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Scams and Markets

A sting operation carried out on three largest private sector banks has brought back the memories of 2001…

Public memory is proverbially short. Since half of India's 120-crore population is less than 25 years old, it is understandable that even recent history is rarely referenced in debates. However, sometimes an awareness of history can help in creating road-maps for possible futures.

History never repeats exactly but patterns show up if you look for them. Over the past few days, I have been nervously recalling events that occurred between February and April 2001.

The dotcom bubble started deflating a year before, in February-March 2000. But optimists still hoped that prices would revert to the heady heights of 1999-2000. ICE (IT, Communications, Entertainment) shares had been bid up to a point where even after a year of correction, some stocks were trading at triple-digit PEs.

In February 2000, the NDA government had just presented a so-so Budget which had a negative impact on sentiment. But plenty of speculative interest remained in Indian stocks. An operator named Ketan Parekh (KP) had mysterious access to vast funds. He and his associates were still pushing up the prices of certain stocks. Traders had a list called the "KP10"; ten stocks (actually more) in which Parekh was active.

KP's operation was, like many scams, a simple game. KP and his associates had relationships with some shady promoters. The KP cartel would deploy cash in targeted stocks. By means of circular trading, by sheer volume of purchases and carefully-seeded rumours, they would drive prices up, often by multiples. Then the inflated shares would be pledged to raise more cash and the whole cycle would be repeated until such time as profits were booked. The opaque badla system, which enabled both stock and cash loans, was still prevalent. It would take several thousand words to explain how badla worked but it made "pumping" operations easier. Nor was there a requirement for declaring pledged shareholdings. So people outside the charmed circle had no means of knowing how much leverage there actually was.

In March 2001, a website called Tehelka went public with a big media sting operation. In "Operation West End", two reporters, Matthew Samuel and Aniruddha Bahal pretended to be arms merchants. They met a string of politicians, as well as retired and serving defence officers, and peddled military equipment that didn't exist. A simple Google search would have revealed that the purported equipment was a figment of their imaginations. However, that was ignored by everyone the duo met. Most of their contacts asked for, and accepted large sums of cash on camera, promising them contracts to sell their non-existent gizmos.

When Tehelka broke the story complete with audiovisuals from hidden cams, there was hysterics across the political landscape. It was difficult to deny that prominent people including BJP office bearers had accepted cash and explicitly offered favours.

The government began a campaign to divert attention. Conspiracy theorists pointed out that one of the financiers of Tehelka was Shankar Sharma, who supposedly had Congress connections. Every government agency was instructed to investigate the personal accounts of the journalists who ran Tehelka. The website was subjected to merciless scrutiny. Sharma and his wife (who was also his business partner and a brilliant analyst in her own right) were arrested. The allegations were that they had engineered the sting (with Congress money) in order to make money by manipulating share prices and going short.

The persecution of Tehelka continued until the NDA regime was voted out three years later. The scam ended the career of at least one BJP politician. It did not lead to a clean up in defence procurement processes.
The market was already bearish. But the Tehelka sting was the trigger. After West End broke, coupled to a poor budget and the deflating ICE bubble, it triggered a sharp correction in share prices. The Nifty dropped 30 per cent in two months. As the market tanked, KP's schemes also unravelled. KP & Co. ended up with margin calls they could not meet. That turned into a separate scandal. KP was arrested and the Sebi instigated multiple investigations of share price manipulations.

In June 2001, badla was banned. Volumes disappeared from the market. After that, 9/11 occurred of course and it put bears firmly in charge. The big bear market continued until mid-2003, when share prices finally bottomed and started to pick up. By then, the Nifty was about 50 per cent down from its lifetime highs of March 2000 and investors had suffered several years of losses.

What followed between 2003-2008 was the greatest bull market in Indian history. Even those who bought the indices at the historic peaks of Feb-March 2000 (Nifty 1,800, Sensex 6,150) have received a compounded return of 10 per cent. Those who stuck to buying systematically through 2001-2003 have received a great deal more in the way of returns.

Fast-forward to the present. In February 2013, a so-so Budget was presented. It wasn't greeted with either joy or deep disappointment. The market has been bullish since August 2012. There was a reaction post-Budget as the FIIs cut back Indian exposures because they were worried about cuts in US federal spending rather than the Indian Budget's contours. There was a recovery in early March, as things settled down in the US and FII money returned. On March 14, Cobrapost, a media outfit run by Aniruddha Bahal, went public with a banking sting. Cobrapost sent out journalists who pretended to be laundering large sums of black political money. Various employees of ICICI Bank, HDFC Bank and Axis Bank were clandestinely recorded offering assistance to turn this black money into white. Share prices in India's three largest private banks crashed and took the Bank Nifty down with them. The concerned banks have started internal enquiries and sacked some employees. The RBI has got involved and other regulatory agencies including the IT Department, Sebi, etc, may soon start taking interest.

There's also an unrelated defence scandal brewing around the procurement of helicopters. In addition, there has been a margin-call-crisis in mid-caps in February. Leveraged operators were hit after share prices collapsed in several high-profile mid-caps. Promoters who had pledged shares were also hit. Sebi is reportedly investigating price-rigging allegations in several counters.

A 9/11 type of event is always unpredictable. But there is civil war in Syria, unrest in various Arab nations, and tensions regarding Iran's nuclear programme and North Korea's nuclear missile tests. So there's no shortage of global tensions that may potentially escalate.

So comparing 2001 and 2013, there are quite a few common events. There is a media sting, a defence scandal, a so-so Budget, an overvalued sector and a tense global situation. The economy is not in great shape now – probably worse off than in 2001. Political instability is also on the cards with elections due in 2014 whereas in 2001, the NDA were firmly in charge.

Against that, Indian banking is not in a bubble unlike ICE in 2001. However, banking is over-valued and since the financial sector has a huge weight in every major stock index, a collapse could drag the entire market down. Take a look at some things that could make most analysts uneasy about Indian banking.

First, there is a massive disconnect between the valuations of private banks (mostly over 25 PE) and PSU banks (mostly low teens). PSU banks, which disburse roughly 75 per cent of advances have much more in the way of bad loans and will bear the brunt of debt write-offs to farmers and bailouts for state government power utilities. Their balance sheets are fragile.

Second, all banks need recapitalisation over the next five years to meet more stringent Basel III norms. Valuations are therefore, important. The government will have to put up cash to maintain stakes in PSU banks. Private sector banks will have to tap the market.

Third, most banks will take a hit in terms of provisioning because the RBI has tightened its norms with respect to recognition of bad loans and restructuring. This means lower profitability. Again, this will hurt the PSU banks more. Fourth, new bank licences could soon be granted to various private players. This would create more competition in an already competitive financial sector.

Fifth, interest rates are high, and economic growth is slow, which means that credit offtake is low and interest margins stretched. Even if rates reduce, the beneficial effects will be lagged.

Will the Cobrapost sting trigger a long-term bear market the same way that Tehelka did? In that case, a journalist with little interest in financial affairs (disclosure: I've had a slight acquaintance with Bahal since 1995-96), would have played a significant role both times.

There are other possible scenarios of course. The Indian and global economy could rebound. The sting and the chopper scam might be swept under the carpet. Global tensions may ease. The UPA might have enough support to stay in charge until May 2014.

The past is a different country as a novelist once wrote and 2001 was very different from 2013. Obviously the differences could be more important than the similarities. But it is enlightening to know how 2001 eventually panned out.