Time to review banking sector valuations

The Economic Survey Volume 2 makes an interesting point about corporate credit growth. The private sector banks saw credit growth averaging out at around 10-11 per cent in 2016-17. This was low by historical standards and it was pulled up by a sharp credit expansion in March 2017. Private sector banks controls about 28 per cent of outstanding assets in the banking system. 

Public sector banks, which control 72 per cent of assets, had credit disbursal dropping into negative territory. This is unheard of. The credit growth rate of public-sector banks was consistently negative through the last fiscal. Overall credit growth rate of 5 per cent was also a historic low.  As the Survey says, the low credit growth was not just a function of low demand for loans. It was also an outcome of caution on the part of public sector banks. Most have huge outstanding NPAs (non-performing assets) and they are more interested in loan recovery and resolution than in expanding credit. Banks overall had close to Rs 2 lakh crore sitting with the Reserve Bank of India. So, liquidity is not an issue. 

Small rate cuts will not make much of a difference to credit supply. Banks could cut spreads between their respective corporate lending rates and the yield from treasury bills if they wished. What's worrying is that the Q1 results suggests that the NPA situation is still getting worse though loans are going bad at a slower pace. Most analysts expect NPAs to continue rising till March 2018 at least.

The latest data suggests that inflation is rising now with food prices showing a jump. The Consumer Price Index (CPI) for July was up 2.36 per cent year-on-year (y-o-y) over July 2016. This is significantly higher than the 1.46 per cent y-o-y in June 2017. The Wholesale Price Index (WPI) was up 1.9 per cent per cent y-o-y in July 2017, from a level of 0.9 per cent y-o-y in June 2017. 

Inflation seems to have emerged from the trough. The CPI has lifted above the lower bound of RBI’s targeted tolerance zone of 2 per cent-6 per cent. If food prices see further rise, RBI's expectations that CPI will climb above 3.5 per cent by December may come true. Under the circumstances, the Monetary Policy Committee might very well decide that it will hold rates at status quo.

Combine the data points of reluctance to cut commercial lending rates, higher inflation and no apparent acceleration in the economy. It is very likely that interest rates will now be stable for a while rather than seeing a further downtrend.

This takes one important variable out of the equation for traders.  Some part of the rise in equity prices over the past few months has been driven by the expectation of rate cuts and more rate cuts. This is especially true for the financial sector stocks. Now it's a question of valuations with rates remaining stable. This should also affect treasury yields and it could lead to Foreign Portfolio Investors cutting back on their purchases of rupee-debt.

The Nifty Bank is heavily weighted in favour of private sector banks (due to the free-float methodology). It has a current PE of 27 and a current Book Value ratio of 2.8. The Nifty Private Sector Bank Index has a similar PE and a PBV ratio of 3.1. The Nifty PSU Bank Index has a PE of 34 and a PBV ratio of 1.1. The price book value (PBV) ratio is a better indicator in the case of banks since earnings can be manipulated by cutting down (or increasing) NPA provisioning. The difference in valuations between the two groups is quite significant.

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