No Definite Answer from Past Episodes
By Dr Chua Hak Bin
Can a stockmarket crash affect the real economy? Alan Greenspan triggered a sell-off in stockmarkets across the globe with the suggestion that "irrational exuberance has unduly escalated asset values." The Fed Chief went to elaborate that a collapsing assets market can threaten the real economy, and thus such considerations must therefore "be an integral part of the development of monetary policy."
The Wealth Effect
Malaysian Economy More Sensitive to Crashes
STOCKMARKET CRASH
No Definite Answer from Past Episodes
Past episodes of stockmarket crashes do not provide a definite answer on whether a crash affects the real economy. The stockmarket crash in October 1987 had hardly any impact on the U.S. or on the Malaysian economy. However, the Nikkei's plunge of over 50 percent in 1990 has been blamed for causing the stagnation in the Japanese economy, including the drop in property values and the risk of collapse of financial institutions. Wall Street's crash in 1929 has also been blamed for causing the Great Depression which lasted for four years.
Looking for a negative correlation between the stockmarket and real economic variables is the most straightforward way of finding out. However, the direction of causality is not necesarily obvious. First, share prices are based on future expected profits. Since profits are closely linked to the economy, a collapse in the stockmarket may occur simply because the economy's prospects have become bleaker. The stockmarket index 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 stockmarket crash is therefore not straightforward given the difficulty of separating out the forward-looking behaviour of investors and the reactionary behaviour of policymakers.
Should we dismissed the argument that a stockmarket crash can have devastating effects on the real economy? The usual theoretical argument suggests that a stockmarket crash reduces the wealth of households. This "wealth effect" curbs consumer spending, affecting production, jobs and profits.
The "wealth effect" is clearly only important if a substantial portion of households own shares and if the stockmarket capitalisation accounts for a substantial portion of the economy.
The portion of U.S. households who own shares have been rising but still constitute only about 40 percent of total households in 1992. The relative share of market capitalisation of the New York Stock Exchange to GNP is about 70 percent. A sharp fall of 30 percent in stockmarket values will therefore amount to 21 percent of GNP. Assuming that the stock of wealth is about ten times GNP, a 30 percent crash amounts to only a fall of 2.1 percent in total wealth. As consumption is dependent on wealth, the fall will not amount to any major fall in spending.
Malaysian Economy More Sensitive to Crashes
The Malaysian economy is however more sensitive to crashes. The representation of households who own shares directly or indirectly is probably similar to the U.S. profile. The market capitalisation of the KLSE is however about 320 percent of GNP. This implies that a 30 percent crash in the KLSE amounts to the equivalent wipe-out of 96 percent of GNP. If the stock of wealth is about 10 times GNP, this still amounts to a dissappearance of about 10 percent of total wealth. Such a sharp fall in wealth will inevitably hurt consumer spending.
The Malaysian economy's sensitivity to stockmarket crashes has been increasing over time with the rising market capitalisation of the KLSE. During the 1987 crash, Malaysia's stockmarket capitalisation accounted for only about 90 percent of GNP. As such, the ripple effects from the 1987 crash did not have such far reaching consequences. However, with the capitalisation accounting for more than 300 percent, Wall Street's sentiment may have become inevitably linked to the Malaysian economy. This worrisome conclusion extends to Hong Kong and Singapore whose market capitalisation have both exceeded 250 percent as well.
TABLE: THE MALAYSIAN ECONOMY IS OVEREXPOSED TO A STOCKMARKET CRASH
|
Countries |
Market Cap/ GNP (%) |
Fall in Value from 30% |
|
|
||
| Malaysia |
320 |
96 |
| Hong Kong |
290 |
87 |
| Singapore |
250 |
75 |
| Bangkok |
109 |
33 |
| London |
105 |
30 |
| New York |
70 |
21 |
| Bombay |
38 |
11 |
| Jakarta |
35 |
10 |
There are some important factors to account for when linking market capitalisation to total wealth. First, the rather high market capitalisation of the Kuala Lumpur, Singapore and Hong Kong stockmarkets are partly a result of its openness to foreign investors. As such, a large fraction of the market capitalisation is "foreign wealth" rather than "domestic 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 percent, then the true "domestic market-capitalisation to GNP" that matters for calculating the local "wealth effect" is reduced to only 224 percent.
Second, consumption is dependent on permanent rather than current wealth. Consumers take into account their future income when deciding on their habits today. If the fall in the stockmarket 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. A word of caution is noted however as empirical studies have provided evidence that consumption is linked to current rather than permanent wealth due to the existence of credit constraints.
Greenspan's Warning Matters More Than Ever
The stockmarket matters more than ever in relation to the Malaysian economy. Listing of privatised assets have boosted the market capitalisation to GNP ratio by more than fourfold over the last 10 years, to over 300 percent. Because the 1987 crash had little impact on the real economy does not imply that the same scenario will apply again. The wealth of Malaysians are increasingly invested in equities and any sharp correction will now matter more than ever for most households. In short, the Malaysian economy is currently overexposed to a stockmarket crash, especially in relation to other economies.
Other asset markets must be developed to enable average Malaysians to diversify their portfolio. The rising market capitalisation to GNP has been partly attributed to the lack of a private debt market. The lack of liquidity on the trading of these instruments have prevented investors from participating in any major way. The issue of government bonds has also dried up as a result of the string of 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 unforseen stockmarket crash. The other course of action will be to wait and see.
Dr Chua Hak Bin is a senior executive in a KLSE-listed company. The opinions expressed are solely his own.
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Greenspan's Warning Matters More Than Ever
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