Both equity and bond markets are jittery with banks fraud expanding and banks hitting the brakes. Strong and visible action is the only way out of the current mess.
The Bank Nifty is down nearly 14 percent from its peak in January. Bond prices crashed on Budget day, with the yield on the 10-year benchmark paper hitting a 22 month high of 7.6 percent. The 18 basis point-upmove on that day was the highest in a single session. The slide in stock prices—particularly of bank shares—began the following day.
Just when sanity was returning to the bond and stock markets, a massive fraud was unearthed at state-owned Punjab National Bank.
The next round of fall in stock and bond markets was aggravated by news of the fraud and how it was spreading to other banks.
A clueless government and central bank did not know how to react to the fraud. While the central bank maintained stoic silence in the initial days, it later ordered special inspection of the bank. Government officials, who are yet to learn that their actions or inaction can rock the market, asked banks to relook at all non-performing loans of over Rs 50 crore for possible fraud.
Financial markets and bankers were on tenterhooks because of this decision. No wonder then the bond yield rose higher, expecting bankers to tighten lending norms and keeping rates higher to discourage lending.
India 10 year bond yields have shot up from a low of 6.408 percent to nearly 7.8 percent in a span of seven months, however, banking stocks have reacted to the rise on since January end. Credit Suisse in a recent report said that the banking sector will take a hit of over Rs 20,000 crore on treasury losses, which is much bigger than the Rs 12,700 crore loss cause by Nirav Modi & Co.
The market had ignored the rising bond yields earlier as analysts expected a growth in non-food credit or advances to offset losses in the bond portfolio. The fraud could not have come at a more inopportune time, as it did just a month ahead of the year-end, leaving little room for the banks to cover the losses by increasing business.
However, the PNB fraud and subsequent action by the government, central bank and interaction with bankers now suggests that bankers will be hesitant to increasing lending and would like to thoroughly scrutinize every case.
Various industry bodies including CII and Assocham have raised the issue saying that lending to corporates should not be choked as a fallout of the fraud. The market, as well as industrialists, were gearing up for a pickup in credit growth despite a mediocre and political budget.
However, the warning has come a little late. Banks reluctance to issue letters of credit, letters of undertaking (LoUs) and similar guarantees has affected the one-year rupee forward rates. These rates have crashed in the currency market as importers rushed to buy dollars in the spot market to meet their payment obligations.
The one-year forward rates have crashed by about 50 paise to a low of 239 paise within few days. The crash indicates the acute dollar shortage in the forward market and occurs only when banks stop lending. The last two occasions when rates had plunged so swiftly was during the Lehman crisis and the weeks following demonetisation.
It is in the interests of the government and the economy that the PNB investigation is wrapped up quickly and the guilty punished. The banking system needs to be stabilised as soon as possible and lending operations have to return to normal. Rather than being a silent spectator, government, as well as the RBI, should be seen assuring the markets that it will do everything possible to set things right.The first sign of semblance of normalcy will be seen in the bond market ahead of equity markets.