The central bank must forecast the capital requirement for the next twenty years or more and then structure their policy to facilitate capital growth. 

--BY AR BHATTARAI

In the recent period, stock market boom and bust have been important factors in macroeconomic fluctuations in both the developing and underdeveloped countries. In light of this experience, how or when, if at all, should central bankers respond to such volatility?

Central banks face a fundamental dilemma. The dilemma is that when we see stock trading at prices that seem lower than normal, or when we see the volume of trading activities is higher than normal, what do they think are "normal levels". We can almost never be sure whether these shortfalls or excess supply reflect a demand supply mismatch or simply a re-evaluation of fundamental values by market participants. And these two different interpretations have very different implications for the appropriateness of central bank actions.

The central bank is an entity responsible for the monetary policy. There has been considerable debate on the appropriate role of stock price (Index) while formulating the monetary policies. Changes in index prices should affect monetary policy only to the extent that they affect the central bank’s forecast of capital formation. Some regulations may reflect quick and positive response in the capital market. Hasty and unstructured regulations will damage investor sentiments towards the capital market on the long run. We had experienced many strong and robust controls introduced by central banks, which have had a negative influence in the capital market and has discouraged capital inflow in the economy.

However, the policy response to bridge the gap between demand and supply influenced the capital market by correcting stock prices to some extent. Current stock price movements are unpredictable and random, as these movements don't support market fundamentals.

Admittedly, the demand supply gap is difficult to measure, but they (central banks) are more confident with their analysts, who have the ability to measure the demand supply gap. But markets are influenced by several other factors, with analysts seldom forecasting the impact of the fundamental component of stock prices. Many times, those analysts inadvertently failed to estimate the percentage of standard deviation of estimates of stock price fundamentals, with that of potential incremental supply.

In reality, however, no perfect indicator has been found. In their attempts to predict the market, economists use technical analysis. Technical analysis is the use of market data to analyse individual stocks and the market as a whole. All researchers working in this area use "historical" already realised data to predict the behaviour of the stock market. A deficiency in adequate research on non-fundamental components of stock prices has generally been treated as exogenous.

Analysis and prediction of the stock market is believed to be a very difficult task. Traditional methods of time series analysis are not adequate for such a problem, because they are not designed to address complications like "turbulence", "chaos", "bias" or "indeterminacy" observed in the stock market. However, shocks to stock prices are not unique in this regard; by the same logic, monetary policy should respond to any shock that changes the natural real rate of interest; there is no theoretical justification for signaling out the stock market.

The efficient market hypothesis, a core concept of investment theory, states that stock prices reflect all information available to investors. In other words, current stock prices factor in investors’ best judgments about the future potential of those stocks. Therefore, stock prices are theoretically the best predictor of future events because they are the market’s consensus of a stock’s expected value.

It is viewed that, there are some good reasons, outside of the formal model, to worry about attempts by central banks to influence stock prices, including the fact that (as history has shown) the effects of such attempts on capital market psychology are dangerously unpredictable. Recent regulations on stock market and robust control introduce by the central bank on capital formation and use of more conventional approach to policies has slowed down the capital formation process.

The central bank should understand capital formation is a continuing process, not something that is a one-off deal. Conditional and unstructured policy response will control the much needed capital inflows. Nepal, as an underdeveloped country, needs huge amounts of capital to finance development projects. The central bank must forecast the capital requirement for the next twenty years or more and then structure their policy to facilitate capital growth. Therefore, while introducing any regulation in the capital market, the central bank must predict long term micro-economic stability and should not be confused with short term control.

Looking at future needs, we must rethink and redesign our rules and regulations to facilitate capital growth. Nevertheless, we must appreciate efforts made by all players and regulators till date to bring the stock market up to this level.

The Nepali capital market is ailing from unstructured and the short-range vision of market players. But, every dark cloud has a silver lining. However, regulators should be taking prompt and proper decisions to cash in on the silver lining of this dark cloud. This threat could be a big opportunity to reshape the country’s capital market. We learnt a costly lesson. As is often said, one has to pay for one’s education!

Chartered Accountant Bhattarai is a former banker. This article is reprinted from his blog.