Reforms, economy and stock market

Economic reforms are useful for boosting the growth rate of gross domestic product and for economic welfare. That is what reforms are for. Now, it has been seen time and again that they affect stock prices too. But do they also positively affect long-term fundamental values of stocks? If no, then there can be considerable pain for investors as prices eventually revert to values. It is important to understand the whole issue.

There can be two types of economic reforms. The first type of reforms includes the initial setting up, and then the subsequent meaningful strengthening, of a regulatory body like the Securities Exchange Board of India. There are other such reforms, which can all indeed increase the long-term real returns that the corporate sector can credibly pledge to the shareholders. These reforms can obviously raise stock values. Let us call these reforms for credible returns. 

The second type of reforms ease barriers to entry in a business, increase competition and creative destruction, and possibly make the natural monopolies contestable at some stage. These reforms can create profits for new businesses. However, such reforms can reduce, and not increase, fundamental values of stocks of the existing businesses in the aggregate. Since most stock portfolios include stocks of existing companies, this is a case of negative effect of reforms for shareholders.

What about stocks of new businesses? Of course, the founders, the angel investors, etc, who are involved in what turn out to be the success stories, benefit considerably. But given the price, on an average, at which they eventually get listed on the stock exchange, much, if not all, of the cream in the milk disappears for the new shareholders. So, again, there is really not much for ordinary shareholders as a consequence of reforms here. 

Consider an example. If the remnants of the Licence-permit-quota Raj — and there are several of these in one form or another even now — are abolished, then it can pave the way for new businesses. The economy can benefit but the existing businesses can do relatively worse. So, there is a possible negative effect for their shareholders. For lack of a better term, let us call these reforms for economic progress (and not reforms for progress of stock values).  

So, while reforms for credible returns increase stock values, reforms for economic progress can even decrease stock values. Overall then we have, at best, a limited positive effect of reforms on stock values. This is contrary to the usual opinion which is based on a misunderstanding, and not on sentiment here. The role of sentiment is sometimes exaggerated in the stock market.

It is interesting that investors in the stock market are often not overly concerned with reforms for credible returns. But the prices are positively affected when there are reforms for economic progress. Sometimes, there is even “double counting” — prices rise in response to signals of a reform and then again in response to realisation of a reform. All this is very ironic, given the reality.

In all this, where does the recent production-linked incentives (PLI) scheme stand? This is indeed useful for the corporate sector. However, there is a larger concern. Even leaving aside the issues of incentive versus subsidy, competition versus oligopoly, and rules versus discretion, the PLI scheme needs to be financed by taxes. The much higher oil tax and the additional inflation tax in the last two years come to mind. All this hurts the economy. So, it is not clear if we have an unambiguous reform in the first place. It is true that the positive effect on not just the stock prices but also the stock values is hardly ambiguous but that can be related more to the support from the government than to the role of, what may or may not be, a reform. 

Let us compare the PLI scheme with the abolition of the remnants of the Licence Raj. The former involves additional taxes while in the latter case, we can have an improvement in the economy without any kind of additional tax burden, let alone an additional tax burden on the common person and that too in the midst of the Covid-19 crisis. This is not to say that the government is not dealing with unnecessary controls and excessive regulations in the economy in one way or another but “ye dil maange more”. Such reforms are useful for the economy. But even so the benefits for the stock values here are, as seen already, actually limited, if they are positive at all. 

Needless to say, the point here is not to discourage investment in the stock market; it is just to present a realistic perspective.

The writer is visiting faculty at the Indian Statistical Institute, Delhi Centre