Question

“In theory, the financial sector is supposed to support the long-term growth of the real economy. In practice, it has become so detached from the real world that it is more akin to a fantasy land, inhabited by a growing number of peculiar characters undertaking nonsensical tasks.”

Source: Stewart Investors Sustainable Funds Group, Alice in Financeland, (Feb 2017).

Please respond to the following questions by drawing upon relevant concepts/theories you have learnt in this unit.

1. Discuss why capital markets have become so disconnected from the real economy.

2. Discuss what are some of the barriers to change (and why is it so hard to change).

3. What do capital markets need to do differently in the future to better support economic, social and environmental outcomes for people and the planet.

Answer 1

1. Discuss why capital markets have become so disconnected from the real economy.

the magnitude of benefit to the real economy will depend on the virus situation and the extent to which the economy is open both officially but more importantly in terms of actual people behaviour. A fiscal stimulus will help better channelize the money supply into the economy too but even the timing of that may depend on the successful control of the virus. Stimulus in a partially open economy may not create the right impact. That the virus has now reached the so far lesser affected areas like Tier 2 and 3 cities, is worrying. At some level, the government can only help curb the virus to an extent. Eventually it must become a people’s movement where citizens, communities and businesses play a larger role. Private sector’s pursuit for profit cannot be without keeping employees along with other stakeholders in mind. Healthcare and reskilling should become central to business leaders’ agenda.

Even if the surge in broad money succeeds in inflating the economy eventually, historically such episodes have quickly led to overheating. The short cycles of capital flow driven boom and bust in India are all too familiar to us. We must make this expansion more sustained through adequate capacity creation for enhanced absorption of this capital. The supply side measures undertaken by the government in the crisis so far are in right direction. Aatma Nirbhar Bharat and associated policy changes should focus on creating industries of scale. We should take this opportunity to reimagine our financial sector-reforming public sector banks, development of corporate bond markets, securitization market, alternative funding mechanisms like AIFs and building developmental institutions to name a few. Infrastructure creation, judicial, regulatory, and administrative reforms and using technology to power our transformation is critical. And so is structural reform on issues of education, healthcare, and reskilling. The global environment is evolving in a way that we increasingly look like being at the right place, at the right time. We must not squander this opportunity.

Yet in the near term, liquidity has led to markets significantly outpacing the economic improvement. Heightened retail activity indicates a degree of frenzy and lends markets vulnerable. Valuations on price-to-earnings (P/E) multiples appear stretched too. However, in past episodes of stretched valuations such as 2007-08, corporate profits to GDP were at multi-year highs while they are at multi-decade lows now. Therefore, peak multiples were being applied to peak earnings then versus high multiples on trough earnings now. The other difference is that global interest rates are near zero now versus say over 4% on US 10 year yields then. The narrative on valuations globally has changed from looking at P/Es to looking at equity risk premiums (ERPs) in the context of low yields. The related asset price inflation has been a key consequence of the unconventional monetary policy (UMP) pursued by global central banks over the past decade.

The EU too announced a large recovery fund which was unprecedented and points to greater fiscal cohesion between member nations. Having done a relatively better job on controlling the virus and with greater monetary-fiscal coordination, EU could well turn out to be a dark horse in the new multi-polar world dominated by US-China headlines! The Euro has already surged post the fiscal deal announcement. On the other hand, prospects of better growth elsewhere and continued monetary accommodation in the wake of surging coronavirus cases in the US have led to sharp depreciation in the dollar. Dollar weakness has historically been good for emerging markets and commodities and can strengthen the reflationary effects of the unprecedented monetary and fiscal stimulus globally. For India, the immediate priority is to control the virus. We must revive demand through decisive fiscal measures. While we look to rationalize expenditure and boost revenue through formalization, growth acceleration remains central to improving our government debt profile. Should debt ratios continue to turn ugly, we may run out of firepower to counter the next shock. A credible boost to growth is the only way out. Additionally, versus continued moratorium extension, a one-time restructuring is the need of the hour. Hasten to add, we must keep an eye on hard-earned gains on credit culture. While creative destruction is essential, sound firms must be saved. With profits as proportion of GDP dwindling, creating sustained economic growth will require large profit pools as well. For it is these profit pools that will help fund innovation, investment, and employment to sustain the economy, while creating scale to compete in the global marketplace. This will also be important as the social welfare agenda needs resources too. At a time when governments are assuming larger roles in the West, the policy prescription for India may just be the opposite.

2.Discuss what are some of the barriers to change (and why is it so hard to change)?

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So far, the main focus of agent-based financial market models is on the dynamics of financial markets and (virtually) nothing is said about how the dynamics of financial markets impacts on the real economy and, likewise, how changes in the real economy affect financial markets. In this paper, we therefore propose a simple behavioral macromodel, enabling us to explore at least some feedback causalities between the real economy and the stock market. The real economy is approximated by a Keynesian type goods market model in which consumption and investment expenditure depend on national income and the performance of the stock market—which links the stock market with the real economy. Our nonlinear stock market approach explicitly recognizes the trading activity of heterogeneous speculators, chartists, and fundamentalists. Since the fundamental value of the stock market is related to national income, the real economy is linked to the stock market. Ultimately, this establishes a bidirectional feedback structure between the real economy and the stock market and a first starting point for studying interactions between these two economic subsystems.

As it turns out, national income and stock prices are jointly determined by a two-dimensional nonlinear map. The model has three coexisting steady states. The inner steady state, in which national income corresponds to the well-known Keynesian multiplier solution and the stock price to its true fundamental value, is unstable. The two other steady states, located around the inner steady state, are locally stable as long as the chartists’ trading intensity is not too high. Initial conditions then decide whether the economy will enter a permanent boom or a permanent recession. The first scenario is associated with a stock market boom in which stock prices exceed their fundamental value. In the second scenario, the stock market is in a crisis and stock prices fall below the fundamental value. If the local stability of the steady states is destroyed by too aggressive chartists, we observe the emergence of two coexisting period-two cycles, followed by two coexisting period-four cycles, and so on, until there are two coexisting regimes with complex dynamics, either located at a low or high national income and stock price level. If chartists become even more aggressive, we observe intricate switches between bull and bear stock market dynamics, which may then trigger fluctuations in economic activity. Overall, interactions between the real economy and the stock market appear to be destabilizing. This becomes particularly clear if our model is compared which a benchmark model in which interactions are ruled out. Then the unique steady state of the real economy is globally stable, and the stability condition for the two locally stable stock market steady states is less strict.

Given that our model is extremely simple, it may be extended in various directions. For instance, the case may be considered that the central bank conducts active monetary policy by adjusting the interest rate to influence private expenditure, national income, and, more indirectly, the stock market. Similarly, the case could be considered that the government relies on countercyclical-fiscal policy rules to stabilize the economy. Another direction to extend our model could be to enrich the goods market. For instance, an accelerator term could be added to the investment function. Preliminary numerical evidence reveals that the goods market may then, at least temporarily, decouple from the evolution of the stock market. Alternatively, one may assume that consumer and investor expenditure are subject to their sentiments. Then one would obtain a model with animal spirits in the goods market and stock market, and both economic subsystems would possess a nonlinearity. Moreover, a time step in the goods market part of our model currently corresponds to a time step in the stock market part of the model. One extension of our model could be to allow for a higher trading frequency in the stock market. Note also that speculators in our model do not switch between trading strategies. This may be modified by introducing switching dynamics into the model. For instance, a speculator’s choice of a trading rule may depend on the rules’ past fitness. Of course, our model could be developed in various other dimensions.

Here we have proposed a rather simple model to improve our basic understanding of interactions between the real economy and the stock market. Changes to our model will, as usual, have an impact on its properties. However, as long as the (quite natural) bidirectional feedback structure between the real economy and the stock market prevails in the model, stock market bubbles and crashes will stimulate macroeconomic booms and recessions and macroeconomic booms and recessions will stimulate stock market bubbles and crashes. We hope that our paper will motivate others to undertake more work in this important research direction.

3.What do capital markets need to do differently in the future to better support economic, social and environmental outcomes for people and the planet.

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Development Finance and Opportunities in Emerging Markets

1.              Growth in Emerging Markets

World Bank Group economists forecast that global growth over the next three years will average about 3%. While advanced economies will grow on average about 2%, the growth we will see from emerging‑markets is expected to be at least 4.5%. Evidently, global growth is going to come from emerging markets, which of course relies in part on development finance. From an investor’s perspective, emerging markets often offer high returns on a risk‑adjusted basis as well as opportunities for diversification. We believe that opportunities abound across many emerging markets sectors. To foster growth, we need to connect investors to products that build human and physical capital. We need to fill infrastructure gaps and improve health and education outcomes. Like the previous speaker said, we need to increase female labour‑force participation.

2.              Learning from History

We need to tackle sustainable development with a sense of urgency. I do believe there is a lot from our experience in the past 50 years that we can learn from. Let me start with the World Bank. Our first bond issuance was in 1947, 70 years ago. Because of the capital markets we can do so much in development assistance. Let me be specific. Our shareholders have paid in a total of only $19 billion for the International Bank for Reconstruction and Development (IBRD), the flagship institution of the World Bank, and the International Finance Corporation (IFC), the private‑sector arm. Together, cumulatively, IBRD and IFC have provided approximately $1.5 trillion of financing for development in real terms. If that does not impress you, let me remind you that our first loan was to France in 1947. Of course, this loan was funded by that first bond issue.

3.              New Opportunities

As many of you may have seen, we launched another World Bank entity, the International Development Association (IDA), into the capital markets in April, last month, with a very successful $1.5 billion transaction. Many of you supported us. I mention this because IDA lends to low‑income countries in Africa, Asia and Latin America. Since it was founded in 1960, it has solely depended on shareholder and internally‑generated funds. Going to the capital markets is transformative. Watch that space, because you will probably see other development agencies that have not leveraged the capital markets go to the capital markets.

4. The Growth in Sustainable Investments

There is also another crucial factor, which everybody who spoke earlier about the green bond markets has mentioned, the success of the green bond market. I believe it demonstrates market appetite for sustainable financial products. When the MDBs started issuing green bonds, it was just MDBs. Today you have utilities, corporates, principalities and sovereign issuers – many of them emerging markets issuers – who have decided the green bond market is an extremely important market. As everybody has pointed out, the Green Bond Principles, which ICMA is the secretariat for, have been instrumental to the growth of the market.

CONCLUSION

To conclude, I believe the next game‑changing action has to focus on how we end global poverty in our lifetime, within our generation. Ending global poverty is key in an interconnected world. Indeed, Eugene Meyer, the World Bank’s first President, said in 1946, “Prosperity, like peace, must therefore be viewed as indivisible. And even from the narrowest considerations of self-interest, each of us must be concerned with the economic development of the world as a whole. For we shall prosper individually only as we prosper collectively.”