Banking Sector:
To grow, but at a slower pace
The Indian banking sector, which has total assets of Rs 43.2 tn, has been growing at a
CAGR of 16.3% for the last 26 years. Still, the penetration of the banking system in the
Indian economy, as measured by the asset-to-GDP ratio of 78%, is quite low as compared
that of the developed economies. We believe that the Indian banking sector will continue
to grow in the next 12 months, albeit at a slower pace. We estimate that total advances
will grow by more than 21% in the next 12 months, resulting in a healthy increase in the
net interest income. Further, we expect the banks earnings to increase from the recent
initiatives announced by the Reserve Bank of India (RBI) and low interest rate
environment as many banks have announced reductions in BPLR and deposit rates.
Thus, we believe that the Banking sector valuations are very attractive at the current
market levels.
Economic growth to drive demand for advances
We expect the Banking sectors total advances to grow by more than 21% in the next
12 months. We have arrived at such a growth rate by applying a credit multiplier of
3.5x to an expected real GDP growth of more than 6.5% for the next 12 months. Our
belief that the Indian economy will continue to grow at 6.5% has been reaffirmed by
the recent estimate of Q2FY09 GDP growth of 7.6%. In addition, the Government of
India plans to spend an additional Rs. 1.47 tn as a fiscal measure. However, growth
may be limited in the next two quarters as banks are slightly reluctant to lend money
to the affected companies to maintain the asset quality.
Falling interest rates and RBI measures to provide additional stimulus
The key interest rates in the economy have fallen significantly in the last four months;
this is likely to result in higher advances growth in addition to a better return on the
banks bond portfolio and the widening of spreads in the near term. The RBI has
reduced the repo rate by 250 bps to 6.50% since October 2008. The yield on the 10-
year benchmark G-Sec, at 5.40% in December 2008, has touched its trough since
June 2004. This is also started to reflect in BPLR and deposit rates offered to
customers as many large banks have announced rate cuts that will take effect from
January 2009.
The RBI has taken a number of measures since mid-September 2008, which are also
likely to positively impact the banks near-term earnings. The measures aimed at
expanding the rupee liquidity, such as the reduction in the cash reserve ratio (CRR)
and the statutory liquidity ratio (SLR), will provide banks more funds to extend
advances and will also reduce the cost of managing liquidity, leading to higher
earnings. The easing of provisioning norms for certain types of standard assets will
also boost the banks bottom line. Furthermore, the reduction in risk weights on the
banks' exposure to certain sectors will allow them to lend more on a given capital
base. To top it all, the Banking sector has lost significant value in the last one year
and valuations look very attractive at the current levels, with many PSU banks
available at less than their book values.
Minimum down side risk
There are also few headwinds to consider in the current scenario. The banks are
facing pressure to provide credit to the affected sectors, such as extension of the
period of pre-shipment and post-shipment credit for exports, which may adversely
affect the banks NPAs. Also, demand for funds from few companies is slackening
due to the delay in the expansion of projects. However, we believe that any negative
impact of the above will be more than offset by an increase in the earnings on the
basis of the factors discussed earlier.
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