". People in the country are Rs.3 trillion poorer. This will prompt them to spend less; to postpone buying things. This will have a contractionary effect on the economy.

The second is the impact on investment. The stock market is a forward looking forecaster of the economy, and directs flows of capital based on views about the future. Lower stock prices correspond to higher cost of capital. Less money will go into startups; fewer IPOs will happen; listed companies will invest less; less foreign capital will flow into the country.

India now has over twenty years of steadily accelerating growth, from 1979 onwards. It is not possible to now drop back to stagnant or dropping growth rates. In the street, there is now a revolution of rising expectations. If the Congress has any hope of winning the next elections, they have to deliver on higher economic growth; they need to get trend economic growth up from 6.3% to 7.3%. There could not have been a more unhappy beginning to their five years than the 26% drop in stock prices.

In addition, there is the problem of fiscal consolidation. It will be impossible to achieve FRBM targets with slower economic growth. If a Congress government gets average growth down from 6.3% to 5.3%, then India will surely not execute a serious fiscal consolidation, we will be in an explosive debt trap, and Sonia Gandhi will be remembered as the person who trashed India's economy.

In terms of political economy, the stock market crash has roused a powerful constituency in favour of economic reforms - the people who lost Rs.3 trillion. As with Maggie Thatcher's popular privatisations, the NDA had done well to disperse ownership of PSU shares into millions of households. These households have all suffered huge losses, and they blame the ignorant mouths of the left.

At the other end, think of the Ambani family. The Reliance group companies had a market capitalisation of roughly Rs.100,000 crore and the family owns perhaps half of this. The Ambani family has thus taken a hit of something like Rs.13,000 crore. Ouch!

This experience has been a powerful and salutary reminder to the Congress and the left about their populist rhetoric. As we know from looking at vote shares, their populism did not give them more votes. And as the stock market has powerfully warned, their populism will endanger growth if it is allowed to turn into economic policy. The Congress and the left must remember that they are no longer banking on a planned economy to deliver growth. They are depending on the markets and on incentives. And, therefore, they can no longer choose to ignore markets.

Bill Clinton faced similar challenges when he first came into power, with an ambitious reformist agenda in terms of many aspects of how government functions. But he was crystal clear about the importance of the bond market. Robert Rubin was brought in to reassure the markets, and "the bond market" was given veto powers on every major policy announcement. Clinton was very clear that he could not execute on his social agenda without first passing the test of the markets.

Sonia Gandhi now faces that very test. The market has served a timely warning: If she chooses the wrong FM, or if the Common Minimum Programme is a throwback to economics of the 1970s, then things will go very wrong in terms of economic growth.

To get five good years, and for Congress to get re-established as a party that delivers results, growth has to accelerate from 6.3% to 7.3%. Only if Sonia can get that package together, can she deliver the promise of growth with a human face.

To those who are unhappy about this stock market response, it will help to think about what things would have been like without the stock market. The markets have done well to serve notice. The market is pointing to a need to discipline the left.

It is unlikely that the Congress would have done many things differently, even without the influence of the left. For example, the sale of profit making PSUs was not in the Congress manifesto. Labour reforms were not on the anvil, even with the NDA. India is hardly going to get out of the WTO and implement QRs again. However, the rhetoric of the left is scaring the market. That rhetoric needs to be contained by Sonia Gandhi so that market expectations do not become a self-fulfilling prophecy.

What can Sonia Gandhi do to decisively gain confidence, and kickstart a constructive focus on the economy?

  1. Manmohan Singh should be quickly announced as the next FM.
  2. Twenty disinvestment/privatisation transactions, of atleast Rs.200 crore each, should be put through in the first month of the new government. There is plenty of opportunity, in GOI's vast holdings of various companies, to do deals that draw on West Bengal's privatisation strategy of "joint venture collaborations".
  3. The Ministry of Finance should get to work on policy, and release a stream of documents into the public, so that discussion and debate on those will replace speculation about what the left might do.

The author is at NCAER. These are her personal views.

Ila Patnaik

Ila Patnaik
ipatnaik at ncaer dot org