Nitin Desai: The real economy is the issue

Asset price bubbles should become the object of monetary policy only when they distort borrowing, lending and spending decisions.

On Wednesday the stock market suffered a big scare. The provocation came from a Sebi proposal on participatory notes, designed partly to moderate foreign inflows and partly to address some KYC concerns. The primary macro concern of the finance ministry seems to have been the rise in the rupee, which is hurting exports. But there is a subtext "" the sense that the boom that saw the Sensex soaring from 14,000 to 19,000 in two months was an asset price bubble that needed to be pricked. Should macro policies be shaped by authorities trying to influence asset price bubbles?

Asset price booms and busts are endemic in a market economy and typically occur in equity and urban real estate markets. Right now, the two booms are getting linked as real estate companies go public and are valued by promoters and investment bankers on the basis of these high property prices.

Asset price bubbles are very difficult to spot ex-ante. The phenomenal growth in corporate earnings since 2003 would justify the medium-term trend increase in the Sensex. But does this apply to the most recent equity boom? Market analysts attribute the recent spurt to the large FII inflow. Can one assume that these FIIs are rational and are buying because they see future earnings justifying the rising prices of Indian stocks? Or is there an "irrational exuberance", an unwillingness to be left out of the party? Are they short-term players who are hoping to make a quick profit taking advantage of other people's foolishness? The bottom line is that asset price increases that are not justified by underlying fundamentals will sooner or later be corrected.

Real estate bubbles are inherently more slow-moving. Property prices do not go up 5 per cent in a day, which one sees sometimes in equity markets. Yet an increase in property prices that is much larger than the underlying increases in disposable income has the characteristics of a bubble. Unfortunately, the bubble is often the product of a severe regulatory failure that generates monopoly rents in the hands of those who have commandeered urban land. But even with real estate, corrections are possible as we saw in the latter half of the nineties.

Does the wealth effect of rising property and shareholding values affect spending? They can if the holders of these assets can encash the increase. But this is not always possible. Real estate is not easily fungible, particularly in India, where the property markets operate in an opaque and often underhand fashion. Even rising share values may be caught in long-term saving schemes and pension funds, where the increase in value does not translate into any immediate increase in spendable cash in the hands of the beneficiaries.

The effects on spending may work through what has been called the balance sheet effect. The increase in the net worth of firms and households may persuade lenders to lend more and thus boost spending power. This may have happened in the US as house owners encashed their capital gains through additional borrowings against their equity. But capital markets in India have more friction and it is unlikely that anybody continuing to live in a house that has increased in value has been able to encash the gain in any substantial way. Stock holdings are more fungible. But the chances are that Indian equity holders who encashed their gains reinvested these rather than splurging on consumption. Borrowing against stock holdings is easier and may have happened.

Should the RBI worry about asset prices? The primary goal of the RBI is to operate a monetary policy that keeps inflation within acceptable bounds. In addition it has a regulatory and supervisory function over the banking system. The RBI also operates as the manager of foreign exchange reserves and of the government's borrowing programme. Which of these functions needs to take into account asset price booms and busts?

Monetary policy, whether it operates through interest rates or monetary targeting, must be based on economic fundamentals. The benchmark here is the general price index, however defined. A boom or a bust in a specific asset market should not lead to contractionary or expansionary moves by the central banker, if the inflationary trends in the general economy do not justify them. Asset prices matter if they are a signal of emerging inflationary pressures, but not otherwise.

The regulatory function vis-à-vis banks and financial intermediaries may require the RBI to intervene through tighter controls on lending against assets where a speculative boom is under way. But this is more like a selective credit control than a macro-economic move. And will it also operate in reverse gear when there is "irrational pessimism" and an asset price bust is under way?

The role of the RBI in exchange rate management poses a particular challenge if, as may be the case at present, the boom in asset prices has been provoked by large inflows from abroad. Exchange rate protection during periods when an asset-price boom or bust is under way requires perverse movements in interest rates. If a boom is under way, interest rates need to be raised; but that may increase the inflow. Conversely when asset prices are declining because foreign investors are withdrawing, the increase in interest rates required to protect the exchange rate will worsen deflationary pressures.

The management of the governments' borrowing programme is least affected by booms and busts in equity or property markets. It can be, if the central bank uses interest rate policy to stabilise specific asset markets. But if, as argued above, interest rate policy should always be based on underlying fundamentals, this will not be the case.

A monetary policy that sets interest rates to manage booms or busts in asset prices that are considered unacceptable can be seriously destabilising. Hence the RBI should worry about asset prices only if they affect the real economy and distort borrowing, lending and spending decisions of firms and households. Of course Sebi has the responsibility for investor protection and orderly stock market development and sometimes what it does can have macro effects that the RBI and finance ministry cannot ignore. But the way to handle this is through emollient words rather than any expansionary or contractionary moves.

nitin-desai@hotmail.com