The deepening crisis in the banking sector

A financial crisis always affects economic growth for long periods. Attempts to shut the stable door by eliminating LoUs etc will simply raise the costs for exporters

The last fortnight has seen selling by retail investors who panicked when the Telugu Desam Party pulled out of the National Democratic Alliance and the dimensions of the banking scams kept expanding. Other political news also made the Bharatiya Janata Party (BJP) look a little more fragile as it suffered reverses in three by-polls and a No-Confidence Motion was proposed.

The fears of a global trade war sparked by the US President, Donald Trump’s protectionist tariff proposals, also spooked Foreign Portfolio Investors (FPI) to some degree. So, despite the release of encouraging GDP and manufacturing data and a trend of easing retail inflation, market indices slid downwards.

There are fair chances of a long-term bear market. In technical terms, the Nifty is poised just above its own 200 Day Moving Average (200 DMA) in the 10,150-10,200 range. If it falls anymore, and especially if it breaks below the round number benchmark of 10,000, prices could trend down for a long time.

Whatever reservations economists have about technical analysis, the 200 DMA is a benchmark tracked by traders who, in aggregate, place large directional bets. If the index breaks down below the 200 DMA, it will create a cascading effect of more selling. This could lead to a feedback loop where more falls trigger further hammering.

Given poor sentiment, good Index of Industrial Production (IIP) numbers for January 2018 have been ignored. The IIP rose 7.5 per cent year-on-year in January. Retail inflation for February 2018 showed welcome moderation, with the Consumer Price Index easing to YoY levels of 4.44 per cent, down from 5.07 per cent in January. That was also ignored but it reduces chances of a policy rate hike in April.

There are multiple state assembly polls due through the next year, culminating in the General Elections, which should be held by April-May 2019. The next assembly poll is in Karnataka. Sentiment under the circumstances will be dominated by changes in the political landscape and market volatility is guaranteed. By and large, market trends will align with the BJP’s fortunes. There could be sharp gains, or equally sharp losses, depending on the BJP's scoring pattern.

Bypoll results in Uttar Pradesh's Gorakhpur and Phulpur constituencies and in Bihar’s Araria went against the BJP. The UP results were especially damaging to sentiment because those are seen as pocket-boroughs, vacated by the incumbent UP Chief Minister and his number two. If the alliance between the Samajvadi Party and the Bahujan Samaj Party holds, the BJP's chances of retaining its stranglehold on UP diminishes. Meanwhile, the exit of its long-term ally, the TDP, reduces its chances of maintaining a viable coalition if it fails to get a majority in the 2019 Lok Sabha elections.

Investment patterns have been interesting in March. Institutions have been net equity buyers but the market has fallen. That’s rare. By last Friday March 1-16, domestic institutions had bought a net ~3.3 billion while the FPIs bought a net ~63.8 billion. However, the FPIs have also sold ~106 billion of rupee-debt in the last fortnight. Those numbers have several implications.

First, retail selling has been high enough to counterbalance institutional buying. The Nifty index is down by 2.5 per cent in March, while the Nifty Smallcaps 250, which is more driven by retail sentiment, is down by 3.3 per cent. As new information about the Punjab National Bank scam has surfaced and been met by knee-jerk reactions such as shutting down letters of undertaking (LoUs), retail sentiment has further deteriorated. Hints that the Reserve Bank of India Governor and the Ministry of Finance might not be on the same page have led to additional nervousness.

Second, the FPI exit of rupee debt underlines concerns about bearish bond markets. Yields have risen across the bond market in the last six months and the yield curve has also flattened. A rising yield means capital losses for debt investors. A flatter bond curve (where short-term yields are very close to longterm yields) suggests recession expectations. It is usually a lead indicator of an equity bear market.

There is no question that the banking sector is deep in crisis and there is also no question that this will impact growth for long periods. There are multiple instances of financial sector crises drawn from across the world, from various economies. A financial crisis always affects economic growth for long periods. Attempts to shut the stable door by eliminating LoUs etc. will simply raise the costs for exporters.

The market may still be in denial about the fact that the proposed ~2.2 trillion recapitalisation scheme will not be enough to restore health to publicsector bank balance-sheets. The proposed Financial Resolution and Deposit Insurance (FRDI) Bill with its proposals for an omnipotent Resolution Corporation and a bail-in clause doesn’t really address the underlying problems and it is running into opposition.

Retail investment has been an important component of the bull run for the past two years. The best tracker for this is flows into equity mutual fund assets. Much of that is locked in by systematic investment plans. We’ll get a sense of possible changes in sentiment when the new financial year starts and the April numbers come in.