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India's Banking Sector - Dealing with Inflation and interest rate hike fears
January 22, 2010

Banking Sector Update


Author : Dhruva Raj Chatterji



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Key Points

  • Even after the steep run-up, banking stocks especially the public sector banking (PSB) stocks are still reasonably priced when compared to the general market.

  • The credit growth has been weak but is expected to pick up in 2010 on the back of resurgence in economic activity. The deposit growth is expected to follow suit.

  • Inflation worries mount up, with food prices recently touching a 11 year high.

  • Markets expect some monetary tightening measures by the central bank, with an initial hike in the cash reserve ratio (CRR).

  • Rise in bond yields likely to hurt treasury income of banks in the coming quarters.

  • Mutual funds have marginally cut exposure to banking stocks in December.

Chart 1: Bankex turns in a robust performance in 2009

Indian banking has come of age, and after witnessing volatile times during the recent global financial crisis, the banking scrips have managed to outperform the market in 2009 (Refer to Chart 1 for performance of key Indian indices in 2009). Due to a sharp drop in interest rates coupled with the prospects of gradual turnaround in economic activity, there has been resurgence in investor appetite for this sector in 2009.

PSBs lead the way

Within the banking space, the PSB stocks have managed to outperform their private cousins. This has occurred because of  improving net interest margins, rise in share of deposits and credit off-take. The valuations of these PSU bank stocks are reasonable compared to their private bank peers, thus offering value play to the investor who is increasingly finding it difficult now to find good value on the Indian bourses (Refer to Chart 2 for Price Earnings (PE) ratio of Sensex and Bankex indices).

Most private sector banks are presently trading at PE multiples ranging between 20 - 30X whereas their public sector counterparts are trading at multiples ranging between 8 – 10X. The good corporate earnings result by PSBs in the second quarter of financial year (FY) ending 2010 has helped boost sentiments further. However, the recent rise in inflation (especially food inflation) coupled with concerns on monetary tightening by the central bank in the near-term have raised questions on the continuity of rally.

 

Chart 2: Banking stocks still reasonably valued

Muted credit off-take and deposit growth

In the heydays of 2007, the bank credit was growing at a robust pace of 30% and above, owing to  increased infrastructure activity and capex plans of India Inc. However, since then the growth has moderated and stands at year-on-year (y-o-y) rate of 13.66% for the week ending 1 January 2010. This is far below the targeted credit growth rate of 18% for the FY ending March 2010 by the central bank in India. Despite this, the credit growth is expected to pick up in the last quarter of this fiscal and continue in the successive quarters, with a recovery in macro-economic conditions within the country.


Similarly, the deposit growth has also been subdued lately due to lower interest rates offered by banks. Compared to 20-25% growth witnessed for most of 2007, the aggregate deposits grew by 17.59% (y-o-y) for the week ending 1 January 2010.

Chart 3: Credit off-take and deposit growth have been subdued, but expected to pick up

Inflation worries

After registering negative inflation growth rate for a few months of 2009, the headline inflation has once again started to pick up, touching 7.31% for the month of December 2009 (Refer to Chart 4 for monthly inflation figures).

The rise in inflation has been primarily caused due to meteoric rise in food inflation which has recently touched a 11 year high of more than 19%. Food articles which have close to a 15% weightage in the wholesale price index (WPI), have seen a surge in prices due to one of the weakest monsoons since 1972 which has hurt farm output and has caused shortages.

Even though the central bank revised the fiscal yearend target for inflation to 6.5% (from 5% earlier), analysts now expect inflation to approach closer to the 8% mark by fiscal year end. However, food inflation is expected to moderate in the coming months due to the base effect. The liquidity position as indicated by outstanding reverse repo volumes has meanwhile been comfortable.

Chart 4: Inflation accelerates due to sharp rise in food prices

Monetary tightening and interest rates

The sharp rise in inflation supported by a recovery in economic activity has prompted market participants to anticipate some monetary tightening measures to be initiated by the central bank in India soon. The central bank has been following an expansionary monetary policy review by cutting key interest rates since mid of 2008 to help support the economy (Refer to Chart 5 for movement of key liquidity rates). The next monetary policy review by the central bank is due at the end of January 2010, and the market is now pricing in a hike in the cash reserve ratio (CRR) to help tame the rising inflation issue. Some are even pre-empting a rate hike before the monetary policy review is due. CRR is the percentage of deposits that banks keeps with the central bank as reserve and presently stands at 5%. A hike in the CRR will  suck out excess liquidity from the system, thus helping to tame inflation. The central bank had earlier hiked the statutory liquidity ratio (SLR) by 1% to 25% during October 2009 end policy review.

With the concerns on monetary tightening, bonds yields have also risen sharply, with the ten year benchmark bond yield surging by 40-50 basis points in the month of December (Refer to Chart 6 for movement of benchmark ten year yield). The benchmark yield had fallen sharply during the year 2008, with the central banks in India and around the world slashing interest rates. The benchmark yield had started off around the 5% mark at the beginning of calendar year 2009. However, it trades close to the 7.6% presently and expectations are that it could breach the 8% mark by fiscal year end. The rise in bond yields are expected to hit treasury earnings of banks as a result of  mark to market (MTM) losses.

 

Chart 5: After an expansionary policy in 2008, RBI is expected to resume monetary tightening in 2010

Economic Activity

The macro-economic conditions within the country are also improving, with GDP growth clocking in  7.9% during the second quarter of the fiscal year, ahead of expectations. The economy had expanded 6.7% in the previous FY ending March 2009, its slowest pace in six years. The government recently revised upwards the GDP growth rate for this year to 7.75% - 8% from the earlier 7%. Growth next year is largely expected to breach the 8% mark comfortably.
Industrial production has also seen an upsurge since the mid of this year with the index of industrial production (IIP) growing by a robust 11.7% in the month of November 2009. The good performance has been supported by double-digit manufacturing growth, supported primarily by sharp rise in consumer durables. IIP has dropped sharply towards the end of 2008 and early 2009, with growth even ending up in the red at -0.2% during the month of December 2008. Refer to Chart 7 for GDP and IIP numbers.

Banking funds performance and mutual funds exposure to banking stocks:

Banking funds turned in a decent performance in 2009, with most of the banking funds managing to match up close to the performance of the benchmark Bankex index (Refer to Table 1 for performance of banking funds). Banking stocks command the largest allocation in the equity assets of mutual funds in India. As per data from the capital market regulator SEBI (Securities and Exchange Board of India), banking stocks accounted for a 12.99% share in equity assets of mutual funds in India at the end of December 2009, dropping from a 14.17% share in the month of October 2009.

Table 1: Banking funds turn in a decent performance in 2009

Chart 6: Bond yields harden on the back of monetary tightening fears

Chart 7: GDP and Industrial growth picks up

Conclusion

Even with the handsome gains in the past year, the banking space has aroused concerns of rising inflation and monetary tightening by the central bank. With the sharp rise in bond yields and further hardening of rates expected, the treasury incomes of banks will be hurt. However, with the pick-up in economic activity, the credit growth is also expected to pick up in the subsequent months, which will augur well for banks. A robust jump of 44% in corporate advance tax collections for the October – December quarter further point to a good performance by India Inc. during the last quarter of this calendar year. Results announced by banking majors so far have been more or less within expectations. Moreover, even with the significant run-up in banking stocks, their valuations still appear to be reasonable (especially for the PSB stocks) in comparison to the general market. Thus they can turn out to be a value play for investors who are now increasingly finding it difficult to find value in the Indian markets. With this view in mind we expect that banking stocks could witness some profit booking in the immediate term, but are neutral to positive on this sector over the medium term.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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