Banks’ preference for investment in Government securities and mutual funds coupled with their reduced recourse to borrowing may result in credit growth falling to a low of 12.4% for FY10. Whilst partial substitution of bank credit by capital markets and foreign capital may keep the
baseline IIP figures steady, bank profitability could be adversely affected by a policy induced upturn of the interest rate cycle.
THE PUZZLE OF HIGH IIP AND LOW CREDIT GROWTH
There is widespread expectation that bank credit growth will pick up in H2FY10. Whilst the RBI expects credit growth of 18% in FY10, most sell side analysts expect ~16% growth. However, credit growth has fallen to a measly 9.8% for the fortnight ending November 6, 2009 confounding both analysts and economists (who betting on the historically strong correlation between IIP and credit growth expected to see a pick up in credit growth)
Why is credit growth not picking up?
The simple answer is that because banks, wary of credit quality, and with an eye on higher treasury gains are investing in Government securities and debt schemes of mutual funds. On the liability side of their balance sheet, banks’ reduced recourse to borrowing is compensating for
continued deposit growth.
How much will credit grow in FY10? Our estimate based on a monetary accounting framework suggests modest credit growth of 12.4% for FY10. This estimate has been cross checked by scenario analysis with projections varying from 9.4% under pessimistic assumptions to an optimistic 14.6% . With corporates finding it easy to tap capital market or foreign funds, this low take up of bank credit should not affect baseline industrial production in the near term.
IMPLICATIONS FOR INVESTORS
Credit growth, or even the broad composition of bank assets, does not really drive RoE and RoA for banks. However, what seems to have a bearing on banks’ bottomline is the interface with the interest rate cycle. The policy induced upturn in interest rates (we expect a 50 bps increase in CRR in January 2010 to be followed a 50 bps increase in repo/reverse repo rate - see our 29th October note) coupled with an economic revival, continued market borrowing and threat of inflation are likely to put upward pressure on the interest rates in the medium term. Since India’s history suggests that banking stocks come under pressure when interest rates are rising (the
crisis years of FY08/09 being an exception to this rule), we continue to believe that
the outlook for the Bankex is grim.
THE PUZZLE OF HIGH IIP AND LOW CREDIT OFFTAKE
In the wake of the Lehman crisis in September 2008, industrial production and bank credit growth came down sharply from their respective peaks in the preceding year. However, since H1FY10 while industrial production has revived, bank credit growth has come down further to a precarious single digit level. The extent of the credit drought can be gauged from the fact that the credit growth for the last two fortnights ending October 23, 2009 and November 6, 2009 failed to capitalize on the low base of the previous years. In fact credit outstanding fell by Rs.210 bn in the
second half of October 2009 vs. the first half.
This sort of drip in credit outstanding was seen in early April. It is important to note that the gap left by bank lending is only being partially offset by financing from others sources. The total availability of finance for corporates is likely to witness a decline in FY10, the second year in succession, in which this has happened.
CREDIT DROUGHT TO CONTINUE
To answer that question we have estimated the credit growth for the remainder of FY10 by projecting credit using two methodologies. At the first instance, we project credit for FY10 which is consistent with the expected growth of other monetary variables in the economy (using a monetary accounting framework). Hence to arrive at the lendable resources available to banks at the end of FY10, we begin with a broad money (M3) projection of ~17%.
Allowing for elevated currency growth (to deal with the prevailing uncertainty regarding the economic recovery in the industrial countries), we estimate the deposit growth at ~16%. Deducting the mandatory reserves (after factoring in a 50 bps increase in CRR in January), statutory reserves (including excess SLR holding) and increase in non-SLR holding we arrive at the growth in bank credit as a residual. This leaves us with a modest estimate of credit growth of 7.8% for H2FY10 (vis-a-vis only 4.1% for H1FY10) and of 12.4% for the full year of FY10. In contrast, most sell side analysts expect credit growth for FY10 to be 16%.
How would banks balance their books?
Both the published data and our discussions with bankers suggest that Indian banks are in no rush to grow their loan books. However, with continued deposit growth and low credit offtake, how will banks balance their books?
With low credit offtake, banks could trim their own borrowing to shrink their balance
sheet; borrowing is traditionally one of the most volatile source of funding for banks. Secondly, in banks’ Treasuries the excess liquidity compels banks to invest more in Government securities. This is particularly attractive in an atmosphere of continued easy liquidity on the back of continued foreign capital flow that puts downward pressure on yield resulting in higher returns from the
Government bond portfolio than in the core lending portfolio.
So what drives bank stock prices?
Whilst the banks’ profitability is relatively immune to the temporary set back in credit growth, the interest rate cycle does affect banks’ bottomline significantly. In particular, bank profitability clearly suffers when the interest rate cycle turns north.
The interplay between the interest rate cycle and banks’ RoE then plays out in the stock market as well with high negative correlation between prevailing interest rates and the return of banking stocks. This relationship which holds true for long time period, however turned around in the crisis years of FY08 - FY10 . A possible explanation for this is that the Bankex’s movement over the past 24 months has had very little to do with fundamentals and a lot to do with the exceptional events in the western world.
This however, is an one off gain and we expect with the return of normalcy in the market and domestic factors gaining ascendency in determination of banking stock prices the negative relationship between bank stocks and interest rates would re-emerge.