The belief that financial markets, especially the stock markets, mirror the real economy has very rarely been supported by empirical evidence in India. Even so, influential sections, including policymakers, tend to view the markets as a barometer for testing or gauging the efficacy of specific policies. The issue is highly topical, with the Union budget due for presentation next week. Budgets have become the most important economic statements of the government, with recent ones evolving far beyond their traditional roles of being mere reports on government finances. Over the years, finance ministers have used the budget process to make important economic announcements, including reform measures, often even those that have tenuous connection with government finances of the day. In the run up to the Union budget, the behaviour of the stock markets is closely watched for what investors expect from the government. It is much less certain as to whether those expectations are realistic, given the political and economic constraints that the Finance Minister has. At the present juncture there is a significant disconnect between the stock markets and economic fundamentals. Major equity indices have risen by 11.5 per cent since August, taking the benchmark stock indices to near record levels. At the same time, most economic indicators are down. Food production for the year is expected to be lower. Consumer price inflation remains in double digits. Economic growth during the year is projected to be at around 5 per cent. Not for the first time, the Indian economy is beset by the phenomenon of economic fundamentals and sentiment moving in different directions.
That should, in the normal course, be a good enough reason to pay less attention to stock market concerns. After all, even if the disconnect were to be less pronounced than now, the fact that equity investors are but a small part of those who invest in financial savings instruments should point to the fallacy of exaggerating the markets’ role in influencing policies. Yet, given the worsening current account deficit and the large dependence on short-term flows from foreign institutional investors, the government is forced to take note of market sentiment. In 2012, foreign inflows amounted to $25 billion and continue to be the principal factor behind the high stock indices. The economy’s long-term interests are better served by encouraging sustainable and more stable flows, such as from foreign direct investors and higher exports. It is unfortunate that in the recent past, the government has chosen expediency over considered economic policy making in attracting these short-term flows even at the risk of weakening macroeconomic stability.