From UPSC perspective, the following things are important :
Prelims level : FPI and FDI
Mains level : Paper 3- Equity market bubble
Even as the real economy returns to the doldrums after being hit by the second wave of COVID-19 infections, the continuing bull run in India’s equity market in the April-June quarter has baffled many observers.
V-shaped recovery of equity market
- The benchmark BSE Sensex had nosedived to below 28,000 in March-April 2020, following the nationwide lockdown.
- The equity market posted a sharp V-shaped recovery in 2020-21.
- The Sensex surged beyond 50,000 in February 2021 and is currently closing on the 53,000 level.
Factors suggesting bubble in equity market
- There was an 81%-plus growth in the Sensex between April 2020 and March 2021 in the backdrop of real GDP growth plummeting to -7.3% during the same period.
- While output contraction had reversed from the third quarter of 2020-21, the inflation rate also rose and remained way ahead of the real GDP growth rate in the last two quarters (Chart 1).
- It is difficult to find any rationality behind the skyrocketing BSE Sensex in the context of such stagflation in the real economy.
- Just like the fall in the equity prices was driven by the exit of foreign portfolio investors (FPI), the return of massive FPI inflows has driven the Indian equity bubble since then (Chart 2).
- Net FPI inflows clocked an unprecedented ₹2.74 lakh crore in 2020-21, the previous high being ₹1.4 lakh crore in 2012-13.
- The Reserve Bank of India (RBI)’s annual report (2020-21) to state stated that: “This order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble.”
- The global liquidity glut, following the expansionary, easy money policies adopted by the fiscal and monetary authorities of the OECD and G20 countries, has led to equity price inflation in several markets driven by FPIs, especially in Asia.
- Following cues from the U.S. and the U.K., Asian equity markets in Singapore, India, Thailand, Malaysia and Hong Kong are currently witnessing price-earnings (P/E) ratios significantly above their historic means.
- The BSE Sensex’s P/E ratio of 32 in end-June 2021 is way above its historic mean of around 20.
What could burst the bubble?
- Change in monetary policy: With COVID-19 vaccination and economic recovery proceeding apace in the U.S., the U.K. and Europe, fiscal and monetary policy stances will change soon.
- Exit of FPIs: Once the U.S. Federal Reserve and other central banks start raising interest rates, the direction of FPI flows will invariably change bringing about corrections in equity markets across Asia.
- India remains particularly vulnerable to a major correction in the equity market because of two reasons.
- Low pace of vaccination: The pace of COVID-19 vaccination in India, given the vast population, lags behind most large countries.
- In the absence of a substantial increase in the vaccination budget and procurement, large segments of the Indian population will remain vulnerable to a potential third wave of COVID-19, with its attendant deleterious impact on the real economy.
- Weak fiscal stimulus: India’s economic recovery from the recession will remain constrained by the weak fiscal stimulus that has been delivered by the Central government.
- Data from the IMF clearly show that while the total global stimulus consisted of additional public spending or revenue foregone measures amounting to 7.4% of global GDP, India’s fiscal measures amounted to 3.3% of GDP only.
Consider the question “What are the factors driving equity market boom globally? What are the factors that could threaten such boom with a major correction?”
With all agencies, including the RBI, downsizing India’s growth projections for 2021-22, it remains to be seen how long India’s equity bubble lasts.
Back2Basics: P/E ratio
- The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).
- The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
- To determine the P/E value, one simply must divide the current stock price by the earnings per share (EPS).
P/E Ratio=Earnings per share / Market value per share