RBI's largesse may spark rally

Markets have survived high valuations & an average Budget. Will the money-laundering sting prove the last straw?

The credit policy tomorrow could determine the short-term trend. It comes at an interesting moment. Inflation, in general, is rising but "core inflation", eliminating food and energy, is lower. There is intense pressure on the Reserve Bank of India (RBI) to cut rates. The finance minister and the chairman of the Economic Advisory Council have both indicated they hoped the central bank would ease monetary policy.

However, the numbers make it pretty much impossible for RBI to "cut hard", if one may borrow from cricket jargon. The RBI governor's recent speech at the London School of Economics indicates he might not want to cut at all.

At best, RBI will reduce the repurchase rate by 25 basis points. There isn't much space to reduce the cash reserve ratio (CRR). Given the stressed condition of their balance sheets, banks could also be reluctant to pass on any cuts, especially public sector ones.

If RBI doesn't cut at all, the market will crash. If RBI does cut by a minimum, the market will lose some ground or, may be, remain, unaffected. If RBI does gamble on kick-starting growth and makes a larger cut of 0.5 per cent, there will be a rally.

If Subbarao believes a big cut makes sense, he will probably wait for the next policy review, in April, when there are more data. The last time RBI decided to cut by more than the minimum, reducing the repo by 50 basis points in mid-2012, it did not trigger growth.

The Bank Nifty and non-banking financials are most sensitive to monetary policy. Since bank stocks hold a very large weight in all major indices, it influences the overall market trend as well. But there is also another factor for traders to consider.

The recent sting operation casts a shadow of money-laundering accusations on three major private banks. This event will be top of the mind in the next few days, as there will be follow-up stories and statements. It could end up spooking investors, especially Foreign Institutional Investors, until the decibel-level in the media drops.

The fuss will eventually die down. Even if there is a serious investigation by regulators, it could carry on for the next decade without any visible outcome. Regardless of the truth in these specific cases, nobody wants to interfere with the chain of money laundering.

India's "black economy" is between 25-40 per cent of official gross domestic product, depending on different estimates. It is impossible to run an election campaign, manage a construction business, build a road or carry out real estate transactions without recourse to the "black" economy. That money needs channels to flow in and out of official systems and, hence, the chances are high that the sting will be buried without cascading.

But the three banks at the centre of the accusations have high weights in the Bank Nifty, as well as in the Nifty and Sensex. Private banks as a group have valuations that are thrice as high as PSU banks. If those stocks see a hammering, financials as a group will drop, regardless of the direction of the credit policy.

This situation is somewhat reminiscent of 2000. The Tehelka arms-sting (co-authored by Aniruddha Bahal, who masterminded the current sting) broke alongside an anodyne budget. The dotcom bubble was then in its last stages of madness. There had been rumblings about stock-price manipulations from the KP cartel. A four-year downtrend started in March 2000. The bear market was helped along by 9/11 attacks on the US, generally poor economic management and a drought.

Now, in 2013, big stocks seem overpriced in general, without being precisely in a bubble. There have been margin calls and rumours of price manipulation as many midcaps have seen sell-offs in the past month to six weeks. The Budget has been average. Maybe the money-laundering sting will prove the last straw to break a market that looks to have unsustainable valuations.