The banking sector is witnessing significant valuation derating on the back of deteriorating fundamentals. Over the past few months, two key concerns have become real—material moderation in credit growth and onset of a new non-performing loans (NPL) cycle. The latter is more pronounced within government-owned banks with private banks reporting resilient asset quality as yet.
With respect to credit growth, the main risk is modest growth in FY13 due to prolonged slowdown. Though the first round of valuation derating seems to be largely over with prices having adjusted to extant fundamentals, the critical question is whether another round would happen. We think its possible if the macro variables behave adversely vis-à-vis current expectations over the next few months. With this perspective, we turn cautious on the sector.
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Given the high near-term uncertainty, we believe that sticking to “safe havens” such as HDFC Bank Ltd and ICICI Bank Ltd would be prudent. We also advise investment in “risky bets” such as Axis Bank Ltd and Bank of Baroda offering a favourable risk-reward post sharp price correction.
In the past four months, Bankex has declined by 18%. Price correction has been severe across the sector with only HDFC Bank standing resilient. The specter of price erosion has been driven more by valuation derating than earnings downgrade. Needless to say, the former is more damaging than the latter. While earnings downgrade has been in the range of 3-10%, the assigned price to book value multiples have contracted by 10-20%.
In the last quarter, there were three key concerns for the sector—material deceleration in loan growth, significant deterioration in asset quality and margin compression. In the past three months, the latter concern has vanished with most banks exhibiting strong pricing power and liquidity returning to normalcy. We believe that net interest margin of most banks has bottomed out and would start improving from the second quarter of FY12. However, the first two concerns have become more real.
With corporate capital expenditure on hold, softening retail loans demand and possibly lower working capital loan requirements (if economy slows significantly and commodity prices cool off), system credit growth is expected to moderate further. We believe that credit growth in FY12 could be lower than the Reserve Bank of India’s projection of 18%. We fear that FY13 credit growth would remain modest if investment cycle doesn’t pick up.
Edited excerpts from a report by IIFl. We welcome your comments at email@example.com.
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