The RBI did a study taking into account the stock prices, money supply, the economic outlook and foreign portfolio investments in the equity market between April 2005 and December 2020. The results showed that the rise in stock prices is mainly driven by money supply and FPI investments which does not reflect its fundamentals and could lead to inflationary asset prices.
“…liquidity support cannot be expected to be unrestrained and indefinite and may require calibrated unwinding once the pandemic waves are flattened and real economy is firmly on recovery path,” RBI said.
Indian stock markets have more than doubled from their lows in March 2020 not reflecting the contraction in GDP growth riding on increased money supply and foreign portfolio inflows as global interest rates have fallen.
The central bank also compared the stock market‘s price-to-earnings (P/E) ratio with its historical trend and found that it could be overvalued by as much as 15 points from its long term.
In the early months of Covid-19, stock indices fell due to a rise in equity risk premium (ERP). However as risk premium fell, easy liquidity and increase in forward earnings expectations contributed to the rise in markets which cannot be sustained for a long time.
“A decomposition of changes in equity prices indicate that the rise in equity prices during 2016 to early 2020 was mainly supported by a decrease in interest rates and ERP, with increase in forward earnings expectations contributing to a lesser extent…. Currently, dividend yields have fallen below their long-term trends. As such, two-way price movements are possible going forward,” RBI said.
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