New issues in Indian macro policy.

Table 2 Banks and markets in the Indian economy

(Trillion rupees)

This transformation of the equity market may have helped reshape the financing of
firms, with a move towards much more equity financing. Table 2 shows an imperfect
comparison about India’s evolution away from a bank-dominated financial system. In the
case of banks, we show the stock of outstanding ‘non-food credit’. In the case of the
equity market, we show the stock of market capitalisation of the CMIE COSPI index.³
The strength of this comparison lies in the fact that both values are accurately measured.
However, it is an imperfect comparison in that it compares the market value of equity of
just 2,763 most liquid firms against all credit given out by the banking system.

This evidence shows that over the recent 17.26 years, non-food credit grew by 19.87
times. Over that same period, the COSPI market capitalisation grew by 106.8 times.⁴ The
COSPI market capitalisation was roughly half of non-food credit in 1990; by 2007 it was
2.6 times the size of non-food credit. In March 1991, the COSPI market capitalisation was
12.9% of GDP; by March 2007 it had risen to 94.4% of GDP.

From the viewpoint of macroeconomics, these developments imply a significant change
in behaviour of the economy. The rise of the equity market implies that there is a new
role for a forward-looking market in the investment behaviour of firms. Expectations of
equity market participants shape investment. This is in contrast with earlier decades,
where financial flows were substantially driven by government decisions.

2.3 The business cycle

In mainstream macroeconomics, the inventory and investment of firms lie at the core of
‘business cycle’ fluctuations. In boom times, profit rates are high, the investment/GDP
ratio surges and inventories are drawn down. In recessions, profit rates drop, invest-
ment/GDP drops, and inventories build up. These developments play out over multi-year
time periods. We call this textbook characterisation the ‘conventional business cycle’.⁵

³ The CMIE Cospi index contains all firms where trading took place on atleast 66% of the days in the
last six months. In June 1990, there were 971 firms in the index; by September 2007 this had risen to
2,763 firms.

⁴Over this period, the COSPI P/E rose from 16.57 to 27.61, a rise of 1.66 times. Hence, the bulk of
the rise in the COSPI market capitalisation was based on the growth of the firms and the growth of the
number of firms.

⁵Strictly speaking, all India has is a ‘growth cycle’, since negative GDP growth rates almost never
materialise.

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