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STU 04-02 : Special Topic - Stock market prices and economic growth [Short Term Update 04-02]

In October, the FPB updated its medium-term outlook for Belgium until 2007. This projection is pointing towards a GDP growth of 2.5% on average from 2003 to 2007. This development can be largely accounted for by domestic demand, whereas the role of (net) exports is expected to be more limited. Private consumption should be more dynamic during the forecasting period than during the nineties thanks to a favourable development in households’ disposable income (stimulated especially by reductions in personal income tax). The growth in gross fixed capital formation should attain an average of 2.9% during the period 2003-2007, notably reflecting the expansion in business investment. Export growth should be 5.1% on average: the structural loss in export market share should be confirmed and the contribution of net exports to GDP growth is expected to decline.

The inflation rate should be below 2% in the medium term. Assuming no shocks on commodity prices, the main domestic factors behind this moderate inflation are wage increases compatible with productivity gains, cuts in social security contributions and the extension of production capacity.

Employment should show a gradual improvement: an increase of 33,000 jobs on average should be observed during the 2003-2007 period (as compared with an increase of 40,000 jobs, on average, during the 1996-2000 period). However, a large proportion of the labour expansion should be absorbed by an increase in the labour force. Therefore, the unemployment rate in a broad sense should only decrease from 13.5% by mid-2002 to 13.2% in 2007.

Assuming no policy change but taking into account (as far as possible) the measures decided within the framework of the 2003 budget, the financing capacity of public administrations should be close to balance between 2003 and 2006 and a small surplus would be observed in 2007. Taking into account the computed output gap and the resulting cyclical budget component, the structural (cyclically adjusted) balance would be positive but slightly declining from 2002 onwards.

The objective of a positive financing capacity (0.5% of GDP in 2005 as mentioned in the new Stability Program for Belgium) is not expected to be reached without additional budgetary measures. However, the total public debt to GDP ratio should continue its decline, but at a slower pace if compared with the 2001 forecast. The decrease should represent about 21% of GDP between 2001 and 2007.

Following the recent fall in equity prices around the world, questions have been raised about the effect of the decline on the ongoing recovery. This special topic describes the main channels through which this fall can affect economic growth. More specifically, we will examine four transmission mechanisms and discuss their possible importance in the euro area as against the United States. Finally, some estimates of wealth effects on the Belgian economy will be presented.

New downward trend in equity prices since spring 2002

Triggered by the bursting of the technology bubble, eq-uity prices in the three most advanced economies have been on an almost continuous downward trend since peaking in March 2000 . After a brief recovery in the autumn of 2001, stock market prices have again fallen precipitately in the last few months. The recent collapse in equity prices is different in the sense that it is now widespread and is not mainly con-centrated in the ITC sector. It reflects partly a loss of credibility of audited accounts, as a result of a number of accounting scandals in the United States. Between the end of March and the end of October 2002 the Dow Jones EURO STOXX 50 and the US Standard & Poors’ 500 dropped by 33% and 23% respectively.

Equity price fluctuations and economic activity

The most thoroughly described and empirically tested channel between equity prices and economic activity in the economic literature is the so-called wealth effect on private consumption. The theory of permanent income tells us that, in addition to anticipated future income, an upward shift in financial and non-financial wealth which is perceived as permanent will induce consumers to spend more of their current income. Based on this mechanism, the impact of a shift in equity prices on consumption will depend on two factors: the level of house-hold equity holdings and the propensity to consume out of equity wealth.

Concerning the first factor, while US households’ direct and indirect equity holdings, as a percentage of total financial assets, remained almost unchanged at around 30% between 1997 and 2000, in the euro area this share increased from 15% to 20% during the same period. This higher stock market exposure implies that, in comparison with a few years ago, a given fall in equity prices will mean a larger decrease in the financial wealth of households in the euro area.

Concerning the second factor, most empirical studies find that in the United States there is a significantly higher marginal propensity to consume out of equity wealth (between 0.03 and 0.05) than in most individual euro area countries (estimated at around 0.01). The explanation put forward is twofold. Firstly, in so-called market-based economies like the US, consumers are less credit-constrained in the sense that they have access to a wider range of credit instruments, which means that it is easier for households to borrow against their assets than in bank-based economies. Secondly, the higher propensity to consume out of wealth in the United States may also be due to the fact that a greater proportion of households have direct equity holdings as compared with the euro area.

Stock market prices can also impact consumption through a second channel. According to the dividend discount model, equity prices should reflect expected future dividends. Similarly, a decline in equity prices could be interpreted by households as an increased downward risk in relation to prospects for economic growth and employment. This may, in turn, harm consumer confidence and lead to an increase in the savings ratio, even if households do not possess equity holdings. A few empirical studies have found some evidence of a (weak) equity price effect on consumer confidence in the United States but no such relationship could be established for euro area countries.

Stock prices can also have a direct impact on business investment, mainly through two channels. The first channel operates via the cost of equity capital. A decrease in equity prices means that the market value of the firm relative to the replacement cost of its stock of capital (called Tobin’s q in the literature) declines. As the cost of financing investment through new issues of equities increases, the firm will lower its investment spend-ing as some projects previously perceived as profitable will be cancelled. Capital stock will gradually adjust to the lower long-term level and q will return to its normal value. The second channel operates through the balance sheet effect. Decreasing equity prices erode corporate collateral and reduce the firm’s ability to borrow and consequently to invest. The link between stock market prices and investment should be stronger in countries where firms rely more on equity funding (as in the United States), but investment also should not be immune to equity price movements in bank-based economies because in these countries financial institutions own large equity holdings and there can be substantial effects on their balance sheets. Nevertheless, only a relatively weak empirical relationship between stock price movement and business investment has hitherto been found for euro area countries.

According to the European Commission, the recent decrease in equity prices “...is somewhat atypical and could be associated with a stronger drop of investment than during previous stock market corrections”. In a ‘normal’ situation, the downward revision of expected future earnings would be associated with reduced borrowing interest rates, reflecting lower growth prospects and lower inflation. But, as has already been mentioned, the current collapse is partly due to a loss of confidence in company balance sheets and it could, in this case, have contributed to a rising risk premium and reduced access to corporate loans, as reflected by increasing spreads on lower-grade corporate bonds since April of this year both in the United States and in Europe.

To summarize, there are good reasons to believe that the recent fall in equity prices will have a negative effect on consumption and investment, particularly now that stock market corrections have hit all the major economies simultaneously, which should reinforce the synchronization in business cycle movements.

STU 4-02 was finalised on November 29th 2002.

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