Columns - The Sunday Times Economic Analysis

The economy and the stock market performance

By the Economist

There is a tendency to think that the performance of the stock market is an indicator of the country’s economic performance. Most people, including foreign observers, draw a connection between the economy and the stock market and the stock market and the economy. It can hardly be denied that there is an association between the two. Yet that relationship is not as strong as it is made out to be. It is often a very tenuous connection, especially in an economy such as ours and in a rather narrow stock market like the CSE. It is because of this presumed relationship that the government has directed government agencies such as the EPF, ETF, state banks and other government controlled institutions to invest in the stock market. This controversial intervention has in turn boosted the share market and made it the second best performing market in the world.

Recent international comment owing to the Colombo Stock Market being the second best performing stock market in the world, and for a while it was even the best performing market, has drawn considerable attention and comment. A television commentary from Singapore maintained that the rise in the Colombo Stock Exchange to over 7000 points on the All Share Price Index was supported by the country’s economic conditions and economic prospects. One of the basic arguments supporting this contention was that the economy has grown by as much as 8.5 per cent in the last quarter and that the economic growth for the year is likely to be 7.5 per cent. This is a high rate of growth and most commentators believe that it would be achieved.

It must however be recognized that the economic growth of this year is high partly due to the low rate of economic growth last year, the spurt of economic activity brought about merely by conditions of peace in the North and East, such as is the case in agriculture and fisheries. These may not have a lasting impact on economic growth. Therefore there is the issue of longer term sustainability of economic growth that requires higher rates of savings, investment and good macroeconomic fundamentals.

There are several other qualifications too that one has to make about this relationship. First, overall economic growth is based on a far broader economy than reflected in the share market. For instance the performance in domestic agriculture that is still important and contributes to the growth of the economy is outside the pale of the stock market. Many economic enterprises are not listed in the stock exchange. This is not so in developed countries like the United States where much of the economy is in the hands of companies listed in the stock exchanges of the country and internationally.

In Sri Lanka even much of the industrial and trade sectors are outside the orbit of the stock market. For instance garment manufacturing firms are hardly in the stock market. This in turn means that particular sector performances could be more relevant. The high performing shares are in investments in those sectors that have good prospects of growth such as the tourist trade and hotels. Diversified holdings and banking and finance whose fortunes are affected by the state of the economy have also benefited. The increase in tourist arrivals by about 50 per cent this year and the prospects of increasing tourists next year is the reason for the prosperity of the hotel industry. Therefore shares in the hospitality trade could be expected to rise more than the rate of growth of the economy. Conversely, the rate of growth in the economy could have little effect in improving the intrinsic value of some shares.

Some foreign commentators believe that the fundamental macro economic conditions for development would be achieved and that the country’s economy would grow at a high rate. The assessment of the IMF too gave hopes of such aspirations. The fundamental question that is repeatedly raised is whether the required fiscal consolidation would be achieved. Internationally there is much expectation that fiscal reforms are in the pipeline in accordance with IMF requirements and that these would be included in the Presidential Tax Commission recommendations and would be implemented with the November budget for 2011. Fiscal reforms that are expected to bring about increased revenues would have to await scrutiny. There has been a tendency for theoretical justification of various taxation measures that may not in fact yield the required revenues. The strategy of the tax net being broadened and tax evasion and tax avoidance being reduced have proved correct in developed countries, but the achievement of such results in Sri Lanka remains to be seen. Some of the expected changes are a decrease in income tax rates and a reduction in the value added Tax (VAT).

One has to be sceptical about the realization of higher revenues as a result of such changes, even though in some developed countries it has had such a desired impact.

The ingenuity of tax evaders, the inefficiency, bribery and corruption and political interference in tax collection have to be factored in. The reduction of certain taxes no doubt has resulted in an increase in revenue collection. The conspicuous example is the reduction in the tariffs on motor cars and other motor vehicles that have resulted in more than a proportionate increase in tax revenue from these items. While this strategy would increase revenue, it is to the disadvantage of the trade balance and the balance of payments. The revenue collection of only 15 per cent of GDP is low for the country’s per capita level and has to be increased to around 20 per cent of GDP.

Besides, there is no evidence of moves on the side of expenditure reduction. Fiscal consolidation would require reform in public expenditure. There is considerable wastage of money in government expenditure. The estimates presented in parliament for 2011 has little expenditure cuts in several ministries. The huge losses in public enterprises are a big burden. Whether the next budget would address these issues is to be seen. There are also huge pressures for increased wages in the public sector.

Those who believe that the rise in the share market was due to the healthy economic fundamentals and prospects for growth may be hard hit to explain why the market that soared to over 7000 points has now dipped. Is the economy in a down turn? Are the fluctuations in the share market a reflection of fluctuations in the economy? This is certainly not so. The Colombo Stock Market performance like most markets is due to speculation. There is little doubt that the recent market performance is not directly related to either economic performance or market fundamentals. It has been guided by market sentiments, speculation and government intervention. The stock market is overheated and a correction is on the cards.

Lord John Maynard Keynes, was nearly wiped out following the Stock Market crash of 1929, but was ultimately a successful investor, building up a substantial private fortune. Keynes who is reputed to have made much money on the London Stock Market, compared share markets to a casino. He said that if an economy is managed like a share market, its work is likely to be rather ill done.

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