The market has already reacted badly to fears of a rate hike and on concerns that US Federal Reserve will reduce its quantitative easing - its $85 billion per month bond buying programme. The coming week will reveal if the fears were justified and the market will respond accordingly.
The Reserve Bank of India's (RBI) meeting on monetary policy will be held on Wednesday (December 18) and the two-day policy meeting of the US Federal Open Market Committee (FOMC) on Tuesday and Wednesday (December 17-18).
The RBI meeting in turn is likely to be influenced by the wholesale price index (WPI) inflation data for November, which the government will announce on Monday. WPI inflation was 7 per cent in October.
In any case the consumer price index (CPI) inflation for November, already announced, has the market expecting the RBI to hike the repo rate (the rate at which it lends to banks) by 25 basis points, raising it to 8 per cent from 7.75 per cent at present.
Overall CPI inflation for November stood at 11.24 per cent compared to 10.17 per cent in October. Within this, food inflation was 14.72 per cent. The announcement, after market hours last Thursday, led to the BSE Sensex falling 210 points on Friday, erasing all the gains made during the week. Overall, across the week, the Sensex lost 281 points.
The market thus is already expecting the RBI to hike rates to curb food inflation. Whether it will actually reduce food inflation is questionable, but certainly a rate hike will help protect the Indian rupee which is highly vulnerable to even a small outflow of foreign currency.
Indeed, Finance Minister P. Chidambaram, speaking on Saturday at a function to commemorate 20 years of the National Stock Exchange (NSE), voiced his concern at the exaggerated impact FII buying and selling has on the Indian market, since there is nothing to counter-balance this.
As India has hardly any foreign exposure in its bond markets, the reduction of quantitative easing - or tapering off as it is widely called - will not have any direct impact on it. But it will certainly lead to negative sentiment. If indeed the Fed decides on tapering off at its forthcoming meeting, there is a high possibility of FII funds moving out, which will lead to the market becoming volatile. Tapering can slow down the flow of money into our markets and exert pressure on the Indian currency as well.
The continuing policy paralysis of the government has been one of the dampeners for the economy. This has resulted in slowing down of investment. A reform-oriented and progressive government after the general elections scheduled for May 2014 will help reverse this situation. Equally if the government fails on this count, the impact will be negative.
GDP growth of 4.5 to 5 per cent is not enough for investors. The only way out is to grow at 7 to 9 per cent. For this, reforms are essential which will lead to investments and job creation.
The private sector is not willing to make investments as it is not confident about the government's policies. In the recent past, the biggest problem has been the reversal of government policies, especially relating to taxation. Irrational and unexpected tax demands have seen investors, especially foreign investors, shying away from doing business with India.
Until business confidence returns and the investment scenario improves, the markets will remain volatile.