Arbitrage Magazine - July 2021 - Finance & investment Club | IIM Rohtak

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presents

July 2021 Vol 4 Issue 17

Our best read - Elon Musk’s influence on the cryptocurrency market-What lies ahead?

Special Mention: DA Hike in India Midst July ’21: A Consumption Boost?; Zomato’s Economics

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INDEX

S.No.

Article

Page No.

1

Elon Musk’s influence on the cryptocurrency market-What lies ahead?

3

2

DA Hike in India Midst July ’21: A Consumption Boost?

7

3

Zomato’s Economics

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4

Immigration- The Growth or Threat Dilemma in the 21st century

16

5

The Intertwining of Blockchain and Finance - #FinChain

22

6

WILL THE STOCK MARKET END IN TEARS?

24

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Elon Musk’s influence on the cryptocurrency market-What lies ahead?

By: Sphurti Srivastava (Gargi College, New Delhi) Cryptocurrency is basically a digital or a virtual currency that serves as a medium of exchange.

One of its main features is that it works independent of a bank or a central authority. It has emerged as a solution to the problems faced by modern banking system such as technical issues, identity theft, restriction on transfer limit and so on. Over the past few years, cryptocurrency has become very popular among the masses owing to its little to no transaction cost, 24/7 access to money, faster international transactions and no limit on purchases and withdrawals.

Elon Musk has emerged as major player in the cryptocurrency market. With over 44.7 million twitter followers, Elon Musk has the power to significantly influence the crypto market. In 2014 Elon Musk mentioned bitcoin to probably be a good thing. In 2019, he ventured into a more into a more committed crypto journey. Elon Musk’s company tesla announced that it had invested $1.5 Billion in bitcoin. He also tweeted that his company will be accepting payments for their cars in bitcoins as well. This announcement added to the credibility of bitcoin and it reached its all time high of $58,000. However very soon, Elon Musk changed his mind and Tesla sold 10% of its investment in bitcoin creating a panic among investors. He also questioned the environmental impact of the asset and announced that Tesla will no longer accept payments in bitcoin owing to its high energy consumption in the mining process. This decision let to the downfall of bitcoin which fell to $30,000. However, he did not stop. He continued to toy with crypto and took to twitter to show his support for greener mining processes. Following this the value of bitcoin jumped by 19% to $39,944.

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Source: weisscrypto Figure 1: Impact of Elon Musk’s tweet on BTC (Bitcoin) The above figure shows how the bitcoin market was impacted within hours of Elon Musk’s tweets.

On the X-axis we have time in hours and on Y-axis we have value of bitcoin. His criticism of bitcoin’s energy consumption and Tesla’s refusal to accept bitcoin as payment led to 16% drop in its value in just 3 hours. His 2nd tweet stating that bitcoin is highly centralized led to fall in its value by 12% in 11 hours. His next tweet clarifying that Tesla hasn’t sold its bitcoin investment led to increase in its value by 8%. Between these three tweets, bitcoin dropped by 22.85% in total. Similar trend was observed in altcoin market.

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Source: weisscrypto Figure 2: Impact of Elon Musk’s tweet on alternative cryptocurrency market (excluding Bitcoin) The blue shaded area represents the total time period of Elon’s tweet. As you can see between this period alternative cryptocurrencies also dropped by 18.41%.

The above discussion paints Elon Musk as a major influence in the crypto market who has the power to shake the market with his tweets. The question which arises is – Is this really true? The answer is no. The decline in market though aided by Elon was never driven by him. Every price cycle of any asset is divided into four phases- Accumulation, markup, distribution and markdown.

In 2020, the crypto market went through an accumulation phase, with many investors entering the market. In mid-February 2021, the asset reached the markup phase and settled at an all-time high of $60,000. The asset reached its distribution phase when RSI indicated that the asset has been overbought, thus triggering its slowdown. A close look at bitcoin chart show that the value of bitcoin was decreasing prior to any announcements made by Tesla. Bitcoin fell over 30% in the month of May but its value is 300% higher than last year. Elon Musk’s tweet questioning the

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environmental impact of bitcoins played an important rule in lowering its value. However, it wasn’t the sole reason for the fall in its value. Many other factors also acted as a catalyst for driving investor’s sentiments. The conclusion that we draw from the above discussion is that the cryptocurrency market is highly volatile. This extreme volatility enables growth in the value of cryptocurrency. The market is expected to remain bullish in the coming years. Although a drop of 22% may seem severe but it isn’t the norm in crypto market. The drop seems to have shaken new comers and casual traders; however, institutions are seeing this as a buying opportunity. The only cryptocurrency that relies on Elon Musk is dogecoin. As for the other cryptocurrencies, we must study cycles theory to navigate this volatility in crypto market.

References •

Marija Matic (2021). Elon Musk’s influence over crypto market. https://weisscrypto.com/en/article/elon-musk-s-influence-over-crypto-market

•

Economic Times (2021). Extent of Elon Musk’s influence on cryptocurrency; where is it headed? https://economictimes.indiatimes.com/markets/cryptocurrency/extent-of-elonmusks-influence-on-cryptocurrency-where-is-it-headed/articleshow/83037268.cms

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DA Hike in India Midst July ’21: A Consumption Boost?

By: Anyatama Basak (Xavier Business School)

Source: Highland financial Advisors The Union Cabinet of India, in the month of July, 2021, has announced an increase of dearness allowance (DA) and dearness relief (DR) to 28% of basic from 17% being the existing rate of basic pay or pension. This can benefit a total of 11.4 million central government employees, splitting into 48.34 lakh existing employees and 65.26 lakh pensioners. The additional annual burden to be imposed due to this hike is calculated as Rs. 34,401 crore on the exchequer. The policy initiative has been remarkable in the trying times of pandemic since developing countries like India has experienced a major fall in the consumption expenditure by the citizens for almost over a year which has affected the collection of revenue by the government as well. Therefore, analyzing the impacts of such initiative has become important since it will directly impact the gross domestic product (GDP) of the nation along with other economic indicators in the upcoming years.

The analysts believe that the measure is well-timed as festive season of the country will remain from September to December to manifest this decision in terms of higher spending. The last year has shown leave travel (LTC) consumption allowances to be given even after months-wide lockdown and having different restrictions on the transportation, tourism in order to give a chance to spend the money in other consumption purpose. As we know, if the people do not have enough

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liquid cash in hand to spend for consumption, demand will not generate, followed by less supply, which in turn will lead to slowdown of the economy and fall in GDP.

Graph 1: Consumer spending in India from January 2017 to March 2021 (in billion Indian rupees) Source: MOSPI (January 2017 to March 2021), Trading Economics, Statistia 2021 Covid has changed household consumption patterns causing a rise in savings than expenditure during last one year. If we review the economic history to see how this kind of allowances have impacted the consumption, we can find that it has positive spillovers on private urban discretionary consumption, effects are typically biased to the furniture, recreation goods and services, consumer durables,. In a normal year we will have similar kind of conclusion regarding the pattern of consumption, but as we are in between a pandemic year, which have induced certain behavioral changes at the household level, we can anticipate that a part of this income boost will find a way to the precautionary savings.

The increases in dearness allowance and dearness relief will cheer up the market in terms of consumption for FMCG, white goods and automobiles. The effect of pandemic in last 15 months, especially in the second wave has hit the most to the middle class, who have the sufficient earning to spend their livelihood, but not excessive savings to spend on luxurious goods and services.

Excessive medical expenses along with unemployment among the family members have been the worst impact, also on the low income group people. Besides, the pandemic has left many emotional

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traits which have drastically changed the usual pattern of savings and consumption expenditure.

Adding to that, we are witnessing inflation now, as different production sectors have experienced a downfall for a long period and there is upsurge in demand, specifically for emergency goods.

Though the headlines showing inflation number may not be alarming, but the common man can actually feel the pinch in their daily needs. The effect won’t be same as seen after the first wave, instead of spending it is expected to be used mostly for basic financial need and savings.

Diagram 2 & 3: Demand-pull inflation Source: EzyEducation.co.uk This hike would have a marginal but a transitory effect on prices. It gives credence to our belief that the drivers of inflation will shift from supply side to mostly as demand driven. Demand pull inflation will take precedence as we move to the second half of the year with the progress of vaccination. This will take place due to an increase in prices which creates a shortage of supply.

Consumers’ demand surpasses the available supply of goods and services, the rise in aggregate demand (outward shift in the AD curve) outweighs the aggregate supply and thus price goes up.

Positive changes in consumption, government spending (other factors being investment, net export) lead to this situation. Then it is likely to create an inflationary effect on the economy due

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to large number of people having more disposable income, where real output keep changing as the price level increases significantly.

Diagram 4 & 5: Difference between consumption and investment driven demand-pull inflation Source: EzyEducation.co.uk As higher disposable income is expected to increase the consumer expenditure on consumption purpose, unlike investment-led inflation having higher rate of capital accumulation and an ultimate rise in output in long run, consumption-led inflation will generate a scope of upsurge of prices of goods and services and the aggregate supply in the short run to meet the increased demand, though in long run real output remains unchanged with high price level assuming ceteris paribus.

34,401 crore is a huge amount for Indian economy to spend for the employees. As given by the fact that fiscal deficit being 7.8-7.9 % of GDP against the budgeted number of 6.8%, in monetary terms the effect will be highlighted. In terms of ratio to GDP, it can effect in different amount.

The absorption of the amount is not an issue at present, but the government should keep in mind that once it is increased which cannot be reversed, this particular amount will be added to the system every year, for what the government has to make provisions in terms of payments to its employees, as well as the pensioners. As the economy is not able to generate enough jobs amidst

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pandemic, this kind of push given by the central government will be fruitful, but it is also expected that the states will follow the rules and will help to impact the fiscal side of the economy positively.

Graph 6: Inflation rate in India from 1986 to 2026 (compared to the previous year Source: IMF, Statista 2021 If our domestic production capacities of vaccine can get ramped up shortly and foreign import for the same is allowed, more than half of the population can be vaccinated with single dose by the end of the year. This will going to have an extremely strong impact on consumer sentiment which has been relatively subdued throughout last year. As we have seen, the countries which having higher percentage of vaccination, consumer demand is used to pick up with it. All these fact put together we can expect that consumption recovery followed by Increase in GDP will look more effective as Indian economy moves towards the end of this calendar year.

References: • • •

News article by Hindustan Times News article by Times of India Report by Business Standard

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ZOMATO’S ECONOMICS By: R.Balaji & R.Jeyraram (IIM Ahmedabad & IIT Palakkad)

Zomato is an Indian Multinational food delivery company founded by IIT Delhi graduates Pankaj Chaddah and Deepinder Goyal in 2008 under the name Foodiebay. Slowly Zomato started expanding across the world. Now, Zomato is operating in 24 countries and more than 10,000 cities. Zomato (IPO) had been in the headlines for the past two to three weeks.

The food delivery behemoth Zomato successfully finalized its Initial Public Offering (IPO) share allotment on July 16, 2021. Zomato’s IPO was greeted with great response from investors and many investors oversubscribed its share by 38 times from its opening day on July 14, 2021, till its close date. Zomato acquired an amount of INR 4,195 crore by bringing down from the initial INR 9,375 to 5,180 crores on July 13, 2021, a day before hitting the open market. Its net proceeds from IPO are about INR 6,750 crore.

This amount has been allocated to growth initiatives by the company. Zomato took a long way to achieve this status. How Zomato financially transformed into a robust food chain in India?

The basic revenue structure of any food delivering company is the commission they charge from restaurants based on the orders. The commission earned is split between the company and delivery partners. Due to high competition and the need to provide huge discounts, it contributes only low percentage of revenue and sometimes losses. This is the field where the company implemented its one rupee profit mantra (positive unit economics). For instance, if Zomato delivers food to the customer by spending INR 20, it tried to get INR 21 as its commission after paying delivery partner. Therefore, no losses from delivering food. But over a long period of time, Zomato couldn’t make break-even here.

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The more important metric Average Order Value (AOV), the average value of any order placed by the customer on the Zomato app. For instance, if a customer places 3 orders with values INR 300, 400 and 500, then Average Order Value is INR 400. Think of the case, where two customers in same locality ordering food from the same restaurant with different order values of INR 100 and 700. The cost of delivery and % of commission (20%) will be same for both deliveries. The later order tends to be more profitable than the former. If a customer consistently makes expensive orders, AOV witnesses a hike in its value. The increase in AOV tends to enhance positive unit economics. The average value rose from INR 264.6 in 2020 to INR 407.8 in 2021 as shown in Fig.1

Fig.1 Trend of average order value of Zomato (2020 – 2021) This gradual hike in AVO is the function of COVID-induced lockdown. When the government started relaxing lockdowns, it first removed restrictions over food delivery units across the country except for the containment zones. When the revenue of so many sectors is dipping, the revenue of food delivery sector boasted this year. The main customers of Zomato are lone working bachelors in cities Due to COVIDinduced lockdown, many bachelors migrated home and influenced their families. This brought a huge change in customer demographics of Zomato. Apart from this bachelors who continued to work in companies during lockdown relied mostly on food delivering companies like Zomato. So, COVID imposed lockdown shot up the value of AVO and company harvested the revenue due to the combined effect of COVID-induced lockdown and its positive unit economics. This is also one of the reasons why many people say Zomato is volatile owing to lockdown.

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Even though COVID assisted Zomato in driving its business, the other financial numbers didn’t inspire much. There was a viewable decline in AOV after the third quarter of 2021 which indicates the active users of the app are declining. Even though the company is getting profit on each order, it is still loss-making as shown in Fig.2. Zomato’s unit economics mantra forgot about the fixed costs like marketing, advertising and other expenses.

Fig.2 Revenue and losses of Zomato (2020 – 2021) The food delivery industries contribute only about 8-10% to the food market in India, whereas in countries like U.S and China it is about 40-50% of their food market. So, there’s hope for growth of Zomato. But, many economic analysts arguing that if Zomato would achieve this, then Amazon would have achieved this before. Doordash is a food delivery company in the United States. It has very good financial numbers. It makes more profits and operates in a hungry market. So, the journey of Zomato to achieve Doordash’s profitable numbers depends in the phones and tongues of people.

Sources & References 1) https://www.moneycontrol.com/news/business/markets/zomato-up-85-after-listing-ubs-jm-financialstart-coverage-with-buy-rating-7248031.html 2) https://indianexpress.com/article/business/market/zomato-ipo-live-updates-price-band-issue-sizeanchor-portion-subscription-status-7402047/ 3) https://www.sebi.gov.in/filings/public-issues/apr-2021/zomato-limited-drhp_49956.html

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Image References 1) https://www.smctradeonline.com/upcoming-ipo/zomato-ipo https://timesofindia.indiatimes.com/city/noida/in-jewar-the-new-one-rupee-coin-suffers-a-selfimposed-ban-by-traders/articleshow/70930058.cms.

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Immigration- The Growth or Threat Dilemma in the 21st century By: Ritika Pal Chaudhuri (XIMB) The debate surrounding immigration has been a point of deliberation for economists and policymakers for many years now. In the 21st century, with the rapidly changing political and economic conditions, immigration seems to be conceived as an unsolved puzzle by nations, both developed and developing. One of the most common implications of immigration is the effects on the existing wage structure and the impact on employment.

The World Migration Report 2020 claims that 3.5% (272 million) of the world population comprises international migrants globally. The male to female ratio is not too much skewed; it has been recorded at 52:48. The top countries with the peak number of migrants in other countries were India, Mexico, and China. The USA topped the list as the most preferred destination country for immigrants, with 50.7 million international migrants.

Fig1: Migrant workers by destination country income level, 2013 and 2017 (Source: ILO 2018)

The decrease in migrant workers in high-income countries can be attributed to stringent immigration policies and increased economic growth in middle-income countries (The World Migration Report 2020). Here, it is essential to note that migrant workers move into the country

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with fewer or less stringent labor regulations because most migrate for a better life than they can achieve by getting employed in better jobs than in their home countries.

One of the most famous works on immigration was done by David Card in 1990 on the Mariel boatlift, which concluded that the influx of Cubans in Miami after Fidel Castro lifted the emigration ban. Over the years, many studies have confirmed this conclusion, but George Borjas denied the claim in his 2015 paper, starting a debate that continues even today. Many economists criticized his paper on many grounds, but some agree with him that immigration had adversely affected the wages of native workers. George J Borjas, regarded as America's leading immigration economists, in his 2019 paper, asserts that the immigration contribution to the growth will be much more beneficial if they compose of high skilled workers.

There is an assumption that natives and immigrants are perfect substitutes, but that is not always true. There is an intriguing concept of substitutes and complements concerning native workers and immigrant workers. If the native and immigrant workers are imperfect substitutes in production, there will not be any insignificant effect on the wages of the native workers (Manacorda,2010).

The rationale is that if they have different skills, they do not pose potential threats to each other's employment opportunities.

Different sectors in the economy need the labor of varying skill levels, so the wages are not affected in a similar way throughout the economy. The sectors behave distinctly to the immigration of workers depending upon whether they are high-skilled or low-skilled. If the immigrants are lowskilled, the labor supply increases in the low-skilled employment sector, and the wages decrease (See figure 2). Therefore, the native low-skilled workers lose out. But on the other hand, low wages mean higher profits for the native employers. Hence, there is a redistribution of wealth from the native employees who lose out to native employers who employ low-skilled employees at lower wages.

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Figure 2: Effect of increase in labor supply on the equilibrium wages in the labor market

An important point here is that with immigration, both labor supply and labor demand increases.

As immigrants start earning, the demand for goods and services increases, boosting the demand for the labor needed for the production. The effect on the equilibrium wage depends upon the extent of the rise in labor supply and demand, and therefore, the outcome remains ambiguous.

There are conflicting ideas about how immigrants affect the wages of native workers; policymakers continue to be divided on this issue while forming immigration policies for the nations. It is commonly believed that most of the workforce moving into a country is composed of low-skilled workers, who migrate for a higher standard of living and better job opportunities. But the fact that high-skilled workers migrate too has magnified effects on the economy; they earn higher wages, pay taxes, and increase demand for goods and services, boosting production.

Therefore, GDP and employment increase overall.

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Opening the borders for immigrants is still a controversial issue in the 21st century. Some believe that immigrants burden the country's existing resources, given that the resources are a constraint for any nation. On the other side of the coin, when more and more individuals work and earn, buy and consume, boosting the economy, the economic pie increases benefitting everyone. The increase in GDP gives the nation the capability to provide better education, health infrastructure, and living standards.

Immigrants not only migrate to another country for a better standard of living but also to seek refuge when the condition in their home country becomes too hostile and violent for them to survive. And then, the political aspect comes into the picture apart from the economic effects discussed previously. The number of individuals displaced due to violence and conflict was at an all-time high since 1998, at 41.3 million globally (The World Migration Report 2020).

Figure 3: Number of refugees by top 5 countries of origin as of 2018 (millions) Source: UNHCR (United Nations High Commissioner for Refugees)

It is a primal human instinct to assist those in need and provide protection, but policymakers often think that such an influx of population might pose security and terror threats for the citizens. There

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are often clashes in ideologies based on political relations with the other nations, and also, the religion of the immigrants plays a significant role in deciding on giving immigrants citizenship in some cases.

There has been an international uproar where immigrants have been discriminated against based on religion because it is inhuman and impractical. Nations try to control the immigration policy to favor the influx of highly skilled labor. The share of governments worldwide has increased to 2 times between 2005 and 2015 (International Migration Policies Data booklet) from 22% to 44%.

Most governments globally have policy mandates to tackle irregular immigration and employ various measures like fines, detention, or deportation, but irregular immigrants are more susceptible to exploitation and abuse by trafficking offenders and crime cartels. But the deportation policies have been widely criticized due to their inhuman nature of detaining and treating undocumented migrants in camps and prisons.

There has been an overall increase in international remittances globally in the past decade.

Remittances continue to be a stable source of capital inflows compared to FDIs (Foreign Direct Investments). India and China continue to remain the leading countries receiving internal remittances with an exceeding margin compared to the following three in line. The USA has remained the highest remittance-sending country for many years now, and usually, high-income countries are the top countries sending remittances.

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Fig 4: Top countries receiving remittances (Source: World Migration Report, 2020) Immigration is not a black and white concept and cannot be viewed by only economists or policymakers because it is much more than just an economic issue. It is a human issue that can alter the lives of millions of individuals and families across the globe. It is a topic of evolving debates and deliberations amongst economists, policymakers, governments, human rights activists, environmentalists, institutions, and most importantly, the most significant stakeholder: immigrants and native citizens.

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The Intertwining of Blockchain and Finance - #FinChain By: Yash Garg & Kanika Mahajan (Shri Ram College of Commerce) Finance is the management of a large amount of money, especially by investment bankers and the government. But what if I tell you that investment banks are spending more than $12 billion on one of the most underrated expenses of the industry, i.e., transaction commission? According to Reuters, popularly called the best minds of the finance in the bulge bracket, IB (investment bank) firms spend more than $12 billion annually in transactions costs and commissions. The above amount is almost equal to one lakh crore, or we can say it is equivalent to the total market cap of Zomato. Surprisingly, this amount can be reduced to zero if they adopt blockchain technology.

Blockchain is a type of computerized ledger, which relies on cryptographic techniques and new methods for consensus to capture and secure data. Unlike conventional banking systems where we find power concentration in the hands of some banks and governments, blockchain technology is based on decentralization. Today, we have to rely on and trust some third party for economic activities such as banking, insurance, etc. But blockchain can remove the requirement for customers to trust a third person or entity to maintain the records on their behalf. Blockchain technology can cut processing time, overall friction in the system, which leads to late transaction clearance. Additionally, it can reduce back-office costs involved in reconciling data across the organization thereby lowering the barrier of entry.

Primary security issue Blockchain technology can help companies to issue primary security in the market. Issuing bonds and loans through blockchain technology helps to share a record of transactions and updates with all the parties (issuer and holder). The blockchain system can automate functions like the distribution of cash flows in accordance with the parties’ (holder of securities) legal rights through smart contracts. Currently, these processes are done manually. The issuer shares the PDF copies of the loan with the holder, amendment if any is communicated through emails. For cash flows, the holder has to rely on and trust the issuer to record the inflow of cash in the database. The enormous use of these resources can be reduced through Blockchain technology, as each and everything will be recorded automatically in a decentralized ledger.

Security clearance Securities transactions can be executed in nanoseconds, but the actual delivery of the securities still takes one to three trading days and even weeks for certain kinds of bonds. A shared ledger system can enable real-time clearing and settlement of the transactions in no time. It eliminates the need for the reconciliation of duplicative records. This is because the consensus mechanism of the blockchain disallows any duplicative or manipulative transaction to be a part of a chain. Many stock exchanges are working on this; NASDAQ is experimenting with the blockchain for early settlement of the securities, they have collaborated with the startup named Chain for the same.

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Derivative clearing Derivatives are undoubtedly the most fascinating and the cash cow for any hedge fund or investment bank. The post-trade process for settling most derivative transactions is relatively more complicated than the securities settlement. Clearing derivatives trade transactions can even take weeks. The contractual clauses of the derivative transactions can be coded into smart contracts through platforms like Ethereum. Even global organizations are taking an interest in blockchain frameworks. DTCC (Depository Trust and Clearing Corporation) collaborated with IBM to provide a blockchain framework that can automate life cycle events, record keeping, and payment management. To provide the market with a standard set of digital definitions and smart contracts, International Swaps and Derivative Association (ISDA) collaborated with Regnosys. Distributing and automating functions reduces the Counterparty risk and cost.

Post Trade Reporting After trading for exactly six hours from 9:30 am to 3:30 pm, the next step for any trader or investment banker is post-trade reporting. Blockchain can be used in post-trade reporting also as Distributed ledger system includes each transaction. It is immutable, and no one can forge transactions, and it would help to reduce the irregularities in recording transactions. Today blockchain technology is so advanced that regulators can also access the ledgers. Therefore, reporting can become automatic and comprehensive with no scope for cheating by IB firms.

Conclusion Today, there are many challenges to implement blockchain technology due to a lack of scalability.

VISA cards can clear 24,000 transactions per second, whereas blockchain technologies such as Bitcoin and Ethereum have a total capacity to clear ten and twenty transactions, respectively. But many zero consensuses or zero proof-based blockchains such as Definity can clear unlimited transactions per second as it doesn’t rely on a single chain; however, it relies on sub-networks, which help it clear numerous transactions per second. Despite many technical challenges around performance, privacy, and scalability, blockchain is the future of finance. This is because the opportunity cost of adopting blockchain is the least, and the profit generated from it is the maximum. Global organizations have taken solid steps to intertwine it in financial markets. Now it's time for India to take the first-mover advantage in the blockchain revolution. The counterparts of India, such as China and the USA, are way ahead, but now it's time to take a leap.

References: • • •

“Blockchain could save investment banks up to $12 billion a year, Accenture” Reuters, 17 January 2017.

“DTCC Milestone: $11 trillion in Derivatives Gets Closer to The Blockchain”, Coindesk, 20 October 2017 “Next Step to CDM”, ISDA DerivatiView, 21 February 2018

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WILL THE STOCK MARKET END IN TEARS? By: Vachi Agarwal (St. Xavier’s College, Kolkata)

“Double, treble, quadruple bubble, watch the stock market get into trouble...”

This famous adage by Garth Nix appropriately warns about the anatomy of a stock market bubble staring India and the prospects of this excessive valuation to end in tears.

The domestic stock markets have touched record high levels and generated high double-digit returns during 2020-21 even as the country’s economy continued to face disruptions on the back of unparalleled levels of monetary and fiscal stimulus. Between 6th February to 30th September 2020, the Reserve Bank of India (RBI) had announced a total liquidity support of ₹11.1 trillion.

Expansionary monetary policies had been adopted worldwide with an aim to bring down interest rates to near-zero levels, drive economic activities through provision of cheap debts and massively scale up the purchase of assets resulting in a rise in direct participation of retail investors and witnessing an opening of over 1.43 crore Demat accounts during 2020-21.The availability of cheap money encouraged increased speculation from novice retail investors and high Foreign portfolio investment(FPI) inflow ,thus, contributing to the rising stock prices. With the temptation to make hay while the sun shines, Initial Public Offers (IPOs), Follow-On Public Offers (FPOs) and rights issues increased manifold by 43.1% during 2020-21. According to RBI, the high amount of liquidity that has been injected into the economy to aid economic recovery has had “unintended consequences” in the form of inflationary asset prices. India’s equity prices continued to surge, with the benchmark Sensex crossing 50,000 in January,2021 and on February 15,2021 Sensex touched a peak of 52,154 — a 100.7% increase from the slump just before the beginning of the nationwide lockdown on March 23, 2020. The BSE Sensex surged by 68% to close at 49,509 while the Nifty 50 increased by 70.9% to close at 14,691 on March 31, 2021.[1] This continuous rise in asset prices has been in stark contrast to the estimated 8% contraction in GDP in 2020-21, thus, posing the risk of a bubble formation.

A stock market bubble refers to an economic bubble wherein market participants inflate share prices to levels exceeding the company’s fundamental value including earnings and assets by a significant margin. It is created on the basis of speculative optimism or increased demand, rather than the real value of the financial assets. The central bank of India noted that the deviation of the actual Price/Equity (P/E) ratio from its long-run trend reflects that the ratio has been overvalued, while measures of dividend yield also signal that markets are getting “overpriced”. According to the annual report prepared by RBI, Sensex is currently trading at a P/E ratio of 32 against a 5-year average P/E of 24.53. The turn in market sentiments “following positive news on the development of and access to vaccines and the end of uncertainty surrounding US election results” have also led to increased valuation of equities.[2]

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This newfound liquidity fuelling the stock prices in an environment where the real economy is collapsing has left little scope of doubt to examine whether the current stock market rally is rational or not. In India, with the unemployment rates sky-rocketing, Debt to GDP ratio spiking and budget deficits broadening while the stock markets are still presenting a buoyant image, the country’s economy is threatened with the possibility of a bubble burst. Sooner or later, these bloated asset prices shall exert inflationary pressures on the economy causing central banks to hike interest rates, lower the circulation of money and thus, dampen expectations of future bubble price appreciation. Massive sell offs causing decline in prices shall lead to greater negative effects on equity return. The stock market shall be in a state of mayhem, derailing any hope of recovery. The financial stability of the economy shall be brutally sabotaged with no significant improvements in economic growth.

To avoid wealth erosion and better navigate the bubble, an understanding of the five stages of a financial bubble i.e., displacement, boom, euphoria, profit taking and panic is essential.

Displacement is the first stage that occurs when investors are captivated by a new paradigm, such as historically low interest rates. In 2020, RBI announced a repo rate cut of 40 basis points to 4% which is the lowest benchmark interest rate India has had since 2000 to mitigate the impact of Covid-19. Following a displacement, prices rise slowly but eventually gain momentum as more and more participants enter the market leading to a spur in speculation activities. During this boom phase, escalating market prices grab the eyeballs of many individuals. Cheap credit and quantitative easing program fuel the boom to levels such that in March 2021, the overall debt held

by Indian households were valued at ₹43.5 trillion approximately. With valuations going through a roof and too many people itching to jump onto the bandwagon, the investors are lulled into false sense of security that should they wish to sell, they will easily find someone who would be willing to pay more. The euphoria stage is characterized by this conviction which leads to investments that are disproportionately higher than an individual’s risk appetites. As prices reach Utopian levels, some investors who are receptive to the warning signs of a possible bubble burst in near future start selling positions to lock in gains at the profit-taking stage. With passage of time, the bubble perforates which acts as the catalyst for economic recession. In the panic stage, asset prices descend rapidly as supply overwhelms demand. Investors and speculators faced with plunging values of their holdings become willing to liquidate it at any price.

As RBI flags risk of a bubble in Indian equity markets, the question that requires addressal is how should retail investors manoeuvre their way in a market that seems to disregard the turmoil on the economic front? While it is impossible for investors to insulate themselves completely from volatility, it is advisable to not let exuberance get the better of investment fundamentals i.e., diversification, asset allocation and rebalancing of portfolios. Another important strategy to safeguard investment from fluctuations is through staggered investments over time and Systematic Investment Plans (SIP) in a mutual fund spread with low correlation, in accordance to the speculator’s risk taking abilities. In the long run, SIP investments in mutual funds due to the benefit of rupee-cost averaging can wipe out the creases left by the bubbles. At the moment, the Indian stock market seems to be rising rapidly after a period of hesitation during the second wave.

Minor corrections are expected throughout the year, depending on the evolving Covid-19

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situation, the pace of recovery of global and domestic economies and developments in global financial and liquidity conditions.

Thus, the efforts undertaken by the central bank to keep interest rates lower and engage in unconventional monetary policy to curb the economic downturn has emerged as a global policy concern. Given the evident disconnect between the glooming economy and booming markets, it is certain that the bloated asset prices may be coming to an end, leaving a trickier future impending on the horizon. With frothy markets sparking worries of bubbles in Indian assets, the only question that remains unanswered is, when?

REFERENCES: [1]

India Today, 2021, RBI warns of stock market bubble: Should investors be worried?, viewed 25 July 2021, <https://www.indiatoday.in/business/story/rbi-warns-of-stock-market-bubbleshould-investors-be-worried-1809096-2021-05-31>.

[2]

Modak, S 2021, Rising stock markets amid GDP contraction pose risk of a bubble, says RBI, viewed 26 July 2021,<https://www.business-standard.com/article/markets/rising-stock-marketsamid-gdp-contraction-poses-risk-of-a-bubble-says-rbi-121052701358_1.html>.

Curran, E 2021, Pandemic-Era Central Banking Is Creating Bubbles Everywhere, viewed 27 July 2021, <https://www.bloomberg.com/news/features/2021-01-24/central-banks-are-creatingbubbles-everywhere-in-the-pandemic>.

Khan, A 2021, Beware the equity market bubble: Experts raise the red flag, viewed 27 July 2021, <https://www.newindianexpress.com/business/2021/jun/16/beware-the-equity-market-bubbleexperts-raise-the-red-flag-2316821.html>.

Bose, P 2021, India’s equity market bubble may burst soon, viewed 25 July 2021, <https://www.thehindu.com/opinion/op-ed/indias-equity-market-bubble-may-burstsoon/article35433609.ece >.

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