The following is from Vivek Paul's Diary.
With the stock market flirting with the 30,000 level and the proverbial question has popped up again: "If the stock market is doing well, why are you writing negative things on the economy?" a few readers have asked.
In this Edition of the Diary, I answer the proverbial question and in the process show that the link between the state of the economy and the stock market is very weak. At least that is the way it is, these days.
This piece first appeared in the Vivek Kaul Letter on April 7, 2017.
Note: The headline/title for today's piece is borrowed from an Urdu couplet written by the poet Faiz Ahmed Faiz. He once said: "aur bhī dukh haiñ zamāne meñ mohabbat ke sivā," which when loosely translated into English basically means that there are other sorrows in life than being in love.
As I write this, the Sensex is flirting with the 30,000 level and the proverbial question has popped up again: "If the stock market is doing well, why are you writing such negative things on the economy?" a few readers have asked.
I guess it is a fair question coming from stock market investors who do not understand the difference between the stock market and the economy.
There are basically two questions that need to be answered in order to answer the above question. First, is the stock market "really" doing well? Or rather more specifically, has the stock market done well over the last few years, given that any measure of performance is always backdated.
The second, and the more important question is, whether, the stock market is a reflection of the state of the economy.
Let's look at Sensex returns first. Between January 8, 2008, and April 5, 2017, the Sensex has given an absolute return of around 43.6 per cent. This works out to a return of 4 per cent per year (3.98 per cent to be very precise). Of course, this does not take into account the dividend yield of the stocks that constitute the Sensex. You can add a percentage or two more for that, it won't make a material difference to the point I am trying to make.
Even after adding the dividend yield, the Sensex returns have been minuscule since 2008. Again, you might come around to tell me that the Sensex was unusually flared up in January 2008. Yes, it was. But it's only fair to compare a peak to a peak, which is precisely what I am doing here.
Of course, this does not mean in any way that investors have not made money from the stock market in the last ten years.
I am sure they have. But that doesn't mean that the stock market has done well. They are two very different things. It is important to understand this crucial difference.
Now let's get into the second point, whether the stock market is a reflection of the state of the economy. A few years back, I asked Professor Aswath Damodaran, a professor at the Stern School of Business, New York University, and a globally respected expert on equity valuation, how strong is the link between economic growth and stock markets? And this is what he had to say: "It's getting weaker and weaker every year."
A major reason for this lies in the fact that in the aftermath of the financial crisis that broke out in September 2008, there is a lot of easy money floating around all over the world. This money keeps finding its way into stock markets and bond markets all over the world. Take the case of India, the Sensex has rallied by 8.4 per cent since the end of January 2017.
This rally has primarily been because of the foreign institutional investors investing more than Rs 40,000 crore in Indian stocks, since the beginning of February 2017. During the same period, the domestic institutional investors have sold stocks worth more than Rs 3,600 crore.
There has been no fundamental change in the Indian economy over the last two months. At least, the domestic institutional investors seem to think so and have sold stocks on the whole. But the foreign money has still come in, largely in expectation of the Bhartiya Janata Party winning the state assembly elections in Uttar Pradesh and it has continued to come in since the win. The hope is that after winning Uttar Pradesh, the Party might finally push some economic reforms through the Indian Parliament.
Let's take a look at a few recent events to establish how weak the link between the stock market and the economy is. Every month around one million young Indians enter the workforce. So, what India badly needs are jobs and these jobs need to be low-end jobs which can employ the largely unskilled Indian workforce.
One reason for India's largely unskilled workforce lies in the fact that the Indian education system has never had a vocational focus. Over and above this, the learning outcomes of even those who have gone to school have been hopeless and have fallen over the years.
Madhav Chavan, of the Pratham Education Foundation estimates that in the period of the ten years up to 2015, 10 crore children completed primary school without the ability to do some basic reading and mathematics. Given this, what we produce is a largely unskilled workforce, and that is hardly surprising.
A recent report titled OECD Economic Surveys India puts the rate of unemployment among India's youth between the ages of 15 and 29 at more than 30 per cent. These youth are neither employed nor in education or training. Indeed, this is a very worrying factor for the Indian economy. Of course, the official rate of unemployment is at a very low 5 per cent. But as I had explained in a Letter in October 2016, this number cannot be taken seriously. There is an inherent flaw with the way it is calculated.
The larger point here is that the way things are currently going on, India's much talked about demographic dividend is likely to turn into a demographic disaster. The stock market isn't bothered about this. What it is bothered about, at least in the long-term, are the earnings of the companies listed in the stock market, and pretty much nothing else.
In fact, instead of creating jobs we are busy destroying them. Take the recent case of the Supreme Court banning liquor sales within 500 metres of national and state highways. I am not getting into the right or the wrong of it, but this decision is bound to have some impact on the economy.
An editorial in The Hindu Business Line points out that the ban is expected to hurt some 35,000 restaurants. Estimates suggest that state governments could lose Rs 50,000 crore in overall tax revenues. Of course, many jobs would be lost as well. The Hindu Business Line estimates that around 15 lakh jobs will be lost. Assuming, an average family size of five, this means that 75 lakh people will be affected directly by this decision.
These jobs are a part of India's informal sector. It doesn't take much skill to work at a booze shop on a highway. All you need to do is serve the brand of alcohol being asked for, open the bottle, pour the liquor into the glass/mug if asked for and then be able to collect money from those who have been served. Such jobs work well for India's largely unskilled workforce, which is going to be impacted with this Supreme Court decision.
Having said that, this Supreme Court decision has barely had any impact on the stock market, other than pushing down the stock prices of a few liquor stocks. Along similar lines, the many jobs lost during the first few months of demonetisation barely had any impact on the stock market.
A major reason for the disconnect between the Indian economy and the stock market lies in the fact that India has a large informal economy. Before we get into anything else it is important to define the meaning of the term "informal economy". Here is a basic definition. It is that part of the economy which is not really monitored by the government and hence, it is not taxed.
As economist Jim Walker of Asianomics wrote in a research note: "There is nothing intrinsic that says that the informal economy is a less effective or beneficial source of activity than the formal economy."
A major reason many Indian businesses operate in the informal sector is because going formal will make them totally unviable having to follow way too many rules and regulations that govern businesses in India.
The National Manufacturing Policy of 2011 estimates that, on an average, a manufacturing unit needs to comply with nearly 70 laws and regulations. At the same time, these units sometimes need to file as many as 100 returns a year. Further, India has 150 state level-labour laws and 44 central-level labour laws, making things extremely complicated for any firm which wants to operate in a legitimate way.
So, the government in that sense is largely responsible for the informal sector operating at such a huge level in India. Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital wrote in a recent research note: "India's informal sector is large and labour-intensive. The informal sector accounts for ~40% of India's GDP and employs close to ~75% of the Indian labour force."
Hence, the informal sector creates most of the jobs in India. As the Economic Survey of 2015-2016 points out: "The informal sector should... be credited with creating jobs and keeping unemployment low." What this tells us is that the government before cracking down on the informal sector should keep the basic fact that it employs millions of people, into account. Also, efforts should be made to ease the rules and regulations to an extent which allows these enterprises working in the informal sector to gradually become a part of the formal sector.
As mentioned earlier, the informal sector forms a significant portion of India's economy and employs three fourths of India's workforce. There are other estimates which say that the informal sector employs more than 75 per cent of India's workforce. As I write in my new book India's Big Government-The Informal State and How It is Hurting Us: "Almost 92 per cent of the workforce works in the informal sector, with a large proportion of them having low earnings and almost no social security. This basically means that only around 8 per cent of the workforce has regular full-time jobs and access to some sort of a social security system. Even within this bracket, upper caste Hindus and other minorities like Christians, Jains and Sikhs have a disproportionate share of good jobs, given their higher educational attainments."
Hence, any impact on the sector has an impact on the overall economy. But the same cannot be said about the stock market, except the price of Fast Moving Consumer Goods stocks, which sometimes do get impacted because lower earnings in the informal sector has an impact on the earnings of the companies that operate in this sector.
Now take the case of the decision of the Uttar Pradesh government to stop "illegal" slaughterhouses from operating in Uttar Pradesh. As a report in The Hindustan Times points out: "In economic terms, UP accounts for nearly 50% of India's total meat exports, a huge industry that provides livelihood to 25 lakh people, directly or indirectly... Of the 72 government-approved abattoirs across the country, 38 are in Uttar Pradesh."
This move will have a considerable impact on the economy of Uttar Pradesh. The report in The Hindustan Times quotes the All India Meat and Livestock Exporters' Association as saying that Indian meat exports are at Rs 27,000 crore, of which Rs 15,000 crore comes from Uttar Pradesh. Of course, this move barely had any impact on the stock market, given that slaughterhouses are not listed. But you cannot take away the fact that the sector provides jobs to many people.
While, the Uttar Pradesh government may have ignored the fact that the slaughterhouses, many of them informal, provide jobs to many people, the Allahabad High Court has taken note of this fact. "To provide an immediate check on unlawful activity should be simultaneous with facilitating the carrying of lawful activity, particularly that relating to food, food habits and vending thereof that is undisputedly connected with the right to life and livelihood," the Lucknow Bench of the Allahabad High Court said on April 3, 2017.
The point I was trying to make in today's Letter is that the Indian stock market is not a reflection of the Indian economy.
And this is primarily because of India's informal businesses and informal labour force.
There are occasions when the stock market and the economy go against each other. Take the case of public sector banks. Between 2009 and now, the government has pumped more than Rs 1,30,000 crore to keep these banks going. Every time the government decides to pump more money into these banks, the stock prices of these banks rally. But the decision does not work well for the overall economy given that money pumped into these banks is money taken away from other areas like education, health, infrastructure etc.
At the same time, every time the government pumps money into these banks, it effectively tells the people who run these banks that come what may the government will keep rescuing these banks. And that again is not a healthy incentive to promote either for the bank or for the economy.
Also, it is important to point out here that investing in the stock market forms a very meagre part of the household financial savings in India. Shares and debentures formed a minuscule of 1.65 per cent of the total household financial savings in India. Within shares and debentures, mutual funds accounted for 0.93 per cent of the total household financial savings. Hence, direct investment in the stocks by individuals in India is less than one per cent of household financial savings. It's probably around 0.5-0.6 per cent.
Of course, mutual funds also invest in stocks. Over and above this, the life insurance companies formed 21.18 per cent of the total household financial savings. Life insurance companies also invest a part of the premium collected in stocks. But an estimate for that is not available. Also, in most cases, people who buy equity-oriented life insurance plans, have themselves got no idea that their money is going to be invested in stocks. All in all, a very small portion of India's household financial savings make it to the stock market.
To conclude, as the famous poet Faiz Ahmed Faiz once said: "aur bhī dukh haiñ zamāne meñ mohabbat ke sivā," which when loosely translated basically means that there are other sorrows in life than being in love. I guess in the Indian context we can safely say: "aur bhī dukh haiñ zamāne meñ stock market ke sivā."