Capital News 3: The stockmarket and the economy

By Dr Chua Hak Bin

"Irrational exuberance". With those words about Wall Street on Dec 5, US Federal Reserve chairman Alan Greenspan drove global equity markets into a tailspin the, after effects of which are still haunting jittery investors around the world. Those two words will ring in the ears of market players for a long time. But Greenspan also made another equally significant comment about the impact of a stockmarket crash on the real economy.

He said: "We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the (US) economy. But we should not underestimate or become complacent about the complexity of the interaction of asset markets and the economy".

How closely tied is the health of the Malaysian economy to the fortunes of the stockmarket ? Dr Chua Hak Bin attempts to answer that question.

Can a stockmarket crash affect the real economy ? Past episodes of stock market crashes do not provide a definite answer on whether a crash affects the real economy. The stock market crash of 1987 had hardly any impact on the US or the Malaysian economy.

However, the Nikkei's plunge of over 50 per cent in 1990 has been blamed for causing the stagnation in the Japanese economy, including the drop in property values and the risk of a collapse of financial institutions. Wall Street's crash in 1929 has also been blamed for causing the Great Depression.

Looking for a negative correlation between the stock market and real economic variables is the most straightforward way of finding out. However, the direction of causality is not necessarily obvious.

First, share prices are based on future expected profits. Since profits are closely linked to the economy, a collapse in the stock market may occur simply because the economy's prospects have become bleaker. The stock market in this instance is simply a leading indicator of the economy's direction.

Second, the impact of a crash is very much dependent on how policymakers respond to the crisis. If central bankers respond by raising liquidity, as they did in the aftermath of October 1987, a potential recession may be prevented.

Assessing the impact of a stock market crash is therefore not straightfoward given the difficulty of separating out the forward-looking behaviour of investors and the reactionary behaviour of policymakers.

The wealth effect

Should we dismiss the argument that a stock market crash can have devastating effects on the real economy? The usual theoretical argument suggests that a crash reduces the wealth of households.

This "wealth effect" curbs consumer spending, affect production, jobs and profits. The wealth effect is clearly only important if a substantial portion of households own shares and if the stockmarlet capitalization accounts for a substantial portion of the economy.

The portion of US households who own shares have been rising but still constitute only about 40 per cent of total households in 1992. The relative share of market capitalization of the New York Stock Exchange to GNP is about 70 per cent.

A sharp fall of 30 per cent in stockmarket values will therefore amount to 21 per cent of GNP. Assuming that the stock of wealth is ten times GNP, a 30 per cent crash amounts to only a fall of 2.1 per cent in total wealth. As consumption is dependent on wealth, the fall will not cause any major fall in spending.

Malaysian economy more sensitive to the stockmarket

The Malaysian economy is more sensitive to movements on the stockmarket. The representation of households who own shares is probably similar to the US. The market capitalization of the KLSE is, however, about 320 per cent of GNP.

This implies that a 30 per cent crash in the KLSE amounts to the equivalent wipe out of 96 per cent of GNP. If the stock of wealth is about 10 times GNP, this still amounts to a disappearance of about 10 per cent of total wealth. Such a sharp fall in wealth will inevitably hurt consumer spending.

The economy's sensitivity to stock market crashes has been
increasing over time with the rising market capitalization of the KLSE. During the October 1987 crash, the KLSE's market capitalization was only 90 per cent of GNP.

This vulnerability of the economy to a stock market crash extends also to Hong Kong and Singapore whose stock market capitalization have exceeded 250 per cent of GNP (see table).

Some comforting thoughts

There are some important factors to account for when linking market capitalization to total wealth.

First, the rather high market capitalization of the KL, Singapore and Hong Kong stock markets is partly a result of its openness to foreign investors.

As such, a large fraction of the market capitalization is foreign wealth. The fraction will be higher in Singapore and Hong Kong than Malaysia.

If the fraction of Malaysian shares which are foreign-held account for as much as 30 per cent, then the true "domestic market capitalization to GNP" that matters for calculating the local "wealth effect" is reduced to only 224 per cent.

Second, consumption is dependent on permanent rather than current wealth. Consumers take into account their future income when deciding on their habits today.

If any fall in the stock market is regarded as temporary rather than permanent, consumers will not treat the loss as a real loss but a temporary paper loss. As a result, consumers will not reduce their spending as sharply when faced with the fall in current wealth.

However, it should be noted that empirical studies have shown that consumption is linked to current rather than permanent wealth due to credit constraints.

Greenspan's warning matters more than ever

The stock market matters more than ever to the Malaysian economy. Listing of privatized assets has boosted the market capitalization to GNP ratio by more than fourfold over the last 10 years. Because the 1987 crash had little impact on the real economy, it does not imply that the same scenario will apply again.

The wealth of Malaysians is increasingly invested in equities and any sharp correction will matter more than ever. In short, the economy is currently probably "overexposed" to the stock market.

Other asset markets

Other asset markets must be developed to enable average Malaysians to diversify their investment portfolio. The rising KLSE market capitalization to GNP has been partly attributed to the lack of an active private debt market and this has prevented investors from participating in a big way.

Government bonds issues have also dried up because of the string of government budget surpluses in recent years. If domestic instruments continue to be in short supply, Malaysian investors and institutions should be permitted to plant their wealth in foreign instruments, whether equities or debt.

Diversification is the most natural way of reducing any impact on the real economy from an unforeseen stock market crash. The other course of action will be to wait and see.