BackA disturbing disconnect between India’s real and financial markets
We should bear in mind that financial services have no limit on growth but our real economy does
PremiumIn the economic sphere, the defining feature of the 1990s was the emergence of the ‘net economy’ as technology enabled a whole host of new transactions both globally and within economies. This trend accelerated after 2000, and, post the global recession of 2008, while world trade in manufactured goods has remained stagnant in terms of share of global gross domestic product (GDP), the only growing segment has been trade in services. In fact, the ‘net economy’ brought about a dramatic decline in the cost of transacting services both nationally and internationally. To that extent, digital technology performed the same function in promoting trade in services (e -commerce) as reductions in shipping/air and land transport costs did for trade in manufactures between 1950 and 1990 or so.
In comparing manufacturing and services, however, there is one difference: Digital transactions can lead to an infinite sub-division of a service in a particular sector, unlike in manufacturing. For example, while the automotive sector can be sub-divided into automobiles, parts and components, there is a limit. You can’t produce a spark plug with 1,000 small sub-components. On the other hand, in theory, in many service sectors, no such limitations exist. What I will argue is that the frenetic pace of technological change in digital technology and its impact on the services sector has led to a disconnect between the real and financial economies, which finds expression in stock markets. This was witnessed in other economies and is seen now in India. This cannot last.
Especially in the new millennium, we have seen the replacement of many traditional manufacturing industry giants (IBM, GM, etc) with new-wave leaders like Apple, Facebook, Amazon, etc. In India, this has found expression in the boom of service-sector ‘unicorns’, like Grofers, Droom, Zomato and others in diverse sectors from automobiles to food. However, all these unicorns have one thing in common: they are all aggregators. Let us look at this in a little detail.
The purpose of any market mechanism (Adam Smith’s ‘invisible hand’, for example) is to coordinate an infinite number of transactions to determine one transaction price. But the implicit assumption is the existence of such a market and perfect information on the part of both buyers and sellers. However, in the case of asymmetric information, that market mechanism breaks down. The purpose of aggregators is precisely to create such markets.
Consider the market for used cars. If I can collect all information on the demand and supply of used cars and match them at one price while assuring quality, I would solve the famous ‘lemons problem’; the nature of the transaction is such that the seller can never know precisely the exact quality of any car. The limiting factor is the need to hold stocks for sale/purchase. If however I can digitally coordinate sales and purchases, I can effect a transaction without any cost of stock holding. All I need is to certify quality and complete transactions via digital fund transfers. Net technology allows me to coordinate these in a larger national market and coordinate the buy/sell transactions digitally, instantly and with no inventory cost. The consumer is a clear gainer, with access to a near perfect market for used cars where actually any number of service providers can participate. In the last few years such service aggregators have mushroomed in areas like food delivery, product delivery, taxi services, education, etc.
What such aggregators sell investors is an idea rather than a specific product. It is these ‘ideas’ that get funded and many aggregators have gone on to become unicorns. This technology-driven economy has some inherent problems. For one, ‘ideas’ have no fixed cost and almost anyone can aspire to build a unicorn. Witness the age group and profile of most unicorn leaders today. Second, very few of these service-sector startups are profitable today, as they tend to plough back profits to grow their business in the face of ever-increasing competition. But seed investors at some point will need to recover their invested funds. Typically, this is done by floating new shares in a booming stock market so the risk of business failure is passed on to shareholders, and the early investors can move on to the next idea. The problem is that these aggregators can only promise delivery of real-economy products to consumers (cars, food, electronic goods) whose growth is determined by the real economy. But, unlike the manufacturing sector, the growth of this financial (services) sector is not limited by the physical economy.
Recent data in Mint (13 October 2021) shows that the ratio of stock market valuation to actual revenues varies from 2,000 (Bharat Pe) to 50 (Grofers). It is also seen that the shareholding of the founders is very low compared to early investors (less than 25%).
The fungibility of services is at once an advantage and a liability: the growth of financial services is limitless, while that of the real sector is not. This is precisely what happened in the ‘sub-prime’ crisis in the US in 2008, which led to a global recession. The recent spurt of initial public offers in India thus has a reasonable element of risk. As the Indian middle class rushes to move out of low-yielding bank financial assets, it may be advisable to watch out for ‘irrational exuberance’ in our stock markets.
Manoj Pant is professor of economics and vice chancellor, Indian Institute of Foreign Trade
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