Stock Market in a Liberalised Economy: Indian Experiences

Author(s): M. K. Roy
Source: Economic and Political Weekly , Jan. 27 - Feb. 2, 2001, Vol. 36, No. 4, Money,
Banking & Finance (Jan. 27 - Feb. 2, 2001), pp. 367-369+371+373+375-376
Published by: Economic and Political Weekly

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 Stock Market in a Liberalised Economy
Indian Experiences
Considerable debate rages about the impact of deregulation on the efficiency of the
market. Free market advocates all too often tend to undermine the unruly behaviour of stock
markets in the post liberalisation scenario. On the other hand, opponents believe that stock
market reforms may lead to over-speculation, financial crisis and even a misallocation of
resources at the cost of real sector growth and stability, as has been seen in the case of
India. However, there is now an increasing recognition in LDCs that given the
competition for foreign funding and limited availability of domestic finance, the equity
market can play a beneficial role in providing capital to the productive sector
as well as facilitate the process of privatisation.

M K Ro

lation can optimally underpin stable inter- this view. Major international institutions
Introduction national financial system [Murinde 1993]. satisfied with the fascinating growth of
On efficiency, it is argued that reform emerging markets also expressed their
converts stock market to fit free economy concern repeatedly over the unruly
shift in the balance in the economy
from state to private sector where society in effect authorises financial behaviour of markets of LDCs.
bestowed on the stock market system to allocate resources [Caprio and In this backdrop, the study aims to
the burden of pooling sufficient resources Levine 1994]. Many of the legal and evaluate implications of financial liberali-
from domestic, regional and international institutional arrangements basic to effi- sation on the growth and efficiency of
sources and allocating them efficientlycient for functioning of the market yet do not Indian stock market. Underlying purpose
productive uses. Only an active and effi- exist in many emerging markets. Reform of the study is simple. Success of liberali-
cient market can be conducive to success- confronts the problems existing institution sation largely depends on efficient mobili-
ful transition of economy. It is argued thatface and helps to season the market for sation and allocation of resources by fi-
a comprehensive liberalisation strategy efficient allocation of savings and invest- nancial system for productive investment.
takes care of both growth and efficiencyments. Theory of Friedman (1953) and If market fails to discharge these avowed
of equity market; many commentators, Fama (1965) on arbitrage operation further objectives, the programme of privatisation,
however, contested this statement. to say the least will suffer a big jolt in
reinforces assumption of pro-reform theo-
There is almost unanimity among aca- rists that efficiency of equity market in- LDCs. Thus Indian experiences along with
demics that liberalisation encourages for-creases in a liberalised economy. It is the lessons of other developing countries
mation of equity markets where they did would contribute to our understanding of
suggested that opening up of capital market
not previously exist and helps in theirwould allow foreign institutional investors the relationship between financial
deepening where they predated the reforms.(FIIs) to operate in emerging markets. Their liberalisation and asset market behaviour
Indeed, recently there has been a proli- policy of 'buy low and sell high'will usher and its impact on LDC economies.
feration of scholarly and popular articles
efficiency in these markets that will finally The paper is organised in the follow-
which extol the virtues of these rapidlyhelp to develop a stable international fi- ing manner. Section II explores the steps
expanding markets for less developed nancial system. taken so far and agenda for future action
countries (LDCs) economic performance Can liberalisation help to improve effi- to complete the goal of liberalisation.
and for investors worldwide. ciency of the market? There is no consen- Section III critically evaluates the impact
The expansion of equity markets of manysus in the scholarly literature about the of regime shift on the growth of the
Asian countries specially after liberalisationpossible impact of deregulation on the equity market. Section IV aims to com-
is truly impressive [Clemente 1994]. The efficiency of the market. Reformers confi- pare share price volatility in pre- and post-
market capitalisation of these countriesdent about the beneficial role of the stock liberalisation period. Very specifically
continues to grow. Some of these emerg-market in a free economy [Cho 1986] tend attempts will be made to verify whether
ing markets are comparable in size to theto undermine the scope of its unruly our finding confirms or belies the assump-
smaller European markets and many ofbehaviour in the post liberalisation period. tion of liberalisation theorists on asset price
them have been growing at a faster rateThose who oppose it often argue that stock volatility. An attempt will be made in
than European markets over the last fewmarket reforms may lead to over specu- Section V to measure the impact of reform
years and are likely to continue to do so.lation, financial crisis and misallocation of process on market efficiency. Thanks to
Fascinating growth of emerging marketssavings and investments to the detriment globalisation, FIIs now rule over Indian
suits 'global neoclassical' model which of real sector growth and stability [Singh capital market. Role of institutional
emphasises international financial openness. 1993, Grabel 1995]. Experiences of India investors in the efficient functioning of
The idea is that global financial deregu- and other developing countries support the market will be critically analysed in

Economic and Political Weekly January 27, 2001 367

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Section VI. Finally, although policy les- The process of development of a market- economic environment is conducive for
sons are always hazardous, some broad oriented financial system in India is farthe growth and expansion of equity mar-
lessons from Indian economy and their from complete and due to slow progressket. Ignoring many of the existing cliches,
development implications are derived in several more years will be necessary to India has rightly emphasised on the syste-
Section VII. While discussing Indian reach the target. Apart from the policy of matic development of both bank and equity
experiences, lesson from other LDCs will 'gradualism', perhaps unending struggle market, which Cho (1986) describes as a
be analysed to evaluate developmental role between reformers and so-called 'conserva- "necessary condition for complete finan-
of equity market during regime shift. tives' [Adams 1994] also compelling govem- cial liberalisation".
ment to follow a policy of 'stop and go'. Importance of a well-developed equity
II We simply mention some of the very market in a deregulated financial system
recent steps initiated by the government arises from: first, the financial services and
Financial Sector Reforms:
to add momentum in the reform process. institutions fostered by equity market are
Speed, Scope and ImplicationsIt includes bringing in electronic trading important complements to bank funding
The reform policies so far ventured by and order matching system; introduction and retained earnings in financial invest-
the government are fundamental to theof sector funds and dedicated gilt funds; ment; second, equity market which is free.
goals of liberalisation. The essence of this allowing trading in index future and other from moral hazard effects can allocate
change is that where market can function derivatives; introduction of national ven- resources more efficiently than banks con-
best, decision should be left to it. ture fund for software and I T industries; strained with imperfect information [Cho
Optimal order for liberalising the do-allowing foreign equity in domestic insur- 1986]; third existence of risk-bearing capital
mestic real sector and financial sector, the ance companies subject to some maximumin the system may help to reduce concen-
process of integration of these two sectors;limit, etc. tration of risk in banking sector. Virtually,
any transitional problems the economy may In spite of these encouraging endeavours, development of equity market has important
face are still matters of ongoing debate ineven a casual observer of Indian economy implications for banking sector reform.
sequencing literature [Edwards 1984, would agree that initiative is urgently Until the country has an active equity
Blejer and Sagari 1988]. In India, how- needed to mitigate the following problems market, as Cho (1986) described, it may
ever, liberalisation of product market of Indian financial system to achieve our have to settle for a second best approach
preceded the liberalisation of factor mar- present mission. Such as, a well defined of the liberalisation in which some govern-
kets. The liberalisation of factor markets short-term yield curve is missing; the money ment intervention is maintained, contrary
was achieved partly through the market is volatile; T-Bills, government to the assumption of the theory of liberali-
liberalisation of financial markets. dated securities and private issues do not sation. Steps taken so far to deregulate
One school of thought emphasises the enjoy secondary liquidity; ability to man- Indian financial system is contributing to
merit of 'gradualism' in the process of age portfolio risk is weak due to lack of develop an integrated financial system com-
financial liberalisation and suggests that risk management expertise; lack of initia- prising of deregulated banks and well deve-
excellent experiences of China along with tive and innovative ideas to manage funds loped equity market, essential for success
other Asian countries support the merit-of of insurance sector; lack of competition in of financial liberalisation [Cho 1986].
evolutionary reform, while others advo- insurance market, etc. However, if this policy Table 1 shows the pattern of change in
cate 'big bang' reforms that include rapid of liberalisation continues, which govern- the Indian stock market with gradual de-
stabilisation, liberalisation and privati- ment describes as irreversible, in the near regulation of Indian economy. Virtually
sation of financial sectors [Sachs and Woo future India will have a completely market- the real sector reform provided the much
1994]. Many Latin American and former oriented financial system like many other needed fillip for the development of the
socialist countries frustrated with control LDCs. Ultimately what it will deliver to equity market and the passion of the market
regime embraced 'big-bang' approach to the economy is of course a debatable issue. in turn contributed to the growth of real
convert quickly a regulated economic sector, thus one helped in the growth of
system into a market -oriented one. In such the other.
Ill
a context, the issue of how to sequence Structural changes were most evident in
Liberalisation and Growth
reform was not very relevant [Rana 1995]. the composition of industry and manu-
The Indian government is determined to of Equity Market facturing output after deregulation of real
implement its avowed objectives of What is suggested is that the speed, sector. There was shift in the relative rate
liberalisation with caution so as to avoid scope and strategies of reform largely of growth in the capital-intensive, skill-
frequent and painful experiences contri- depend on country - specific typical pro- intensive and high technology manu-
buted by 'big-bang' approach in many blem of the existing financial system. facturing industries compared with the
Latin American countries. In fact, gradualAssumsing inactive capital market in most labour-intensive, low-skill and low techno-
deregulation and policy of close supervi- LDCs, Mckinnon (1973, 1991) and Shaw logy industries. This structural change in
sion by monetary authorities over the finan- (1973) emphasised the beneficial impact the real sector was possible due to efficient
cial system so as to minimise the scope ofof liberalised financial system dominated switching of funds by stock market.
distortions during the change process areby banking sector. Substitutability and However, there is the scope of study, the
the two principles that the government iscomplementarity between banks and secu- role of 'leading' and 'lagging' industries
following meticulously. The guiding prin-rities market, as argued by Kumar and in the process of the growth of the economy,
ciple is, while long-term objective of reformTsetseko (1992), appear to be sensitive to the issue which has been intentionally
is to minimise the role of government inthe level of economic growth. They sug- ignored in the present study.
the functioning of the financial system, gest, in a developed economy where pri- Financial sector reform added further
regulatory intervention may be necessary vate sector has fully blossomed, banking tempo to the growth of equity market.
during the transition period. system is well established, only such an Capital raised from new issue market,

368 Economic and Political Weekly January 27, 2001

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average turnover, activities of mutual fund, lative investment practices, result in mis- improved legal and regulatory environ-
market capitalisation, foreign institutional allocation of scarce resources and broader ment and institutional arrangements basic
investment all increased considerably. The macroeconomic instability that are sufficientto reform process would contribute to
vigour of the market substantially reduced to defeat the basic objective of equity market.restrain excessive speculation and a de-
the bank burden for corporate financing, Volatility means changeability or cline in price volatility. Furthermore, even
already bogged down in bad debts due to randomness of asset prices. If share priceif financial liberalisation leads to an in-
misallocation of resources during control changes in response to fundamental eco- crease in volatility, the capital asset pricing
regime. The fairly comfortable liquidity in nomic factors or because of informationmodel suggests [Friedman 1953, Fama
the banking system enables Reserve Bank and expectation about them, prices will 1965, Merton 1980] that increases in
of India (RBI) to complete most of the always be in 'equilibrium'. As informationvolatility would not impair macroeconomic
budgeted amount of the central govern- arrives in the market infrequently, in aperformance provided that stock returns
ment borrowing with ease. Thanks to perfect market, price generally movesincorporated appropriate risk premia i e,
buoyancy of the capital market in the post- within a narrow band sufficient to promotemarkets are efficient.
reform period, not earning from efficient a cozy feeling among investors [Fama From a Keynesian perspective, however,
debt management but dividends have 1970]. Alternatively, 'animal spirits' that quickened pace of financial transaction
become the single most important profitresult in big rise and fall in prices contri-following liberalisation may be expected
multiplier of banks in India (Economic bute to the anxiety of investors regardingto contribute to higher volatility which is
Times, December 4, 2000). prospects of their investment. From ain effect self-nourishing. Volatility forces
Truly, it was a period of developmentmacroeconomic perspective bubble andinvestors to shorten their horizons of in-
with chaos. All the indicators that financial fads in share prices, defined as the differ- vestment for both offensive (profit-seek-
economists generally favour to measureence between market price and fair value ing) and defensive (loss minimising) rea-
the activities of the market, e g, turnover,lead to misallocation of resources and defeat sons, with the paradoxical effect of induc-
p/e ratio, new issue, market capitalisation,the basic objective of share market. ing increased volatility in the post-
flow of FIIs started behaving unpredict- Financial liberalisation hypothesis pre- liberalisation period that may lead to re-
ably with regime shift. What would be thedicts a decrease in volatility in asset priceductions in real sector investment activi-
impact of current stock market behaviour in the post-reform period and discounts itsties [Keynes 1964; Singh 1993;Grabel 1995].
on macro-economy is a debatable issue, macroeconomic effect [Grabel 1995]. Table 4 shows the pattern of share price
but the fact remains, the array of servicesTheorists suggest [Grabel 1995] thatfluctuations of Indian capital market for
that the market provides to the society
now-a-days were not available in the pre- Table 1: Key Indicators of Growth Pattern of Indian Stock Market
Pre- and Post-Liberalisation Period
liberalisation period.
Experiences of other Asian countries Description of the Period
Indicators Mixed Real Sector Financial Sector
also confirm the views that financial
Economy Reform Reform
liberalisation helps in deepening the acti- 1961-62 1980-81 1990-91 1991-92 1992-93 1994-95 1999-2000
vities of the stock market. The countries 1979-80

that succeeded to overcome the notorious No of stock exchanges 7 9 19 20 21 22 23

task of development of equity market inNo of listed companies 120 2265 5968 6229 6480
7811 NA
P/E ratio N A N A 19.82 55.17 48.96 21.81*
the post-liberalisation period were also Estimated no of share
successful to attract domestic and inter- owing individual (lakhs) 6.25 24.00 NA 60.00 200.00 N A N A
national funds for the growth of the Average turnerge ver (Rs crore) NA NA 36012 71777 45695 67740 685000
Capital raised by private
economy. In fact it is a two-way process, sector (Rs crore) 99 196 11190 14400 29000 49200 51533
as equity markets develop, they facilitate
Mobilisation of resources
the inflow of external and domestic funds by mutual fund (crores) - - 2729 5 129 3021 175 22710
Net investment of FlIs (crores) - - - - 2595** 6791 6697**
and the inflow in turn stimulates further
development of these markets. Notes: * Average of last week of October 2000.
** For 1993,1994 and 1999.
Source: Different Issues of Bombay Stock Exchange Official Directory, CMIE and RBI Bulletin.
IV
Table 2: Capital Issues: Distribution by Broad Industry Group
Liberalisation and Stock
Year
Market Volatility Leading Industries (per cent share) 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99

What is the impact of regime shift on Services (excl utilities) 39.45 39.28 37.52 48.51 60.35 63.3 65.8
asset price behaviour? Is there any indi- Chemicals 13.6 12.8 21.09 14.47 8 11.5 9.3

cation of decline in share price volatility

in the post-reform period? If not should Table 3: Financial Liberalisation And Development of Equity Market:
Select Asian Countries
we bother it? What are the experiences of
other emerging markets? Year of Liberalisation

The answer to these questions partly Number of Listed Companies Market Capitalisation (US $ Billions)
Before After Before After
depend upon the level of volatility that the
market exhibits. Markets with severe priceMalaysia (1980) 182 621 12.39 307
Philippines (1980) 138 216 3.47 81
swings that can be hardly explained byS Korea (1982) 334 760 4.44 139
fundamental economic factors might dis-Indonesia (1983-84) 16 253 .85 91
courage genuine investors to participate in Taiwan (1987) 141 382 49 470
the market, indulge in short-term specu- Source: Emerging Stock Market F

Economic and Political Weekly January 27, 2001 369

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a period of nearly 39 years. Following the central theme of the financial economics Expected real returns from investment
Keynesian views, in the present case, - are financial markets efficient? Only an are determined in the real sector. This
volatility has been simply defined as the efficient market can allocate scarce re- section attempts to study whether succes-
magnitude of asset return fluctuation sources of the society to the most produc- sive changes in real and monetary vari-
measured in terms of standard deviation tive sector of the economy. This is espe- ables can logically defend the gruesome
(SD per cent). Current level of volatilitycially important for developing countries rise in asset price fluctuations in the post
(SD) has been compared with reference to where credit markets are characterisedreform by period (1991 - April 1999). Simply
what it was in the past. imperfect information and oligopolistic it is a test of market efficiency. A market
Adverse impact of liberalisation on banking structure. failure occurs when competitive market
market volatility is distinctly prominent operates inefficiently and fails to bring
from Table 4. The stage of self-reliance V about an optimum allocation of resources
and systematic crisis emerging from mixed Liberalisation and Stock [Dixit 1987, Besley 1994]. It obviously
economy (1961-1980) may be broadly Market Efficiency complicates the macroeconomic adjust-
described as the regime of control economy. ment process and shatters confidence of
This was the most tranquil period of Indian Efficient market theory claims that all people on the non-interventionist approach
price movements must be interpretable by
stock market, the price fluctuation of these of development.
two decades was minimum. information about economic fundamentals. We believe that allocative efficiency of
Is it possible to explain post liberalisation stock market needs to be examined in the
When the period of hibernation was over,
the market awoke in early 1980s. Almost (April 1991-1999) as volte-face image of context of practical realities. Impeccable
from the beginning of the 1980s, bidding Indian stock market by economic realities? pricing leading to Pareto-efficient alloca-
farewell to controlled and closed economy, To adjudge, allocative efficiency of capitaltion of resources cannot be achieved in the
the country was gradually entering an market,
era most of the studies [Grabel 1995] real world where information is costly,
of market economy. With a change inmisplaced the their emphasis on measurement monitoring is not costless and enforce-
regime, it appeared as if an otherwise soberof volatility in pre- and post-liberalisationment is not perfect. It surely narrows the
market had started behaving disorderly. period. Presumably, post-reform vigorousdefinition of market failure. We expect,
During the days of real sector reform price swings in most of the LDCs followedgiven all these constraints, market must
(1981-90) share price fluctuation increased by consecutive market breaks led to the operate at a level of efficiency sufficient
from .51981 to 1.00239 and it reached its popular concept that higher volatility to justify its existence in the changing
top after liberalisation of financial sector.implies market inefficiency that adversely environment. With this note, we aim to
It is interesting to observe that magnitudeaffects capital formation and welfare. measure market efficiency so as to analyse
of asset price volatility is closely relatedMarket break surely suggests that the system its developmental implications.
with the stages of reform of financial systemis not functioning properly. But it does not It is unrealistic to assume that only one
(5.4875 in April 1996-1999). appear all of a sudden. Instead, it results economic factor will exhaust possible ex-
Experiences of other developing coun- from prolonged over or under reaction of planations for movements in stock prices.
tries also confirm that any regime shift investors to the arrival of information which Six measures of economic activities were
very often activates and encourages in in its extreme form results in disastrous looked at, such as changes in index of in-
excessive volatility of share price. 'bubble burst' kind of episodes. dustrial production (DIIP), yield on treasury
The findings negate the assumption of Financial economists suggest that cur- bill (YTB), yield on long term government
reform theory that deregulation contributes rent stock price is the discounted present bond (YGB), interest on debenture (DEB),
in minimising share price fluctuation. value of expected cash flows to stockhold- rate of inflation (DINF), money supply (M3)
Following Keynes, is it possible to ascribe ers. If market truly prices share in such an
to explain changes in earning from index
this increased trend of volatility as a prod- elegant fashion, scope of 'poaching' or (RET). In an efficient market there exists
uct of undisciplined functioning of equity exploiting the mistaken belief of ill infor- a sharp linkage between changes in eco-
market in the post-liberalisation period? med virtually withers away. This is con- nomic activities and asset price. Since stock
Can we describe this rise in volatility as a sistent with rational expectation view in prices adjust continuously to change in the
symptom of financial fragility? Is it pos- which markets for goods and securities set macroeconomy, it is reasonable to assume
sible to claim that while 'big bang' ap- current prices on the basis of forecasts of that it can share the main burden of adjust-
proach followed by Latin American coun- relevant real variables. If macroeconomic ment in the short run while other variables
data provide information about the vola-
tries failed, gradualist practice of seeking such as wages move more gradually cushio-
to reform Indian financial sector had not tility of either future expected cash flows or
ning the real side of the economy for ex-
succeeded in delivering any better result.discount rates, they can help to explain why cessively harsh short-run adjustment
All these issues are directly related to stock returns volatility changes over time.[Murinde 1996].
Relationship of some of the variables with
Table 4: Volatility of Daily Return: Pre and Post Liberalisation Period expected return from stock is simple and
Time Period Mean Daily Return S D Per cent straight. The proxy for the state of the
Pre-Liberalisation 1961-80 .01564 0.51981 industrial economy is index of industrial
Real Sector Reform 1981-90 .06674 1.00239 production (DIIP), the variable is expected
Financial Sector Reform 1991-95 .0947 1.31294 to influence return from stock indices (REX).
1996-99 (April) -.004 5.48752
We assume a positive relationship between
Note: Economic Times Daily Share Price Index has been used to calculate mean daily return for the these two variables. Data on IIP is available
total period and different sub-periods. Rate of return may be defined as percentage change of
only on a monthly basis, hence to maintain
index in two successive periods. SD of return (r) from a sample of n observations is square root
of the average squared deviation of returns from the average of the sample. uniformity monthly data for all other vari-
Source: Calculated by author. ables have been employed.

Economic and Political Weekly January 27, 2001 371

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 Yield on treasury bill (YTB) is a measure markets are a boon or impediment to real investors to benefit from arbitrage and to
of riskless rate of return and rate of interest sector growth and stability largely depends discipline these markets favourable for the
on debenture represents opportunity cost on the level of efficiency it operates. Indian
emergence of a stable international finan-
for investors in equity. These two variables experiences are sufficient to frustrate propa-cial system. The theory described, neatly
are likely to influence discount factor. We gators of reform theory of our country.fits in the Friedman (1953) Fama (1965)
expect a negative relationship between The study reveals a confusing state of framework of efficient market and global
interest rate and asset prices. development of Indian capital market - new classical model [see Murinde 1996]
Broadermeasure of money (M3) is expect- growth followed by total inefficiency. Theof financial liberalisation that emphasises
ed to have a strong relationship with stock tendency to overemphasise growth and to on perfect capital mobility.
prices than the monetary base. Increase in discount efficiency most probably stems Based on the above theoretical frame-
money supply introduces liquidity in the from the theory of 'Constrained Pareto-work, we aim to evaluate the role of domes-
financial market, increased liquidity re- efficient' allocation of resources. We tic and FIIs in the noise driven Indian stock
sults higher demand for financial assets emphasise that this paradoxical situation market. India along with otherLDCs consti-
that contributes in higher return from stocks. cannot last long. tutes a good laboratory to test some of the
In fact money supply and equity return has Clearly big institutional investor basic whoassumptions of liberalist literature on the
an intricate relationship and any simple ex- happens to be 'guardian' of the market role of institutions as arbitrageur and "guard-
planation may fail to capture reality in full. failed to act in accordance with Friedman- ian of efficiency of emerging markets.
Quantity theory of money suggests that Fama framework to maintain efficiency of Though change of economic variables
increased money supply results in increased the market. Do they violate the norms of have a nominal role in the movement of
inflation holding real activity and velocity rationality intentionally? Is it possible to Indian share price index, concerted inva-
of money constant. The interrelationship assume that 'Knights' instead of disciplin- sion of domestic and FIIs along with other
between inflation and stock return is a ing the market often deliberately destabilise variables account for 96 per cent variation
subject of long standing debate in financialit to swallow the untutored investors in of Sensex (Table 7). It's a typical symptom
economics. opportune time? of LDCs where big institutions belying
Findings of Fama and Schwert (1977) hopes of Friedman-Fama often use their
followed by the evidences of scores of VI Table 5: Volatility of Share Prices of
researchers shattered the previously ac-Role of Institutional Investors Some Select LDCs:
Pre and Post Liberalisation Period.
cepted wisdom that there should be one-
to-one relation between changes in nominal Opening up of the capital market of Country Mean of Pre Mean of Post-
return and expected rate of inflation.LDCs allowed 'smart' and wealthy FIIs to F L Volatility F L Volatility
Common stock representing ownership of diversify their portfolio in investing in
Argentina .6416 .3945
the income generated by real asset, should growing economies. Financial economists Chile .0767 2.9606
be a hedge against inflation. Fama andsuggest [Shlefier and Vishny 1997] thatColombia .0123 2.6010

Schwert, however observed that stock the scope of arbitrage opportunity widens Venezuela .163 1.72
Korea .0490 2.9428
returns are negatively related to current with increased volatility and extreme
Philippines .5221 2.257
and lagged values of inflation. mispricing. Virtually messy behaviour of
Source: Ilene Grabel, 'Assessing th
Considering return from index as depen-emerging markets offering an excellent Financial Liberalisation on Stock Market
dent variable, we tried to measure the opportunity to 'better informed', 'more Volatility'. Journal of Development Studies,
influence of each of the economic variablesrational', domestic and foreign institutional vol 31, No 6, August 1995.

in the movement of asset price (see Exhibit). Exhibit

Undeniably, a number of importantVariables List of Variables and Comments

variables which may influence stock prices
RET Return from stock indiex(RBI index number of security prices, all India, all Industries).
namely external sector disturbances, for- Return not adjusted for dividend payment. All time series excluding the interest rate
eign exchange rate, imports, etc, have been series are transformed into rates of change by the formula In (Xt/Xt.1) and measured
ignored in the present study. With this from period to period to avoid overlapping time periods which often produce serially
correlated error terms. Period of the study extends from January 1991 to April 1999.
caveat, observations of the present workDEB Interest on debenture. After 1992-93 average interest of high grade debenture has been
to be accepted.1 considered. Interest on t-1 is assumed to be a good predictor for expected rate of
Findings of Table 6 systematically dis- interest in period t.
YTB Yield on Treasury Bill. Yield on t-1 is assumed to be a good predictor for expected rate
approve rational expectation theory and of interest in period t.
refute the assumption of improved effi- YGB Yield on Long Term Government Bond. Yield on t-1 is assumed to be a good predictor
ciency of stock market in the post reform for expected rate of interest in period t.
DINF Change in the rate of inflation measured in terms of WPI. As inflation is highly
period. Findings of the present work are
autocorrelated overtime, the rate of inflation at time t-1 is assumed to be a good predictor
in accordance with the study conducted by for expected rate of inflation in period t.
Pethe and Karnik (2000). It appears fromDIIP Change in the index of industrial production. Actual future values forthe period t+1, t+2,
the findings that there is no long run stable etc, have been used as estimates for the expected values for future real activity at time,
t, in order to examine how stQck prices were influenced by the expected value of real
relationship between stock prices and factor. This consistent with the views of rational expectation theory.
macroeconomy. Value of R2 is even lessM3 Broad based money supply.
than 10 per cent in most cases, the valueNotes: 1) Return from index (RET) - Change in the index of Industrial pr
of the coefficients are broadly insignificant, 2) Return from index (RET) - Yield on treasury bill (YTB).
often they show some fuzzy relationship 3) Return from index (RET) Interest on debenture (DEB).
4) Return from index (RET) - Yield on long term government bond (
with share price earnings that hardly suits
5) Return from index (RET) - Change in rate of inflation (DINF).
in the existing theoretical framework. 6) Return from index (RET) - Money supply (M3)
Whether and to what extent expanded stock Source: Different issues of RBI Bulletin; The Economic Times, CMIE and Repor

Economic and Political Weekly January 27, 2001 373

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wealth to cater market tyranny so as to present trend continues, the theory of econo- allocation of resources in support of growth
castigate 'fool' by market timing.2 mists that capital market can allocate resour- and development. Specially, it is increas-
Experiences of India [Samal 1997, ces more efficiently than banks will suffer ingly recognised that, given the competi-
Mohanty 1997] along with other emerging a setback and the growth of the productive tion for foreign sources of funding and the
markets show, excessive speculation in- sector would be adversely affected. limited availability of domestic finance in
dulged by institutional investors is the single LDCs relative to their development needs,
most important reason for abnormal fluc- VII equity market could play an important role
tuation of share price in the post liberalisation in providing capital to the productive
period. Experiences further show that ram-
Conclusions and Policy sectors, as well as facilitating the process
page of hot money of FIIs gradually emerg-
Implications of privatisation. But efficient functioning
Why should we care about excessive
ing as a major source of shock for systematic of the market is an essential condition to
fluctuation of share prices? What are the
development of markets of less developed ensure the above benefit to the economy.
countries. Thus, there is no wonder that implications
the of irrational behavior of From the time of Adam Smith econo-
countries enjoying maximum blessing market
of for public policy? mists have extolled the virtues of the
Flls such as ASEAN and otherLatin AmericanThere is an increasing recognition among competitive price system as a mechanism
countries are experiencing consecutive policy-makers of LDCs about the benefi- for allocating scarce resources. The free
market breakdown. These experiences pro- cial role of stock market in mobilising and operation of the competitive market can
voke us to assume that the concept of 'global
Table 6
neo-classical model' of financial liberalisation
(1) Industrial Production and Stock Prices: Changes in the Stock Prices (RET) in period
suffers from 'doctor is the disease' syndrome. Regressed on Changes in Industrial Production (DIIP) in Period t+n.
'Price rigging', 'switching of funds', all
CONS DIIP DIIP DIIP DIIP DIIP R2 F DW
these standard strategies which FIIs often to t+1 t+2 t+3 t+4
follow to squeeze maximum benefit from
.0135 -.1217 -.2646 -.2917 -.1583 -.0375 .0739 1.437 1.11
globalisation can be nicely packaged under
(1.72) (-1.016) (-2.015) (-2.224) (-1.23) (-.31)
the cover of 'building casino to exploit
gamblers' theory [Delong et al 1990]. Strat-
(2) Money Supply and Stock Prices: Changes in Stock Prices (RET) in Per
on Measures of Money Supply (M3) in Period t-n
egy they follow of course neither fits in the
CONS M3 M3 M3 M3 M3 R2 F D W
Friedman-Fama model nor satisfy the social
to t-1 t-2 t t-3 t-4
needs but helps FIIs to defend their own
goal. The policy suggests - in response to -.045 .9607 -.0995 .6443 1.241 1.045 .0658 1.31 1.147
strong fundamentals when investors of (-1.509) (1.458) (-.153) (1.003) (1.9) (1.575)
emerging markets are in a buying spree, (3) Interest on Long-term Government Bond and Stock Prices: Chang
(RET) in Period t-Regressed on Interest on Long-term Governmen
ignoring cliche of rational expectationists,
FIIs employ their wealth to keep up the price. CONS YGB YGB YGB YGB YGB R2 F D W
The moment infatuation of crowd reaches to t-1 t-2 t-3 t-4
its pick, they offload shares to make profits. .1332 .0065 .0109 -.0071 -.0109 -.0094 .0464 .905 1.23

Thus we observe a positive correlation of (1.398) (.379) (.503) (-.321) (-.500) (-.552)
return during the period over which the naive (4) Interest on Debenture and Stock Prices: Changes in Stock Pr
domestic investors extrapolate and smart t-Regressed on Rate of Interest on Debenture (DEB)) in Per
FlIs collaborate with them and a negative CONS DEB DEB DEB DEB DEB R2 F DW
serial correlation of return in the long run to t-1 t-2 t t-43
when price reverts to mean. .3569 -.0010 -.0185 .0151 .0484 -.0656 .1011 2.09 1.421
This observation has a theoretical under- (2.217) (-.035) (-.463) (.379) (1.212) (-.311)
pinning that initial demand of FIIs always (5) Yield on Treasury Bill and Stock Prices: Changes in Stock Prices:
result from arrival of information about t-Regressed on Yield on Treasury Bill (YTB)) in Period t-n
strong fundamentals from LDCs and then CONS YTB YTB YTB YTB YTB R2 F DW
the whole process roles in. We maintain if to t-1 t-2 t t-3 t-
strength measured in terms of wealth influ- .403 -.0068 .0062 -.0158 .0118 -.0006 .042 .8156 1.2
ences pay off, powerful FIIs may manipulate(1.669) (-.648) (.415) (-1.048) (.781) (-.060)
price even in the absence of information so
(6) Inflation and Stock Prices: Changes in Stock Prices (RET) in Peri
that domestic trend chasers follow them.
Changes in the Price Level (DINF) in Period t+1
These sorts of price rigging are synonym to
CONS DINF DINF DINF DINF DINF R2 F D W
noise trading; clearly the attempt is to
to t+1 t+2 t+3 t+4
manipulate demand based on anything but
-.0130 1.457 1.037 .5601 -.1864 .4031 .0501 .9498 1.19
information. In any case price becomes noisy,
(-.862) (1.63) (1.158) (.620) (-.209) (.454)
it carries less information, it results in faulty
(7) Past Inflation and Stock Prices: Changes in Stock Prices (R
distribution of wealth, it causes excessive
Changes in the Price Level (DINF)) in Period t-n
gyration of share price that ultimately af-
CONS DINF DINF DINF DINF DINF R2 F D W
fects allocative efficiency of the market.
to t-1 t-2 t-3 t-4
The lesson of all these experiences is that
benefit that accrue to developing economy -.0162 1.1528 .7048 .5357 .1113 1.088 .0488 .9555 1.166

due to globalisation has a cost in terms of (-1.126) (1.349) (.823) (.634) (.131) (1.287)

higher risk of frequent market break. If the Note: Absolute t values are in parentheses below each coefficient.

Economic and Political Weekly January 27, 2001 375

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