Sensex@50,000: How RBI played a part in creating the stock market bubble

Outside the Eco-Chamber

The BSE Sensex, India’s premier stock market index, has been hobbling around 50,000 points over the past few days. It has risen by a whopping 78% from around the end of March, when it had fallen to 27,591 points as Covid-19 hit India and a national lockdown was announced.

This astonishing rise has now got the Reserve Bank of India worried. RBI Governor Shaktikanta Das, in the foreword to the latest Financial Stability Report, points out: “The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India.”

People who run central banks don’t always talk in plain English. Das is only following tradition here. The statement basically refers to stock prices. Das feels they have risen too fast in the recent past and have become disconnected from the overall economy.

While the economy is expected to contract this year, the stock market has rallied 80%. How’s this possible?

Vivek Kaul

Theoretically, a possible explanation is that the stock market discounts the future, and the stock market investors think that the future of the Indian economy is bright. Another explanation offered by stock market investors is that corporate profits this year have been at levels never seen before.

But even after taking these reasons into account, the current level still cannot be justified. As Das put it in his foreword: “Stretched valuations of financial assets pose risks to financial stability.” One way to figure out whether valuations are indeed stretched is to look at the price-to-earnings (P/E) ratio of the stocks that constitute the Sensex index.

In January 2021, the P/E ratio has been at around 34. This means that investors are ready to pay Rs 34 as price for every rupee of earning of the stocks that make up the Sensex. Such a high P/E ratio has never been seen before. Not even in late 2007 and early 2008 when stock prices rallied big time, or in the first half of 2000 when the dotcom bubble was on.

Clearly, stock prices are in bubbly territory. The current jump in corporate earnings isn’t sustainable for the simple reason that corporates have pushed up earnings by cutting employee costs as well as raw material costs. This means that the incomes of everyone connected with corporates -- from employees to suppliers and contractors -- have fallen.

This fall in incomes has limited the ability of these individuals to spend money, which will lead to lower private consumption in the months to come, which, in turn, will impact corporate revenues and eventually profits. A sustainable increase in profits can only happen when people keep buying things and corporate revenues keep going up.

This brings us back to the question, why then are stock prices going up when the overall economy is not doing well. A part of the reason is the RBI, though the central bank glosses over this totally in the Financial Stability Report.

Since February 2020, the RBI has pumped in a massive amount of money into the financial system through various measures, some of which involve the printing of money. By flooding the financial system with money, or what central banks refer to as liquidity, the RBI has ensured that interest rates on bank deposits have fallen.

The idea here is three-fold. A drop in interest rates allows the government to borrow at lower interest rates. This became necessary because, thanks to the pandemic, the tax collections of the government have dropped this financial year. Between April and November 2020, the gross tax revenue stood at Rs 10.26 lakh crore, a drop of 12.6% in comparison to the same period in 2019.

Secondly, lower interest rates ensured that the interest cost of corporates on their outstanding loans came down. Also, the hope was that at lower interest rates, corporates would borrow and expand economic activity. Thirdly, at lower interest rates, the hope always is that people will borrow and spend more, and all these factors would lead to a faster economic recovery.

But there is a flip side to all this. A fall in interest rates on deposits has hurt the ordinary depositor, especially senior citizens, and sent people in search of a higher return. This has led to many individuals buying stocks, in the hope of a higher return, thus driving up stock prices to astonishingly high levels.

This can be gauged from the fact that in 2020, the number of demat accounts, which are necessary to buy and sell stocks, went up by nearly a fourth to 4.86 crore accounts. This also shows the rise of ‘Robinhood investing’ in India. The term comes from the American stock brokerage firm Robinhood, which offers free online trading in stocks. India has seen the rise of similar stock brokerages offering free trading.

What has added to all this is the fact that many individuals now out of jobs have turned to stock trading to make a quick buck. All it needs is a smartphone, a cheap internet connection and a low-cost brokerage account.

Of course, this search for a higher return isn’t local, it’s global. Hence, foreign institutional investors have invested a whopping $31.6 billion in Indian stocks during this financial year, the highest ever. This stems from the fact that like the RBI, central banks in the West have also printed a huge amount of money to drive down interest rates. This has pushed more and more investors into buying stocks despite the fact that the global economy isn’t doing well either.