We are growing up

The CMIE Cospi index is a total returns index of all firms in India where trading took place on atleast 66% of the days in the last six months. This is a weak liquidity filter. For all practical purposes, this is the Indian equity market.

The index level has fallen quite dramatically in recent months: from above 3200 to below 2000:

The bulk of this fall lies in a reduction in (trailing) P/E which dropped from 35 to 20. The world looks more gloomy as compared with what we saw in December 2007:

The market capitalisation of the index was above Rs.70 trillion; it's now below Rs.45 trillion:

The Economic Times would scream in their headlines that over Rs.25 trillion of wealth has been destroyed. But even at Rs.45 trillion, the stock market remains the most important component of Indian finance. As I often like to say, Indian finance is a plane running on one engine: the equity market.

I interpret the number of firms in the CMIE Cospi index as a measure of how many management teams in India have access to modern finance. This is has dropped by roughly 100 firms:

I'm impressed at the equanimity with which the Indian economy has digested this decline in stock prices. In the past, these kinds of large movements would have generated a lot more turmoil.

On one hand, every time large price movements took place, there would be accusations of a scandal. It would be claimed that there is some fraudulent foundation of the change in prices. Or, there were fears of a payments crisis whenever prices moved. And, sadly, India had a long history of difficulties on the equity market, so some of these fears were justified. But with the equity market reforms from 1994 to 2001, these fears have largely subsided.

Under socialism, prices did not change, so fluctuations of prices are often bewildering to people who spent their formative years under socialism. People who do not understand how financial markets work are prone to jump to the conclusion that these fluctuations are somehow wrong. On one hand, this leads to claims that the markets are a gambling den. I have met some senior economists in India, who had occupied prominent positions in government, who believe that all capital inflows into India are based on fads and whims, that there is no information processing or forecasting or economic logic underlying capital flows.

This kind of ignorance leads to demands that the government should do something every time prices change. When prices go up, the government is pressured to try to bring down prices. When prices go down, the government is pressured to try to push prices up. In the socialist worldview, prices are fixed, so all price volatility is bad.

But we're getting better: The CMIE Cospi market capitalisation dropped by Rs.25 trillion and we're hearing none of this. As the years go by, people out there in the real world are grappling with India as a market economy, and particularly the younger generation is coming to terms with the idea that prices must change in response to news; that a market where prices do not change is actually rigged.

So the good news is that we're growing up. When we attain this state of equanimity with fluctuations of the exchange rate, I will write a blog post saying that we have grown up.

On the subject of finance as a shock absorber, see Finance and growth: When does credit really matter? by Fabrizio Coricelli which offers new arguments about the mechanisms through which financial sector development influences economic growth in developing countries.