Financial fragility in Indian stock markets: the decade of the nineties - a time series study

Abstract

The decade of the nineties (particularly since 1991) witnessed major deliberate policies, bearing on almost all sectors & segments of the Indian economy, aimed at reforming radically the functioning of the economy. Furthermore, the policymakers are affirming their commitment to the same with renewed vigor, even to the extent of phased follow-up of second generation reforms targeting, among others, particularly, the financial sector. It is time, therefore that we take a look at the impact of these reform measures in making the financial system stable, resilient i.e. solid or fragile. We have long been aware of the beneficial impact of a well functioning financial infrastructure on the real sector of the economy. Conversely, the economic turmoil in the recent East Asia crisis have once again brought into sharp focus the key role of financial fragility in aggravating crises through the banking, currency and securities markets in particular, hampering investor confidence operating in such markets and thus seriously impeding the ability of securities markets in performing the intermediary role between the savers and investors. Given the intertwined financial and real sectors, the conduct of proper macroeconomic management and attainment of macro-objectives is dependent in a large measure on the health – in respect of both width and depth – of the financial system as well. The lack of this or financial fragility has been identified as a major source in the periodic crises within the last couple of decades and the recent East Asian Crisis in 1997 with problems in the banking sector, deepening of the currency crisis and an almost meltdown in the stock markets, with one setting the crisis in motion and the other exacerbating the others. Our study (Sarkar, et.al, 2001) delves into a detailed empirical analysis of the stock markets, in particular, looking into the existence of (larger than normal) deviations and their persistence over time, i.e., presence of asset bubbles, and as such presents findings on extent of financial fragility or the lack of it in the stock markets. In order to investigate the extent to which the stock markets are linked to the fundamental variables, we look at (1) an assortment of basic financial/real variables, e.g., net worth per share (book value per share), profit per share (EPS), dividend per share and debt-equity ratio; (2) dynamic variables, like rate of growth of net worth per share, profit per share, dividend per share and debt-equity ratio as surrogates for expectations; and (3) macroeconomic policy variable, like prime lending rate. We (Sarkar et. al, 2001) have attempted both cross-section and time-series analyses on (1) and (2) and a timeseries analysis on (3). The time-series study is discussed in sections on introduction, the dataset, the model, analysis of the results of goodness-of–fit, analysis of the results of volatility and finally, the conclusion. The time-series study in respect to the stock market, reveals that the structure of these markets in India is best described by the presence of historical real (net worth per share, profitability per share) and financial (debt-equity ratio, dividend distributed per share) variables as well as their rationally expected growth values over the future. This structure is cointegrated with the stock price so that it may be said that in corporate governance, price is an important consideration in making decisions on the above explanatory variables at the corporate level. This is in the light of the fact that although there is a lot of residual volatility, lack of explosive components makes cointegration possible. If one compares it with the fact that the relationships within the model are stronger in the annual data in periods distant from 1993 and 1997, the two periods of crashes and other significant events, as discussed in the beginning (which therefore opens up areas of further analysis of structural breaks), then the linear fit, on average, suggests that in spite of a high degree of volatility, "planned competition" has been responsible in preventing markets from crashing more often, and changing the overall structure of the interplay between price formation, history and expectations along with it.