For some time now, the word in Delhi is that according to an internal study by the US embassy, US firms earn a return of around 40 per cent in India, compared to just about 5-6 per cent in China.

There is no way of knowing whether this is true or not and, if true, what the qualifiers are. But the fact that there is money to be made in India is now generally accepted, as compared to, say, five years ago - and certainly 15 years ago when India was seen as a poor prospect.

It would seem that this is true of the Indian stock market as well. A recent paper* by Rajnish Mehra, who teaches economics at the University of California in Santa Barbara, says, "Indian equity premium has been quite high in the post 1991 period, averaging 9.7 per cent above the corresponding risk-free security." The comparable figure for other
countries is around 6-7 per cent.

The equity premium is the return earned by a well-diversified stock portfolio in excess of that earned by a risk-free security. It determines, when the time comes to leap off the diving board, how resources will be allocated.

In the US, according to data for the last 115 years, the average annual inflation-adjusted return on a risk-free security was just 1 per cent, compared to 7.5 per cent on stocks. In the UK, the annual return after 1845 has been 5.7 per cent while the average return on bonds was 1.1 per cent.

The same thing is true of France, Germany and Japan who, together with the US, account for more than 85 per cent of capitalised global equity value.

For India, the author has used BSE 100 and the Sensex index as a proxy. The equity premium has been calculated with reference to deposit rate in banks, which is used as the perfect substitute for a risk-free security, such as a US treasury bill.

In India, he says, "the doubling period for investments in stocks is about six years compared to about 55 years in a risk-free asset." This, he says, is what should drive the debate on where to invest retirement funds and so on. This is what the Marxists don't want so that people can be kept poor.

One reason why returns on stocks are higher, of course, is that "the standard deviation of the returns to stocks in India (about 30 per cent a year historically) is larger than that of the returns to T-bills (about 2 per cent a year)."

To explain why this has been happening Mehra harks back to a paper he wrote along with Edward Prescott in 1979, where they found that "stocks in the US on average should command at most a 1 per cent return premium over bills" but in fact earned a lot more.

They took six years to explain that "the puzzle arises from the fact that the quantitative predictions of the theory are an order of magnitude different from what has been historically documented."

In short, the theory is all bull because the data doesn't fit it. Many attempts have been made to show that Prescott and Mehra are wrong. But, combatively, Mehra concludes with "the following assertion: the equity premium in the future is likely to be similar to what it has been in the past and returns to investment in equity will continue to substantially dominate returns to investment in T-bills for investors with long
planning horizons."

If what he saying is right - and there seems no immediate proof to the contrary - the case for making the stock market stronger and safer becomes all the more pressing. In practice, this means far better regulation than we have so far achieved.

*The Equity Premium in India, NBER Working Paper No. 12434, August 2006. The article is an entry prepared for The Oxford Companion to Economics in India, edited by Kaushik Basu.