Relationship between stock market

performance and economic growth in India

Introduction
The relationship between financial sector development and real economic activity has been a
debatable issue in theoretical and empirical research. The stock market performance and
economic growth has been the subject of intensive theoretical and empirical work. This debate
revolves around whether stock price movements are influenced by economic changes or stock
market performance helps in promoting economic growth. In this regard questions under
consideration are; is there a relationship between financial sector development on economic
growth and the identification of causal nexus between economic growth and financial
development.
There is significant development in stock market of India after introduction of ‘New Economic
Policy (1991)’ in India and debate commenced on the role of stock market performance
promotes economic growth or vice versa; one stream of research suggests stock market
development promotes economic growth. Opposite view is held by some researchers who have
argued that this effect is marginal or in some extreme cases even negative. There are number
of studies that have tested direction of causation between financial development and economic
performance both at developed and developing countries. India has adopted modern strategies
to promote its stock market development since late 1980s and this has become more
sophisticated after the introduction of economic reforms of 1991. These reforms brought
expansion in terms of number of listed companies, number of shareholders in the market and
market capitalization; this has resulted in India to become one of the most active and leading
market among all developing countries of the world. Economists often say that the movements
of stock prices either ‘up or down’ are reflective of public expectations towards policies. An
increase in stock prices is reflective of future expansion of economic growth and a decline in
stock prices is associated with expected potential economic recession.
Data over the last four decades indicate that outsized gains in the Sensex — annual return
exceeding 50 per cent — have always coincided with major turning points for the Indian
economy, which was accompanied by improvement in GDP growth.For instance, the Sensex
gained 93 per cent in the 1985, when the first set of reforms were rolled out , which included
de-licensing of industries, abolishing price and distribution controls on construction material
and introduction of the modified value-added tax. GDP growth improved to 5.25 per cent that
year, higher than the 3.82 per cent the previous year. In 1988 too, the Sensex’s 50 per cent gain
was aided by a phenomenal 9.6 per cent growth in GDP.As the liberalisation of the economy
began in December 1991 with the opening up of the economy to foreign investment, reduction
in tariffs and deregulation of the markets, the stock market gave a thumbs-up with the Sensex
surging 82 per cent in 1991 and 37 per cent in 1992.The Sensex’s other large gains— in 1999,
2003 and 2009 — have also coincided with pick-up in growth compared to previous years. The
last instance will be fresh in everyone’s minds when the Indian economy revived from the blow
from the sub-prime crisis, thanks to large fiscal stimulus by the government. GDP growth was
8.48 per cent in 2009, compared with 3.89 per cent in 2008. The Sensex gained 81 per cent in
2009 after losing 51 per cent in 2008.Years in which Sensex gained between 20 and 35 per cent
were also accompanied by decent growth in GDP.One explanation for the growth years
boosting stock price is that corporate profits tend to improve as the economy picks up, giving
a leg-up to demand. The converse could be true in a year of sluggish growth when lower
consumption and investment could hurt the bottomline of companies as well.
The main objective of this study is to investigate the causal nexus between stock market
performance and economic growth and to find the short-run and long-run dynamics of the
variables by considering both monthly and quarterly data on Index of Industrial Production
(IIP), Gross Domestic Production (GDP) and Stock Prices in the Indian context. Understanding
of this relationship is important for policymakers to assist with development of policies for
future economic development and direct allocation of resources in an optimal fashion. This is
also of interest for investors in terms of understanding future movement of the stock prices in
the market place.