Tag: Economy

Categories
Issue 6

India’s Dominant Family Businesses Need Newer Challengers

The great Indian business family is dead. Long live the next great Indian business family. Like taxes and death, this key pillar of life in this country is ubiquitous. But like much of society around it, there are clear signs it is atomizing. No longer is the son of the rice merchant destined to continue the family tradition. He, and in some rare cases she, is experimenting with newer opportunities being constantly thrown up by a rapidly changing economy. 

That though doesn’t mean the end of the business family’s  dominant role in the Indian environment. Family Business Network, the Lausanne-based federation of business families, estimates their contribution to India’s gross domestic product at a whopping 70%. 

Not that there’s anything particularly aberrant about this. According to consulting firm Ernst and Young, 85% of companies in the Asia-Pacific are family-owned. Similarly, family businesses make up more than 60% of all European companies ranging from sole proprietors to large international enterprises. What’s more these businesses create value for themselves but also for the broader markets. Across the world, including in India, returns generated by family-owned businesses have been consistently higher than those by non-family owned ones.

For this they have been amply rewarded. According to the Billionaires Insights Report 2020 published by UBS and PwC the net worth of India’s billionaires has surged 90% in the 11 years since 2009.

It mirrors a worldwide trend of big businesses getting bigger. Thus, the Wall Street Journal recently advertised for the position of Reporter, Google. It isn’t uncommon for media outlets to assign reporters to cover specific sectors or countries but doing that for selected companies is rare. But so dominant are some global companies and so pervasive their influence that it may be blasphemous but not entirely untrue to say that Google matters more than many countries. As WSJ goes on to say in its job description: “Google’s impact on business and society is vast. Beyond its core search-and-advertising business, it is one of the world’s biggest video distributors through YouTube, the largest smartphone-software supplier thanks to Android, a leader in developing self-driving-car technology through Waymo, and a top contender in the booming cloud-computing industry.”

As it is with Google today, so it has been with others like McDonald’s, WalMart and General Motors in the past. Size leading to market dominance has ensured that some businesses have a disproportionately large influence on the world. It has led to the constant tussle between big business and regulators keen to ensure they don’t squeeze smaller competitors out of the market.

That’s where the biggest danger of business family dominance in India lies. The first two decades following the liberalization of the economy threw up new names in the business landscape of the country. Entrepreneurs like Sunil Mittal in telecom, Uday Kotak in banking, Naresh Goyal and later Rahul Bhatia and Rakesh Gangwal in aviation, rushed to take advantage of the opening up to the private sector of areas that had hitherto been reserved for state-run monopolies. Some like Naresh Goyal came to grief. Others soldiered on and have become the business families of today. At Wipro, the software-to-consumer products conglomerate that was set up by Hasham Premji in 1945, the third generation of Premjis, in the form of new chairman Rishad Premji, is now in charge.

It is the way economies with relatively free markets grow. In fact, crystal ball gazing in the late 1990s led several analysts to predict that in the future Indian business would be driven by companies like Ranbaxy, Samtel, Infosys, ILFS, Kotak Mahindra and Yes Bank, as much as it would by existing powerhouses like Reliance and Tata. 

The future is here and sadly most names in that list of future stars have dropped off with only Kotak and Bharti holding fort. In fact, over the last few years, a disturbing trend has  emerged with a handful of powerful families mopping up businesses across sectors. Despite a surge in entrepreneurship generously funded by private equity and venture capital, there aren’t too many start-ups that look like challenging the incumbents whether it is in existing business areas or even brand new ones like e-commerce, green energy, telecom or retail.  

Worse still, if some recent changes proposed by the country’s central bank are implemented, that dominance may grow to dangerous levels. With capital being the first need of any new venture, RBI’s proposal to allow business groups to set up banks may just add more heft to their existing clout. In a linkedin post two former deputy governors of the RBI, Raghuram Rajan and Urjit Patel warned that allowing corporate entry into banking “will further exacerbate the concentration of economic (and political) power in certain business houses.”  

The tragedy is that going forward the Indian business world could end up looking more like that of the pre 1990s era when a handful of names reigned supreme. Groups like Aditya Birla, Ambani, Mahindra and Mahindra, Vedanta, Bajaj, Jindal, Munjal, RPG, Hinduja, Murugappa, Lalbhai and Adani are a throwback to our past. In the 21st century, they need to be challenged by newer groups. That’s not going to happen if regulation, and regulators, continue to throw their lot with the incumbents. 

Picture Credit: “India Map on Indian Map” by Kush Patel is marked with CC0 1.0

Sundeep Khanna is a columnist, business writer and executive editor at the Mint.

We publish all articles under a Creative Commons Attribution-Noderivatives license. This means any news organisation, blog, website, newspaper or newsletter can republish our pieces for free, provided they attribute the original source (OpenAxis).

Categories
Issue 5

A case for caution: India’s path to economic recovery

India, as with most of the world has been impacted severely by the coronavirus pandemic and the subsequent lockdown imposed by the government. While we are in the process of reopening the economy, many of us hope for a quick return to normalcy. However, According to the production and inflation data, normalcy might be a far cry for the Indian economy. 

The headline figure of a decline of 23.9% in the GDP for the first quarter of financial year 2020-21 released in July showed the depth of the shock to the economy. Index of Industrial Production (IIP) shows a sharp decline in manufacturing across all sectors. Labour intensive sectors such as textiles (-37.3%), leather (-32.7%) and primary products such as basic metals (-21.6%) have been hit hard by the lockdown(Source- IIP Data and author’s calculations). As more workers get laid off, consumption declines which leads to low demand for manufactured goods, which leads to even more workers getting laid off thus creating a vicious cycle. Many pundits point to the increase in expenditure around the festive season and gradually increasing industrial production as signalling economic recovery. However, as the adage  goes,  one swallow doesn’t make summer, India’s economic recovery may not come easily. It faces more challenges than just production numbers as other core sectors dip significantly. 

Source – IIP Data and author’s calculations

India’s economy is heavily dependent on the services and agricultural sector. The agricultural sector employs more than 50% of the entire workforce while services contributes to 50% of India’s GDP. The services sector has seen a decline of 20.6% in Q1 of FY21 in gross value added (GVA) while the trade, hotels, communication and transport sub sector is facing a decline of 47.0%. 

The only sector that has shown growth is agriculture with an increase of 3.3%. This is expected as the government has imposed the least restrictions on this sector.  A copious monsoon has also led to a good harvest. However since the pandemic has now spread to rural areas it could cause a reduction in the agricultural sector. 

According to SBI research, manufacturing has seen a decline of 38% in gross value added. Net taxes (the difference between GDP and GVA) has declined to 1.36 lakh crore, the lowest in 7 years. The decrease in tax payments also limits the government’s willingness to spend as it increases the fiscal deficit.

The problem facing the Indian economy is threefold- demand has dipped significantly, inflation is rising and the supply chain has been disrupted. In the past year where the economy has seen a slowdown due to disruptions in the credit market, private consumption has been a significant pillar which has stood strong. In 2019, it contributed to about 57% of the total GDP. With private and public investment unlikely to increase due to underutilized capacity, private consumption will be a significant contributor to GDP this year as well. According to an SBI report the private consumption is set to decline by 14% due to the decrease in spending during the pandemic. The expenditure side of the GDP also shows a decline of 22% in demand impulses. Until the government intervenes directly to stimulate demand, we are unlikely to see a quick recovery. 

India is also facing a problem of stagflation (high inflation, low growth, high unemployment) as we take a look at the latest inflation numbers released by the RBI. CPI has gone up by 11.07%, 10.68%, 9.05% in the past three months. In India, inflation is measured using two indices. The Consumer Price Index (CPI), which measures the prices the retail customer gets, and the  Wholesale Price Index (WPI) which measures the wholesale price of goods and services. 

 The WPI came into positive territory only in August. Over the past three months, it has been 0.41%, 1.32% and 1.48%. The numbers show a clear divergence between consumer prices and wholesale prices. While one might point out this divergence may be due to hoarding/overcharging by wholesalers, this is unlikely to be the case. What these numbers point to is a supply chain disruption, wholesalers are unable to supply goods consistently to retailers leading to short term supply drops and increasing prices. This is due to the uncoordinated unlocking between states. As states continue to unlock/impose restrictions on their economies with respect to the number of cases, this trend of disruption seems to continue until next year. 


Source – IIP Data and author’s calculations

Policy Proposals

The Indian establishment faces a unique challenge as the biggest shock of its existence comes to fruition. The RBI has already lowered the repo rates (the rates at which RBI lends money to commercial banks) by 125 basis points this year. By decreasing the repo rates, RBI has made it easier for banks to obtain more money which can be used for loans to the populace.  The finance ministry has announced a slew of measures focusing on emergency credit lines, loan restructuring and providing support to distressed sectors such as housing under the brand name Atmanirbhar Bharat. However, as we see private consumption and investment collapsing, now is the time for even more radical measures to support the rural and urban lower class. 

One way the government can find immediate impact is to increase the outlay towards the National Rural Employment Guarantee Scheme (NREGS). NREGS guarantees 100 days of unskilled work to all households for a fixed wage rate. This can be increased to 150 days to support many migrant workers who have been laid off. The wage rate can also be increased to provide further support to households. Another way of directly stimulating demand is to implement something like stimulus payments like the USA. This would directly put money in the hands of the people helping shore up demand quickly. In the longer term, a Universal Basic Income (UBI) could help mitigate these shocks. While we expect economic recovery to be quick in the coming months looking at festive demand spending and increase in industrial production. The data shows us that the path to recovery requires a lot more proactive measures from the government.  

Rochak Jain is a fourth year student of economics at Ashoka University.

Image Credit: pexels.com

We publish all articles under a Creative Commons Attribution-Noderivatives license. This means any news organisation, blog, website, newspaper or newsletter can republish our pieces for free, provided they attribute the original source (OpenAxis).

Categories
Issue 4

Reforming Antitrust Law To Regulate Big Tech

On November 10, 2020, there were two landmark events in the universe of antitrust law – China drew up its first set of antitrust laws to address anti-competitive practices in tech firms, and Europe laid out its first charges against Amazon for abusing its position as an e-commerce giant. Just last month, the United States filed a case against Google, alleging that it abused and furthered its position as the dominant search engine by unlawfully impeding its competitors. Google has also faced similar charges in India over the past three years. These include abuse of dominance across the search engine market, Android smartphone market as well as the Google Flights service. 

These cases bring to the forefront a larger structural problem at the intersection of technology, economics and the law: how can traditional competition law, which was designed to ensure free markets for brick-and-mortar stores, be reformed to include firms in the digital economy? 

Firms in the digital economy here refer to tech platforms like Google, Amazon, Facebook, ride-hailing apps such as Uber and Ola, and food-delivery apps like Swiggy and Zomato. They have gained an increasingly larger market share in recent years, and have faced few to no competitors. Here’s where regulating competition among them becomes tricky: these firms rely on the principle of network externalities, where an increase in the people using the service improves its quality. One can argue then, that the firm can only succeed when the number of people using it increases. So then, is regulating competition and ensuring the reduced market share of a firm really the best move, especially when these firms have provided services to customers at low rates? A counter-argument to this can be made regarding predatory pricing, which refers to cutting prices below cost in order to increase market share. This is considered to be anti-competitive as it drives competitors out of the market since they cannot keep up with such low prices. 

Concerns such as predatory pricing are similar across firms in the digital economy as well as regular brick-and-mortar stores. However, the unique features of the digital economy, such as network externalities, consumer lock-in effects, and usage of collected consumer data for targeted marketing are new problems that haven’t impacted businesses in the past. This calls for countries to update their antitrust laws, in order to sufficiently address anticompetitive practices among firms of the digital economy.

One way to contextualise this issue is to look at the history of American antitrust law framework, as done by Lina Khan in her seminal paper Amazon’s Antitrust Paradox. She explains how the current laws focus on regulating competition through a consumer welfare perspective which primarily looks at keeping consumer prices down. She stresses the need for restoring traditional antitrust laws that looked to preventing companies with large market shares from exploiting their dominance. 

To do this she suggests two approaches: First, to reform antitrust law in a way that it preemptively prevents a firm from becoming the dominant player in the market. This means making laws against predatory pricing more robust and scrutinising mergers that allow firms to acquire valuable data and leverage it, i.e. introducing a component of data threshold to mergers, apart from existing laws on monetary thresholds. Second, is to accept that online platforms are inherently monopolistic or oligopolistic and regulate them accordingly. This reforms antitrust law such that it allows a firm to become dominant and take advantage of the economies of scale, but neuters its ability to exploit its dominance. This includes ‘public utility regulations’, which allow a firm to maintain business across multiple lines of business while ensuring that it does not unfairly advantage its own business or unfairly gain market power. Another reform is ‘common carrier duties’ which require platforms to ensure open and fair access to other businesses, similar to the argument made regarding net neutrality.

Although Khan’s paper was primarily written in the context of American antitrust law, the arguments made can be applied to Indian competition law as well. To implement such reforms in an Indian context, Shah, Parsheera and Bose look at the Competition Act 2002 and propose certain changes to make it suitable for the digital economy age. 

They propose that the CCI use a “recoupment test” to differentiate between firms that have slashed prices competitively versus those who have done so in an anti-competitive manner (such as predatory pricing). This test checks whether a firm that currently has low prices can sustain these prices in the future and still remain solvent, or whether they would need to increase prices in the future (after having gained significant market share and kicked their competitors out of the market.) This would mean an amendment to the current definition of predatory pricing from being about merely cutting prices below cost to include the recoupment test too. 

Parsheera et al. also suggest that the CCI examine the role of investors, in cases where the same Private Equity fund has invested in the leading firms in a market. Examples of this include Tiger Global investing in Flipkart and Shopclues, ShopBank in Flipkart and Snapdeal, and so on. In such situations, the common investor could determine the level of competition in the market. This could lead to harmful outcomes such as high prices for consumers, as well as reduced quality and types of products.

There have been other reforms suggested by politicians such as Elizabeth Warren, who called for “Breaking up Big Tech.” However, experts like Charlotte Slaiman, a former antitrust lawyer in the US Federal Trade Commission, says that such solutions are unfeasible as it is difficult to determine which parts of a firm belong to which broken off entity. Nevertheless, regulators can take a retrospective look at mergers that they may have given a green light to in the past. In the Indian context, the CCI can reassess previous mergers and antitrust cases with respect to current situations of the market. This can allow for an ex post facto correction of possible anti-competitive mergers.

As Big Tech becomes increasingly intertwined with our everyday lives, it’s important now more than ever, to consider the tradeoffs of its current benefits to future disbenefits. Whether it’s trading data for the ‘free’ service of social media, or getting deep discounts on your Amazon purchases, there are significant downsides. By amending our laws to consider the economics of the digital economy, we can continue to reap the benefits of technology while sheltering ourselves from its potential pitfalls.

Samyukta is a student of Economics, Finance and Media Studies at Ashoka University. In her free time, she enjoys discovering interesting long-form reads and exploring new board games.

Categories
Issue 3

Tanishq: Victim of an uncontrollable beast

Image: screenshot from Advertisement

Much has been written about the controversy raised by the Tanishq ad that depicted an inter-faith marriage.

Since all of you would have seen the ad, I’ll refrain from wasting time and space describing the ad.

The big tragedy about the reams of editorial coverage in print and on news TV is that the focus is on the advertising industry and the debate has been reduced to a discussion on whether brands should ride on ‘political’ developments and ‘divisive’ subjects.

As far as I am concerned, the issue has little to do with advertising and all to do with the larger issue of the collapse of tolerance in society. Much of this erosion of tolerance is provoked by the need to follow the herd to be popular in social media.

Before we get to the crux of this article, which is ‘the interaction between social media and advertising in the Tanishq case’, let me give you a quick lesson in media.

For a moment, think of all news TV consumed as represented by a one-meter rule. All the viewership of ALL the news channels is represented by the one-meter rule. If you look at the share of ALL the English news channels, it will occupy perhaps ONE centimeter of this one-meter rule. “English news is very niche in India, and therefore accounts for only 1% share of News viewership at an All India level,” says BARC.

That’s it. That is the reach of English news channels. 

Yet, English news channels are not without influence – perhaps they enjoy unnatural and undue influence, thanks to the scale of India, the low allocation of funds to news-gathering in India – and social media.

So let me illustrate how this undue influence works.

Republic TV does a story, say, on match-fixing.

Republic’s social media handles all talk about this issue.

Republic’s social media team creates a flurry of hashtags connected to the story.

Republic’s social media team ‘buys’ reach (legally) on social media and cause the story and the hashtags to trend.

The underpaid and under-resourced journalists in small towns across India, with no budgets for travel or, indeed, for endless phone calls across the country, take the easy way out and follow ‘influencers’ on social media. In the current illustration, they’re following Republic’s handle and, of course, keeping an eye on trending topics.

So journalists across the country, thanks to this extraordinary, unchecked and unfettered ‘source’, viz social media, decide that the match-fixing story is VERY IMPORTANT.

And they write and file their own stories as well.

So much for what the media does.

The consumer, the citizen, does his or her own amplification, spurred by similar provocations.

The consumer, too, follows influencers and keeps track of hashtags and trends. In addition, the consumer keeps an eye on social media updates of friends and relatives and truly LOCAL infleuncers. 

And if the Republic match-fixing story pops up on these pages, up pops the Fear Of Missing Out (FOMO). In dealing with the fear, the consumer adds his or own bit of spice to the story, based on the echo chamber he or she lives in.

Now, let’s get back to the Tanishq ad.

Consider what has happened to a citizen of Jamshedpur who has no knowledge of Tanishq or the controversy, no problem with Hindus and Muslims marrying each other and has never seen the ad and has not seen the coverage on TV.

The story appears on Twitter because the citizen’s classmate RT’ed a tweet. In the RT, the citizen’s classmate denounced the ad, denounced Tanishq and denounced the Tata group.

Aware of FOMO, our hero, the citizen of Jamshedpur referred to earlier, RTs the RT.

And, as thousands of similar citizens do the same, a controversy is born, even if the ad has hardly been seen by the majority who protest about it.

Now it gets worse. Politicians of all hues, too, are on social media and follow the same trends.

And, very quickly, they find that they have the opportunity to ‘ride’ a trend. They can profit or lose by choosing one side of the controversy; in the Tanishq case, the ‘profitable’ side was to denounce inter-faith marriages and, consequently, denounce Tanishq.

So they ‘protest’ at Tanishq showrooms, confident in the knowledge that the protest will be covered by media.

And a new story will be born and aired by news channels.

And the new story will find its way into social media.

And the new story will come back to Jamshedpur.

And FOMO will make the new story trend….

It’s a new news cycle. Unchecked and without a sense of responsibility. More frighteningly, no one has control over this beast.

Tanishq was a victim of this uncontrolled and vicious beast.

The question is: Who is the next? And the next? And the next?

Anant Rangaswami is the editor of Storyboard, the advertising, media and marketing show on CNBC TV18. He is also senior editor at FirstPost.com, and has authored two books, ‘Watching from the Sidelines’ and ‘The Elephants in the Room: The future of advertising in India 2016.

We publish all articles under a Creative Commons Attribution-Noderivatives license. This means any news organisation, blog, website, newspaper or newsletter can republish our pieces for free, provided they attribute the original source (OpenAxis). 

Categories
Uncategorized

How COVID-19 is adding to the existing NPA crisis in India

As described by the Reserve Bank of India (RBI), “An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank.” When banks give out loans to borrowers, these loans are treated as assets. In some instances, when borrowers stop providing interest and other payments for a period of time, banks treat these as NPAs. 

Increasing NPAs burden the financial system and deteriorate the health of banks. As banks stop getting returns from these assets, their profitability is affected. Along with the negative effects on profitability, the loss rate of banks also increases. As the funds of the bank decrease, the future lending capacity of banks is heavily affected. These different events leave banks vulnerable to various unexpected events, namely economic shocks.

Now that the COVID-19 shock is in place, “The level of the NPAs is going to be unprecedented in six months from now if we really recognise the true level of NPAs. We are in trouble and sooner we recognise it, better it is because we really need to deal with the problem,” said Raghuram Rajan at the India Policy Forum in  July earlier this year.

Take a look at the table below that indicates the Gross NPAs of banks from 2016-2019.

Source: Department of supervision, RBI

From the data, we can see that banks had made an overall recovery in 2019 with lower Gross NPAs compared to the previous year. This progression made by banks is now being undone by the pandemic. 

Additionally, the data shows that there is a stark difference between the Gross NPA levels of public and private sector banks. 

Public sector banks (PSBs) have relatively lower capital adequacy compared to private sector banks. PSBs are not efficient at managing their NPA ratios, even the technology used by these banks is not as leveraged compared to private sector banks. Another contributing factor to relatively high levels of Gross NPAs in the PBSs is the vulnerability of these banks to promote certain economic sectors of society due to political pressure. 

The stabilization of PSBs and restructuring of their financial affairs is essential for the PSBs to absorb the shocks caused by the COVID-19 pandemic.

During times of an economic crisis, testing the resilience of financial institutions becomes imperative for the government to get a ground reality of the situation. Doing this helps the government understand how volatile the market is. Once the assessment is made, governments can then apply relevant reforms to stabilize the financial system. 

To assess the current health of banks in India, stress tests were taken by banks under certain guidelines of the RBI. Though it was known that the results of the tests would be disappointing, they are far worse than expected. Reports show that the Gross NPA ratio of the banking sector is likely to increase from 8.5% in March 2020 to 12.5% by March 2021, or even up to 14.7%, if adequate measures are not taken. While the GNPA ratio of the PSBs is expected to increase from 11.3% in March 2020 to 15.2% by March 2021, the private sector banks are expected to increase from 4.2% in March 2020 to 7.3% by next year. 

We should be extremely worried about high NPA levels as it starts a chain of deteriorating financial events. High NPAs lead to low profitability of banks. The lending capacity of banks as well as their income decreases. Additionally, since the banks are unable to increase their lending, money flow is reduced. To add to this, the confidence that the public has on the banking system is heavily impacted and shareholders start contracting their investments. Thus, the issue of rising NPAs is not just an issue that banks individually face but is an issue that impacts the financial system of the country and in turn the economy.


In an attempt to curb the financial distress caused by the pandemic, the RBI attempted to bless financial borrowers by extending the moratorium on all term loans by six months. Though the moratorium ended on August 31, the government recently announced an extension that allows for a two-year loan moratorium in the case that a borrower’s cash flow has directly been affected by the pandemic. An interest rate cut has also been issued to boost the economy. 

While there is an appraisal that the new monetary policy is accommodative to the plight of the borrowers, it is unlikely that this policy is going to ease the financial burden faced by the banks. The balance sheets of banks may improve, they may gain temporary relief from the pressure caused by NPAs and even increase market liquidity by increasing the amount of money that banks may have in hand, either to invest or to spend. The fact remains that the lending capacity of banks will not improve as the amount of money flowing will remain restricted. People’s spending capacity is not going to improve for a while and even with loan extensions, it remains uncertain whether the NPAs would get converted to profitable assets in the future financial years. 

Before India was struck with the COVID-19 pandemic, the banking sector already faced issues with poor health. Bad loan judgements, ineffective asset management strategies and over-relaxed lending norms have previously contributed to high NPAs of banks. For an emerging economy like India, the road to recovery is going to be a difficult process indeed. While it is imperative for banks to internally re-structure lending processes, the RBI and the government also play an important role in the strengthening of bank systems. 

Shrishti is a Politics, Philosophy and Economics major at Ashoka University. In her free time, you’ll find her cooking, dancing or photographing.

We publish all articles under a Creative Commons Attribution-Noderivatives license. This means any news organisation, blog, website, newspaper or newsletter can republish our pieces for free, provided they attribute the original source (OpenAxis). 

Categories
Uncategorized

What do stock market fluctuations in 2020 tell us about human behaviour?

By Srijita Ghosh

If I ask you what’s common between choosing the wrong major and not being able to lose the last 5 kgs that you thought you’d lose by summer, most of you would think there isn’t one. But if I ask you the same question for the stock market behaviour during the dot com bubble (most of you were probably not even born by then) and the same stock market behaviour during the recent pandemic, you can probably name a few. However, the common thread amongst all of them is that they are all driven by incorrect beliefs about future events. 

You were so sure that economics was the right major for you, but at the end of the second year, you realize you have gravely underestimated the technical skills required to finish it and now you wish you had chosen something else. It is natural and quite common to have a wrong belief or estimate about a future event since future events are fundamentally uncertain. 

Economists have been aware of incorrect beliefs and their impact on decision making but modelling them formally has started fairly recently. Taking motivation from psychology and neuroscience, economists have started modelling decision-making under the assumption that the agents are cognitively constrained. They can make mistakes while predicting some uncertain events about the future which can have severe consequences on their life and living. 

It’s the same cognitive constraints that drive the seemingly irrational behaviour in the stock market. But the mistakes that people make in the stock market or most economic context are not random. By studying the patterns of mistakes, we can design effective policies to improve welfare. 

In the context of the stock market, recent studies by Bordalo et al (2020) have found that people overreact to good news and overvalue them in the long run. If we overestimate the long-run valuation of stocks, then eventually we will be disappointed since our predicted value will not be materialized. This can lead to perverse behaviour in the market.

For example, during the current pandemic, the stock market remained more optimistic than what would be expected from the condition of the economy per se. It might be driven by the overestimation of the long-run fundamentals of the stock market. The problem, however, is that the pandemic initiates a “regime change”, which means we cannot be sure where the fundamentals of the stocks would lie in the post-pandemic period.

Another cognitive function that severely affects our belief is that of memory. Various puzzles in the stock market can be related to the nature of memory. There are different features of the memory that affect what we believe. The most obvious one would be the temporal nature of memory; we remember things with more clarity that have happened in the recent past than a distant past. This implies that while forming belief we put more weight on the recent phenomenon that is the underlying trend. This can lead to having an overreaction to bad news. 

The other, more complex feature of memory is representativeness, which implies that different cues about the same underlying object can lead to very different beliefs depending on what comes to mind. In a recent study by Wachter and Kahana (2020) has shown that we often associate two events that are temporally related. If one of these events repeats again we remember both the events, as they are contextually related events. This can lead to further distortion in belief and some examples of such behaviour would be under or over-reaction to news, fear being a leading motivator of financial decision-making, and so on. 

However, we should note that this literature is fairly young and researchers all over the world are trying to understand the impact of cognitive functions on beliefs and subsequently on decision-making. So we should proceed with caution when interpreting the results from the early experiments. Just like any other scientific discipline, we can only conclusively make remarks after several studies have reproduced similar results. 

One major problem here is that human behaviour is complex and when combined with the stock market framework the scope of non-standard (from a neoclassical economics perspective) is large. This makes analyzing and predicting behaviour in the stock market particularly difficult. But one way forward would be to understand how humans form beliefs generally and extend that to the stock market scenario. This will also help us become better decision-makers and be more consistent with our own world-view. 

Srijita Ghosh is an Assistant Professor of Economics at Ashoka University and has done her Ph.D at New York University.

Sources:

Expectations of Fundamentals and Stock Market Puzzles by Pedro Bordalo, Nicola Gennaioli, Rafael La Porta, and Andrei Shleifer (2020)

Memory and Representativeness by Bordalo, Pedro, Katherine Coffman, Nicola Gennaioli, Frederik Schwerter, and Andrei Shleifer. 2020

 A Retrieved-Context Theory of Financial Decisions by Jessica A. Wachter and Michael J. Kahana

We publish all articles under a Creative Commons Attribution-Noderivatives license. This means any news organisation, blog, website, newspaper or newsletter can republish our pieces for free, provided they attribute the original source (OpenAxis).