Veteran banker K.V. Kamath is of the view that interest rate cuts have reduced the challenge of bank recapitalization for the government. In an interview to this newspaper, Kamath said that for now treasury gains would probably take care of the capital requirement.
A somewhat similar story has played out in the banking sector before. Indian banks were struggling with high levels of non-performing assets in the late 1990s and early 2000s but, among other things, the fall in interest rates helped them strengthen their balance sheets. Yields on the benchmark 10-year government bond fell by about seven percentage points between 1998 and 2003, this helped the banking sector a great deal.
Yields have come down by about 70 basis points in the current financial year and are now hovering around the levels last seen in 2009. The rally is expected to continue and the latest data on inflation will provide further strength to bond prices. Retail inflation for September came in at 4.31%, compared with 5.05% in the previous month, and was lower than the market expectation. Some analysts are now working with the target of a further reduction of 25 basis points in 10-year yield by the end of the year from the present level of about 6.75%. Yields have come down by about 175 basis points since September 2014.
The fall in bond yields has prompted banks to book gains on their holdings to improve profits. Data for the June quarter results showed that treasury profits went up sharply for a number of banks. For instance, Bank of Baroda’s treasury profit jumped about 90% year-on-year. It rose 63% in the case of Canara Bank. The trend is expected to continue in the coming quarters as banks will want to cover losses arising from bad assets with gains from treasury operations.
Improvement in balance sheets and falling interest rates are positive factors for the valuation of banks and will help them raise equity capital from the stock market. Reduction in the risk-free rate anyway makes the equity market more attractive for investors. Activity in the primary market has increased significantly in recent months—issuance in the first nine months of the year was the highest since 2007. Vibrancy in the primary market will enable banks to raise equity capital from the market at better valuations.
Although the fall in yields will give a push to the ongoing clean-up drive, it may not be able to solve all the problems that banks are facing at the moment. Treasury profits may not completely eliminate the need for capital infusion by the government as the requirement is very high. According to estimates published earlier this year by India Ratings & Research, a rating firm, capital requirement of public sector banks will be to the tune of Rs1.2 trillion for FY17-FY19. Therefore, treasury gains may only partially reduce the need for government intervention. Also, the scope for further reduction in interest rates remains limited and banks are unlikely to see the kind of gains witnessed around the turn of the century.
The Reserve Bank of India (RBI) expects inflation to be around 5% by March 2017 and there are upside risks to this forecast. For instance, implementation of the recommendation regarding house rent allowance by the Seventh Pay Commission could have an impact on retail inflation. A similar pay hike by state governments and a steep increase in minimum wages could put pressure on prices. Implementation of the goods and services tax (GST), depending on the revenue neutral rate, could also have an impact. As noted in the latest monetary policy report of the RBI, evidence from countries such as Canada and the UK suggests that inflation could increase at the time of implementation of the GST.
What is perhaps required at this stage is that the government reassess the capital requirement of public sector banks in light of the changed interest rate scenario and developments in the bond market. This will reduce uncertainty in the marketplace and might further push valuation for banks. The government will also gain from lower yields as it will lower outflows on the account interest payment over time. It can use this saving to recapitalize public sector banks.
The government will do well to take advantage of the present situation and redraw the plan to aggressively recapitalize public sector banks.
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