Bubble in DSE

Posted in economics by jrahman on March 1, 2010

Is there a bubble in Dhaka stock exchange?  That’s the conclusion reached by Ahsan Mansur and Nurul Hoque of Policy Research Institute in a recent article in Financial Express.  They conclude:

Currently the market is entirely being driven by mob frenzy, and how long this will continue is to be seen. However, if this frenzy continues for a few more months, the bubble would become much bigger and it would be too late to defuse this ticking bomb. The bubble will explode like it did in 1996. Should we allow the market to give investors such a hideous solution? Should not the government come forward to give people a better solution?

It seems that the authors are right.  While asset price bubbles are often very difficult to identify, in the case of DSE, it’s hard to reach any other conclusion.  But having agreed that there is a bubble, it’s not clear what the government should do — I discuss some options, but not really sure how effective any of them would be. 

Anyone has any idea?

Update 14 March, 5pm Dhaka time.

From a marketwatcher:

On the issue of the high market, I think it is important to look into the impact of black/undisclosed money in the budget (allowed from July 1, 2009 for a period of two years, with the stipulation that the money has to be kept in the market for two years from the date of investing), combined with the fall in interest rates, the relatively low P/E prior to that period, along with the increasing role of institutional investment need to be taken into consideration as well. While it is beyond reasonable doubt that many shares are overpriced in this market, with many have P/Es beyond 50, 75 and even 100, one also needs to consider that even though some share prices are higher than they were in the 1996 bubble, some of those shares have higher earnings as well. I won’t be surprised with some correction, but I doubt that there will be any crash as was the case in 1996. The market is much more mature now, as are many (but definitely not all) investors.

Let’s start with why this seems to be a bubble.  Mansur and Hoque compare recent price rises in DSE with what happened in 1996.  In the autumn of that year, DSE rose sharply, to be four times higher in November than its January value.  Then the bottom fell out of the market, and prices returned to January 1996 level by the end of 1997.  That kind of sharp rise and fall in asset prices, with little changes in the fundamental economic reality, is what we call bubble. 

Chart 1 below shows that this time too we see sharp rise in prices that look suspiciously like what happened then.  In this chart, the horizontal axis shows number of months since the beginning of the bull run, while the vertical axis shows the DSE indexed to that beginning.  Back in 1996, DSE started rising from January, so that’s what the grey line is indexed to.  Back in November 1996 (that is, 11th month of the run), DSE peaked at 395% of its January value.

Now, the market is indexed to March 2009, when the global asset markets reached the post global financial crisis trough.  Since then, DSE had risen by nearly 125% by February 2010 (that is, the 12th month of the bull run). 

Mansur and Hoque argue quite convincingly that nothing about the fundamentals of our economy suggests why DSE should be rising so fast.  They show that the supply of stocks have remained largely unchanged, but the demand is going through the roofs.  And to further make the case that we are looking at a bubble, they point to rising price-earning ratio.

All else being equal, high price-earning ratio means the stock has a high growth potential.  But if price-earning ratio rises very quickly in the absence of any new information, then that might point to a bubble.  The weighted average ratio for the DSE has nearly doubled to 30 during the current bull run.  But looking at the ratios in individual industries, it seems cement and textile are the two industries where prices have really skyrocketed (chart 2). 

What fundamental breakthroughs have happened in these industries to justify such rises in the price-earning ratio?

If anyone is wondering whether this is really a vote of confidence on Bangladesh’s solid performance during the global recession, then chart 3 (showing stock market gains since March 2009) should disabuse one of that notion.  The recent rise in DSE dwarves our neighbours.  While Pakistan or Thailand might be suffering from political instability, it is hard to put up a case that the medium term prospects are brighter for Bangladesh than India, China or Indonesia.

So, there are strong reasons to think that there is a bubble in DSE.  Since bubbles always end badly and usually the unsophisticated retail investor suffers, something ought to be done.  The question is, what exactly should be done?

Mansur and Hoque trace the bubble to excess liquidity:

Obviously when there is a lot of liquidity in the system, and money being fungible, there is no way to prevent people from borrowing on one account (for the officially stated purpose of trading, housing, agriculture and other uses) and investing in the stock market. As surging flood water cannot be contained by a putting a small/weak dam downstream and water simply bypasses or overwhelms/washes away the barrier, money keeps pouring into the stock market ignoring the SEC signals lured by quick capital gains.

With broad money (M2) expanding by more than 20% last fiscal year and once again this year, fueled by inflow of workers’ remittances, certainly there is more than enough liquidity (like surging flood water) to shrug off the limited efforts by the SEC. The budgetary provision to allow whitening of undisclosed money into the stock market is also playing an important role in flooding the market with liquidity.

In simple English, there are too much cash floating around our economy, but not enough investment opportunity.  As a result, every Ram, Rahim and Abdullah are looking for a quick buck in the share market. 

So the solution is to turn off the liquidity tap?  But how do you do it without killing the real economy?  That is, if the Bangladesh Bank raises interest rates, that’s going to hurt investment, and we are in this situation partly because people with savings have little options to invest.

Perhaps one solution might be to let the taka appreciate.  I’ve argued for a taka appreciation before to help stem rising inflation.  Could the undervalued taka be attracting foreign currency in anticipation of an appreciation?  Could we be floating on the global dollar carry trade?  Could this be behind the excessive reserves the Bangladesh Bank is holding?  And could those reserves be sipping into the domestic money supply?  If the taka appreciates, would that not effectively tighten money supply? 

I am not sure if this line of argument is water tight, and would very much appreciate comments from those who know the Bangladeshi money market better. 

An alternative to monetary tightening, through appreciation or interest rate, is for the policymakers to try to persuade the market of the bubble.  Essentially, this involves the Bank Governor or the Finance Minister to make a few speeches where they highlight the ‘irrational exuberance’ in DSE.  

There are of course problems with this approach.  If the Finance Minister were to give this speech, he will justifiably come under political fire for ‘mismanaging  the economy’, while I am not sure the Bank Governor has the credibility to sway the market.  So I am not sure this is actually going to work.

Yet another option might be for the government to provide alternative avenues for savers to invest their money.  For example, the government could sell bond — that is borrow from the public — to fund various infrastructure projects like the Padma bridge. 

Whatever the government chooses to do, it probably should act fast.  The thing with bubbles is, the longer you let it fester, the bigger the usual aftermath is.

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  3. Syeed said, on March 11, 2010 at 11:47 am

    The bubble is definitely there, but I don’t see the solution is in monetary policy (i.e. exchange rate) or in fiscal policy (i.e. selling bonds).

    One needs to understand the socio-economic reasons behind people’s apathy to invest in long-term projects and interest in quick-and-easy risky business. We have long been debating/arguing the impact of worsening law and order situation in domestic investment which has resulted in increasing consumer expenditure and inflation. Its not about people having too much money at hand, its about people not being interested in going through the saving and investment cycle with whatever money they have at their hand. Its a cosmopolitan Dhaka phenomenon and needs some social research.

    Selling of bond for bigger projects will be counter-productive. At one hand, this high-rate government borrowing discourages people’s investment behaviour, makes savings in the private banks less competitive (though with the amount idle money, this can be ignored for the time being)… but more importantly, this high lending usually puts government into higher debt/deficit which ultimately ends up influencing the inflation rate.

    • Syeed said, on March 11, 2010 at 3:14 pm

      btw, just to clarify: by send bond as fiscal policy, I meant selling bond as part of revenue collection… not standalone monetary policy … can’t be conscious enough about terminologies while posting on an economist’s blog 🙂

    • jrahman said, on March 14, 2010 at 3:31 pm

      Syeed, you’re very right about the social angle. In fact, most asset price bubbles anywhere in the world have a social element of get-rich-quick.

      On the selling bond bit, you’re right that government borrowing in general distorts private savings. However, I understand the government is funding infrastructure projects like the Padma bridge by borrowing from overseas. Given the government is going to borrow, selling bond in the domestic market is safer.

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