Yes, it is a bubble. But it may last some time since it is part of a global bubble blown by major central banks printing money massively to combat the Covid-induced recession. They aim to keep interest rates close to zero. No policy reversal is imminent, so the bubble is not about to burst. But at some point, the US Fed will return to normalcy, raising interest rates. That could cause another “taper tantrum” as in 2013, when fears of higher US interest rates caused global investors to pull billions out of all emerging markets, including India. The rupee crashed from Rs 55 to Rs 67 to the dollar, and the Sensex collapsed. Former RBI governor Raghuram Rajan has warned this could happen again.
Why was it called a taper tantrum? Because the US Fed in 2013 proposed to taper its massive printing of money to assist the slow recovery from the 2008 recession (the Europeans and Japanese had done likewise). US interest rates were kept near zero. Global investors, dissatisfied with low US bond yields, plunged into emerging markets like India, seeking higher yields despite the higher risk. So, the Sensex and other emerging markets boomed.
But in mid-2013, the Fed said it was time to return to normal and raise interest rates. This was unanticipated. The same global investors that had charged into emerging markets now charged out in panic, causing havoc.
Will this happen again? Optimists believe that, learning from experience, the Fed will give ample notice of any future rise in interest rates, avoiding any panicky tantrum. If so, rather than bursting, the emerging markets balloon may deflate gradually. Nonetheless deflation means a big reverse flow of dollars back to the US and other safe havens.
To grasp the impact of foreign inflows on the Sensex, see what happened in 2020. When Covid struck, foreign institutional investors (FIIs) withdrew almost Rs 62,000 crore from Indian stock markets in March, and the Sensex crashed from 41,000 to 26,000. But as stock markets recovered across the world, FII inflows into India soared again, touching Rs 47,080 crore in August, Rs 60,350 crore in November and Rs 62,016 crore in December. This has driven the Sensex to record heights, but also highlighted its vulnerability to outflows.
Domestic investment in our stock markets is now substantial, cushioning foreign outflows. However, by historical standards Indian markets are highly overvalued. The ratio of Sensex share prices to company earnings is now over 34, against under 20 historically. China’s ratio today is just 17.5%. The Sensex has been bloated by the global flood of central bank money. The flood will ebb one day.
Some economists disagree. They think the world suffers from “secular stagnation” that keeps interest rates and inflation permanently lower than historical rates. They cite long-term trends like slower productivity growth; ageing and population stagnation that reduces the proportion of people available for work; and the shift from industry to services which are less investment intensive. The combined effect is a persistent glut of global savings and reduction of investment demand. This will put downward pressure on prices and interest rates even in the long run. Hence, these economists believe countries can run much bigger deficits and print much more money than earlier without causing inflation. This will keep money flowing to emerging markets, justifying high price-earnings ratios.
Other economists disagree, arguing that printing money has indeed caused inflation, but of assets (stocks, bonds, land, gold), not consumer prices. This is better than consumer inflation but is inflation nevertheless. Many people love booming markets and the prospects of massive investment in infrastructure at low interest rates. But massive money printing also has undesirable side-effects. First, it keeps low-productivity enterprises alive that should normally go bust. The “creative destruction” that drives economic growth requires resources to constantly shift from old, low-productivity companies to new ones with higher productivity. The flood of printed money props up dud companies artificially, preventing the creative destruction required for long term economic growth and prosperity.
Second, cheap, plentiful money will induce investment in risky areas, producing many flops. This too will slow long-term economic growth and employment. Third, inequalities will rise sharply. Assets are owned mostly by the rich, who benefit most from asset inflation. Fourth, soaring stock markets create an illusion of prosperity that reduces the political urgency of much-needed reforms.
I see merit in both sides of the argument. On balance I side with the pessimists. I am not overjoyed with the Sensex at 50,000.
