Abheek Barua: A car buyer's tale of woe

Macro-policy makers should recognise the importance of the stock market

I am now the proud owner of a reasonably snazzy new car. But the process of buying it has been harrowing, to say the least. For one, it involved a long and uncertain wait.

In between, I was asked to upgrade to a more expensive variant of the model since the cheaper model was out of stock and then told that since there was just one colour (not the one I had chosen) in ready supply for the next few weeks, I should stop being picky. To cut a longish story short, there was no end to my woes.

Finally, after many phone calls, endless name-dropping and threats, I managed to lay my hands on the vehicle. My case is not an exception. My colleague who booked a car pretty much at the same time has apparently faced worse harassment.

This might seem like a throwback to the good old days of Soviet-style planning. However if one looks at the automobile market data even cursorily, it is not difficult to see why such a situation has come to pass.

Car sales in January and February this year clocked a growth of 48 per cent, up from an average of 27 per cent in the period from April to December 2003. February was a scorcher of a month with growth of 73 per cent. The growth was spread across segments, compact, mid-size and luxury and only the mini segment lagged behind a trifle.

Clearly, manufacturers had not anticipated this kind of a spurt in demand and ran into huge problems trying to match it with supply. The result was, in some instances, a complete breakdown of the inventory and supply chain.

I have a feeling that this phenomenon in the car market holds important lessons for Indian economy watchers. For one, it underscores the growing importance of the "wealth effect" (the impact of rising asset values) on consumption in the Indian economy.

If you try to explain the spurt in car sales in January and February, the only thing that you can really attribute it to would be the spectacular rally in the Indian stock-markets in November and December which led to a quick and sharp appreciation in investor portfolios.

There is no other variable that could be remotely related to car demand that changed significantly in the period. Factors such as falling interest rates and improved corporate performance had been around for a while.

The sales spurt also suggests that stock holdings among the Indian middle classes are fairly widely distributed either directly or through mutual funds. If share-holdings were concentrated in just a few individuals and households, the rise in car demand would have been far more muted and confined just to the higher-end of the price spectrum.

Instead, the rise in car demand was spread across segments and hence the underlying increase in wealth is likely to be widely dispersed as well.

There is another hypothesis that I would like to float here. A study done in the mid-1990s by US economists James Poterba and Andrew Samwick for the Brookings Institution found that that for the US, a household's marginal propensity to spend out of gains in indirect stock market wealth such as mutual funds is significantly lower than that of households that have direct investments in the stock-market.

If this also holds for India then given the apparent size of the wealth effect in the car market, I would argue that households have a fair share of direct holdings of equity.

What are the implications of this? The role of the stock market in India, despite its ability to make the front pages of pink papers, still perceived to be somewhat peripheral particularly in policy circles.

Its importance is often limited to its ability to support disinvestment efforts of the government and to help firms raise cash. I would argue that given the apparently large ownership of equities, variations in the markets are now perhaps more important from the demand perspective and hence have to form a critical element of any macroeconomic management policy.

Sharp movements in equity prices can thus have a tangible effect on sales of consumer goods (automobiles in this case) and actually either propel a business cycle forward or harness it depending on the direction of movement.

A measure that should capture the rising importance of the stock market to consumer demand is the ratio of market-capitalisation (the sum of the values of all shares put together) to GDP. It gives you the fraction of GDP that all the stock-market wealth put together can buy. From a measly 3 per cent in the early 1980s it has risen to an average of a little over 30 per cent over the last five years.

This ratio can also vary quite sharply over the short term, setting off cycles in demand in the process. According to institutional stockbroker, Morgan Stanley's estimates, the market cap to GDP value went up from an average of 26 per cent in 2002 to 48 per cent in 2003.

If you do a thought experiment and imagine a representative consumer who owns all the stocks in the Indian market, you will, perhaps, appreciate the intuition of the wealth effect. Between 2002 and 2003, he discovered that with his basket of stocks he could buy 18 per cent more of the national product. That seems to be reason enough to go on a spending binge, doesn't it?

Clearly, the growing importance of the wealth effect makes life a little more difficult for manufacturers. Particularly those who produce stuff like consumer durables that are most susceptible to the wealth effect.

Unfortunately, the wealth effect works very quickly and leaves little time to adjust production schedules, let alone build additional capacity.

In fact, setting up additional capacity might not be a prudent response at all because the wealth effect could turn out to be all too ephemeral "" sales that blipped up in a particular quarter could disappear in the next quarter if the stock-market plummets.

One option is for manufacturers to work with some slack in production and inventories to handle these contingencies. This comes with its own cost and goes against the sprit of the ruthless efficiency drive that Indian manufacturers have been following over the last few years. This is however the price that manufacturers need to pay for operating in a riskier environment.

This phenomenon also raises serious issues for macroeconomic, specifically monetary policy. If, indeed the stock market has such a strong impact on the real economy, should the government, perhaps through the central bank, prop the stock market up.

The US Fed, despite Chairman Greenspan's famous "irrational exuberance" speech, certainly did its best to support the bull-run in the US stock market through expansionary monetary policy. The stock market expansion, through the wealth effect kept the pressure up on consumer demand and the business cycle leading to the longest phase of economics expansion in US history.

Should the RBI take its cue from the Fed? This is not the kind of question the government should answer in a hurry. A good way to start though would be at least recognise the importance of the stock-market in macro-policy making.

abarua@crisil.com

(The writer is a senior economist at the Crisil Centre for Economic Research)