What explains the apparent disconnect that exists between the financial sector and the real economy? Can that be explained in rational terms? The relationship between the financial economy and the real economy has been a fascinating subject in India and elsewhere.

Particularly topical now in the context of stock price movements, the divergence between the two sectors has been examined in great detail over a fairly long time by different categories of people, including stock market analysts, policy-makers and central banks.

The textbook belief

Unfortunately, there has been no consensus — on, for instance, whether the real economy leads or should the stock markets (the most visible component of the financial sector) or — as has been the case recently — the other way around. The textbook belief that the financial sector should mirror the real economy is not supported by any empirical evidence.

The divide between the financial sector and the real economy has widened recently. Many would argue that the rise of the financial services sector, as indeed many other services, is part of a global trend which has seen the eclipse of manufacturing in the developed countries. In India too, the services sector has bloomed and contributes to a larger share of the GDP than the industrial sector.

While the above could be elaborated, the key issue in India now is simply this. How does one explain the obvious disconnect between the stock markets and the economy? Are the current market valuations, with the major indices, the Sensex and the Nifty, at record, near time highs, justified? The macroe-conomic scene is not all that bright. Growth rates have slumped, and cannot be much more than 5.5 per cent for this year. In fact, recent CSO figures place growth at just 5 per cent. There is there the problem of twin deficits, the current account deficit (touching record unsustainable levels) and the fiscal deficit. Both feed on each other. The Finance Minister hopes to keep a check on the fiscal deficit this year, and bring it down drastically from the next year onwards. There have been feeble attempts at checking gold imports — a primary cause for the worsening trade balance — through higher tariffs.

Short-term measures

The government has adopted short-term measures to encourage capital flows. Non-residents are being given greater incentives to shift their funds to India. Some of these may not be to India’s long-term interests but are justified on grounds of expediency.

In any case, foreign funds have been flowing into India, and they have been principally responsible for the stock surge. The timing for such flows is about right in mid-September, 2012, when the U.S. Federal Reserve announced another round of quantitative easing. Earlier, the European Central Bank announced measures to stabilise the euro. Both these have resulted in plenty of easy, inexpensive money which has taken a fancy for the riskier assets, including those in India. The surge late last year took inflows to $25 billion in 2012.

They have continued to flow in 2013. The government has helped in the surge. In September last, it announced a raft of measures to shore up investor confidence and expedite implementation of delayed projects. The diesel price hike, to check subsidies, will not be the last of such measures.

‘Prudent’ budget

More recently, senior ministers have been wooing foreign investors in Hong Kong, Singapore, Frankfurt and London. There is a promise of a ‘prudent’ budget, meaning less populism and more fiscal discipline.

All the above and more are meant to keep foreign funds flowing. That alone explains the puffed up valuations. The question is whether the stock prices will remain elevated if the not-so-good news is taken into account as they should be.

There cannot be ‘a please all’ or an entirely painless budget. Nor will GDP growth rates move up spectacularly. The XII Plan assumes an average growth rate of 8 per cent for each of the five years, beginning fiscal 2012-13.

It is not as though India is the only place where stock markets are reflecting an optimism, which is not grounded on facts. The U.S. economy has suffered a contraction in the fourth quarter, the first since 2009. The U.K. and the eurozone economies seem to be heading towards another recession. In Japan, the authorities are pushing down the yen in a move akin to devaluing the currency. Yet, in all these countries stock markets have been flourishing.

The only convincing answer is that decision-makers are willing to look beyond the immediate gloom, and, remarkable as it may seem, sense a recovery. In the U.S., additionally, the fact that the two political parties are today more inclined to consensus than at any time before in the recent past is a positive factor.

Whether a similar explanation holds good for India is not certain. Some analysts say that the big stock market rally is a harbinger of an economic rebound. While that would be good news for the government, anyone conditioned by stock market volatility cannot be too sure.


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