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Thursday, Sep 29, 2005

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Is the stock market boom a sideshow?

Saumitra Bhaduri

AS THE euphoria on Dalal Street seems to know no bounds, a fundamental question is whether the booming stock market is doing any good to the economy, particularly corporate private investment.

A security market fosters economic growth by augmenting real savings and capital formation, increasing net capital inflows from abroad, reducing the cost of capital and raising the productivity of investment by improving the timing and allocation of investible funds through market signals.

However, it is the latter function that has attracted the attention of academics and corporate managers and debated widely in emerging markets. The debate goes back to a seminal work by Tobin (1969), who advocated a positive association between investment and `q', the ratio of the market's valuation of capital to its replacement costs and predicted that any rise in the return on capital would lead to investment.

However, investigation seem to provide little consensus on this issue. One strand of the literature argues that the stock market is a passive predictor of future activity and mangers do not alter their investment plans based on highly volatile changes in stock prices (Bosworth, 1975).

Another suggests that share prices provide key price signals to managers on corporate investment decisions (Fischer and Merton, 1984). Though this might suggest a possible misallocation of resources through processing of inefficient price signals by managers, some advocates of this view would argue that even experienced managers who know the true value of their firms are still likely to react to non-fundamental share price movements. For instance, an over-valued firm may take advantage of the market assessment by issuing capital at a relatively low cost to use these proceeds for investment.

The significant liberalisation of our financial system in the 1990s made access to the equity market easy and corporates resort to equity finance much more frequently than many of their developed country counterparts. However, many economists continue to be sceptical about the role of a booming stock market in influencing investment decisions. A recent study by the author sheds some light on this debate.

The study indicated that both at the aggregate and firm levels, the stock market valuation plays a limited role in influencing such decisions as investment (see graphic). The Indian stock market seems to be a sideshow in providing price signals to managers and the investment decisions are determined mainly by the firm's fundamentals captured by the growth of sales and cash flows.

However, the study also concluded that the stock market plays an important role as a source of finance in influencing the investment decision.

If these findings are robust, it could have saved us from a many distorted investment decision, preventing considerable misallocation of resources. For now, the bull run continues to be another expensive sideshow for Dalal Street.

(The author is Associate Professor, Madras School of Economics, Chennai.)

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