Saturday, February 14, 2009

Stock Market and Macroeconomic Policies

This article is intended for people who do not know how the Macroeconomic policy works through Reserve Bank of India (RBI) but has some interest to learn it. Many people invest in stocks and some of them might be even successful but only few people understand why the stock market behaves erratically to the announcements made by the Government and the RBI. You might have heared Bank Rate, Repo Rate, Cash Reserve Ratio (CRR), Tax Cuts, Government Spending, inflation and many more words these days and whenever some major announcement comes from RBI regarding these, SENSEX and NIFTY either goes up or comes down. Why? These are all Macroeconomic tools at the Disposal of Government of India to keep the Economy in Balance. I will try to explain important Macroeconomic tools to the best of my knowledge.

Macroeconomic tools involve two main things namely Monetary Policy and Fiscal Policy. The new “Buzzword” Stimulus Package derives inputs from both these policies to have “Multiplier Effect” on the economy and my aim is to show how this works and how the economy improves and it’s bearing on Stock Markets. Let me start with Monetary Policy first.

Monetary Policy

It is an “Economic Lever” by which the Government and RBI keeps the money supply under control to leave the Economy in balance.

I will explain this with a simple example. Assume inflation (Rise in Prices of goods) level of 5. At this inflation level, you are buying 1 Kg of tomato for Rs.15. Let’s assume the inflation goes to 8 which simply mean that “Currency” available in the open market is more than the demand and you will be buying the same 1 Kg tomato by giving more money (Rs.20) because you have more currency (Please do not assume that price goes up only because of this. In this case Tomato price might have gone up due to the increased cost for the Farmer because of lack of economic activity). Many things are interwoven here and I am explaining only important things. Now lets assume inflation comes down to 2 which means “Currency” available in the market is less than the demand and people have less money to buy the same 1 Kg tomato.

At present we are facing less supply of money in the market and that’s the reason for current recession. Since the money supply is less, companies are not able to borrow money for their operations. They do so at higher interest rate which lowers the company earnings which in turn reduces the stock price. So, both over supply of currency or under supply of currency in the market is not good for the economy and thus Stock Market. Here comes the tool of Monetary Policy to keep the money supply and inflation at the optimum level. There are various options for the RBI under Monetary Policy and some are as follows.

1) Cash Reserve Ratio(CRR)
It’s a percentage of money that a commercial bank must keep with RBI as a reserve. At present the CRR is 5% which means if Axis bank gets Rs. 100 as a deposit; it must keep Rs.5 as a reserve with the RBI and will have Rs. 95 for loaning. How does CRR affect money supply and stock market? Here is how. Suppose RBI hikes the CRR to 10 %. Then Axis bank must keep Rs. 10 as a reserve with RBI and it will have only Rs. 90 to give loans instead of Rs.95, which reduces the available currency in the market. The stock market will react based on the prevailing market sentiment to this change but mostly downside. Suppose the CRR comes down to 3% means Axis bank will now have Rs. 97 to give loans which in turn increases the currency supply in the market and stock markets move up to this kind of news (Because companies can get credit at cheaper rates without hindrance which reduces the cost of capital and the company Earnings Per Share (EPS) improve).

2) Bank Rate or Discount Rate
It’s a rate at which the RBI lends money to the commercial banks. The principle I explained under CRR applies here too. If the RBI hikes the rate, then banks will not seek more money as the rate is high, hence less money supply in the market. If the rate is low, then banks will try to get more loans from RBI to take advantage of the low interest rates, hence more money supply.

Stock markets move up or down based on the increase or decrease in the rate. The graph (In US Dollars) explains pretty much the same idea and it even includes description.

3) Open Market Operations and Repo Rate
If the RBI feels that available currency in the market is less, then it purchases government securities or bonds in the open market to temporarily create more money supply and vice versa. Repo rate is a rate at which it transacts the securities and bonds with commercial bank to create or destroy money supply as explained earlier.

4) Interest Rates
RBI announces the interest rates at which commercial banks lend themselves for overnight loans or short term loans. If the rate is high, then money supply will become less and stock market might go down. If the rate is less, then money supply will be more and stock market will react positively.

In the graph, the shaded bars indicate the recession period and the blue line indicates the currency in circulation. Whenever there was no increase in supply of money proportionate to the economic growth, there was a recession as you see in the graph. Between 2000 and 2008, you see a steep increase in money supply which is disproportionate to the economic growth. Because banks gave credit too freely (We saw higher inflation in 2008 because of this) to people and the stage came where people started defaulting. Once they started defaulting, others got scary and they all sold stocks to be on cash. Hence, credit crisis arose and we have the recession now.
Depending on the situation, RBI uses either one or all of these tools to control the money supply in the market. Now you know what Monetary Policy is and its uses. What is this “Stimulus” Package and Fiscal Policy and how it is related with economy and stock market?

Fiscal Policy and Stimulus Package

We all show eagerness to the budget announcements. Why? Because government defines the path for the economy and aggregate demand to travel, through budget and the whole idea of spending is based on Keynesian economics. So, the fiscal policy is a tool by which government influences it’s spending and tax related issues. This concept is as simple as our family spending. There are three situations as follows.

Optimum Budget.
Under optimum budget Government spending = Government income (Taxes). Suppose government collects Rs. 1000 crore as a Tax means, just like our family, the government can spend only Rs. 1000 crores. If the government is able to provide all the facilities to its citizens within this amount, then that’s where, economy is in optimum.

Surplus Budget.
Government spending <= Government Taxes. This is a dream situation where the government collects Rs. 1000 crores in Taxes but it requires only lets say 750 crores to provide all the facilities for its citizens.
Deficit Budget.
Government spending >= Government Taxes. This is our familiar situation where the government collects Rs. 1000 Crores in Taxes but requires Rs. 1500 Crores to provide all the facilities for its citizens. Where does the government go for the additional Rs.500 Crores? Well, that’s when government sells securities and bonds to mobilize money by promising a fixed interest income to you and definitely not to make you or me rich if you felt that way. Government also gets loan from IMF, Asian Bank and other agencies. How the hell government will repay that Rs. 500 Crores? Just like we start a business by getting loan from SBI thinking our business will generate enough income to repay the loan, the government also thinks, the additional spending will stimulate the economy by “Multiplier Effect”. The idea of “Stimulus” Package originates under this principle. Since, the government thinks that additional spending will improve the economy by “Multiplier Effect”, the stock markets react positively thinking company earnings will go up and thus stock prices.

What is this “Multiplier Effect”?

I will explain two scenarios here. 1) Government spending and Tax cuts. 2) Lending or Deposit multiplier. This is the situation we are facing these days. Let’s take the government spending and tax cuts first. Government spends the “Stimulus” money in infrastructure or other projects. These projects employ additional people (Employment). These employees earn income (Earning) and they buy goods (Spending) with that money. The seller earns income and he spends it to expand his business. To expand his business, he buys more goods and employs more people. This process goes on and on which “Multiply” the effect of initial amount that government spent, hence the name “Multiplier Effect”. Government cuts Tax. Why? Because tax cut increases the disposable income of a household and since they have more money, they will spend it to buy goods and it will follow the same process which I explained above. Stock markets react positively to “Stimulus” package since market thinks economy will get a boost through this so called “Multiplier Effect”. But why stimulus package is not working overnight? Because people fear the current situation and they try to keep cash like you and me, rather than spending. Since they do not spend, the situation of “Multiplier Effect” does not arise leaving the economy in trouble and stock market either moves down or moves sideways. Then why government is spending? The government thinks that the stimulus package will create more employment which leads to more income and people slowly will come out of their groove to spend it. When that happens, you and I will rejoice with a hope to invest some of the money in stocks and stock market begins to move up. Hope now you understand why the entire “BUZZ” about Stimulus package.

Deposit multiplier is directly linked with CRR. Suppose Axis bank gets Rs. 100 as a deposit. Then it must keep Rs.10 as a reserve since the CRR is 10%. Axis bank lends remaining Rs. 90 and people borrow it and spend. That money is deposited in another bank and that Bank keeps Rs.9 as reserve in RBI and loans the rest of Rs. 81. This goes on and on till the loan amount reaches Rs. 1000 (Rs. 100 /0.1). Money multiplying money situation, right? Hope you now have a better idea about Macroeconomic tools and its association with stock market.

This article is not for people who know Macroeconomics well to whom it might not be useful but for retail investors who have the interest to learn how the Macroeconomic environment is linked with Stock market. You might have questions or need explanations. If so, please leave a comment.

Kumaran Seenivasan.


Chirag Ali,  November 26, 2009 at 1:18 AM  

Excellent article.

Thank you very much

Chirag Ali


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