DSIJ Mindshare

PSB PENDULUM READY TO SWING

The Indian banking sector presents a perfect dichotomy of performance between two sets of banks i.e. the public sector banks (PSBs) and their private counterparts. Despite largely operating in the same economic environment, we have been witnessing a strong contrast in the performance of these two sets of banks. There is no better way to gauge this contrast other than the analysis of stock price movement of these banking stocks. Since the start of 2011, returns provided by the Bank Nifty consisting of five public sector banks with total weightage of around 20 per cent and seven private sector banks has yielded return of 56.96 per cent. Comparatively,   the CNX PSU bank index consisting of 12 major public sector banks has remained flat with return of a mere 1.4 per cent in the same period.

The stock prices that largely track the financial performance for these banks have remained weak in the last few years. The net profit on an aggregate basis for 26 PSBs, including associates of SBI, has declined by six per cent annually for the three years ending FY14. What is worth noting is that 21 out of 26 banks have seen their profits declining or their profits have de-grown between FY11-14 with two banks going into loss for FY14 after posting profit in FY11.

Regardless of this scenario however, the tide seems to be turning around now if the stock prices are any indication to go by. Since the start of October 2014, the PSU bank index is up by almost 23 per cent compared to 18 per cent returns provided by the Bank Nifty. So if the mean reverting principle is going to play itself, are we going to see the PSB stocks continue to outperform in the coming days? Or is it going to fizzle out soon as had been witnessed post the March-June 2014 upward movement? In the following paragraphs we will try to analyse the factors that have changed in the last few months which have led to such an exciting outperformance and how these will impact PSBs in time to come.
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NPAs: Nuances, Pain and Agony

The primary culprit for the PSBs’ jaded performance is the level of non-performing assets (NPAs). The gross NPAs of PSBs have increased at an astounding pace of 45 per cent per annum since FY11 while the advances during the same period have increased at a much slower pace of 17 per cent. This has resulted into a disproportionate increase in the share of PSBs in NPAs in the whole banking system. The gross NPAs of the entire banking system was to the tune of around Rs 2.4 lakh crore at the end of FY14 and what is disturbing to note is that out of this Rs 2.16 lakh crore or around 90 per cent was accounted for by the PSBs. This has increased from below 70 per cent at the end of FY10. These PSBs in turn account for only around 75 per cent of the total bank credit, which has remained stagnant over the years. If we take a holistic picture of the bad assets of the banks, as on September 30, 2014 the stressed assets in terms of gross advances for government-owned banks were at over 12.5 per cent while in case of the private sector banks the ratio was below 5.5 per cent.

The reasons for such an increase in the bad assets of the PSBs are beyond the scope of this article. However, the much claimed slowdown in economic activity remains only one of the factors. Other factors such as lax credit management also remained equally culpable. Regardless, going ahead as the economic activity picks up, we will see a significant drop in the gross NPAs and improvement in asset quality. There stands an inverse relationship between GDP growth and NPAs. What this essentially means is that as GDP growth picks up, the level of NPAs comes down and vice-versa. According to a study done by CARE for 24 quarters of 38 banks, the aggregate level of NPAs for all the 38 banks put together and when regressed on GDP growth shows that GDP growth and NPA ratio have a negative correlation of negative 0.599. This means that higher GDP growth rates are related to lower NPA ratios. What is also important is that the inverse relationship gets deeper with a time lag of one quarter and the correlation stands at negative 0.607.

The other two important factors that have a statistical bearing on the NPAs are credit growth and interest rate. While there is an inverse relationship between NPA and credit growth, there is a direct relationship with interest rate. In simpler words, as credit growth increases the NPAs come down while when the interest rate rises, the NPAs too increase. These three factors i.e. GDP growth rate, interest rate and credit growth with a lag of one quarter explains about 73.7 per cent of the variations in NPAs. Yet another revealing conclusion by the study is that the interest rate and its lag alone do not have a significant impact on NPA ratio; it is in combination with credit and GDP growth that yields a meaningful result.

The present condition is playing itself perfectly and that will help in an improvement of the NPAs of the banking system, especially in the case of those owned by the government as they are more saddled with bad and stressed assets in their books. The GDP growth rate after recording below five per cent for two consecutive years in FY13 and FY14 is showing some sign of revival. For the first quarter of FY15 GDP growth clocked at 5.7 per cent and for the second quarter, though it decelerated, it remained at 5.3 per cent.

According to Paris-based Organisation for Economic Cooperation & Development that provides a monthly composite leading indicator (CLI), India was the only major economy where the CLI points to a clear pick-up in growth momentum. We believe that the growth will further accelerate its momentum going ahead. According to various estimates by different financial institutions like World Bank, IMF or Fitch and S&P, economic growth is slated to pick up from here on and will be in the range of 5.5 to 5.8 per cent for FY15 and more than 6 per cent in the coming years.
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Credit Growth: Early Signs Of Revival

Credit growth is also showing early signs of revival though it will take some time to reach the desired growth rate. The overall credit off-take in October 2014 improved to 11 per cent on a yearly basis after witnessing a growth rate of 9.7 cent in the month of September 2014, which was the lowest in the last five years. A sudden spike in the bond yields last year due to a hike in interest rate by the RBI to arrest the fall of the rupee forced many corporates to switch their funding from CD/CP market to bank loans and hence increased the base, which partially explains the low level of credit growth for the month of September.

Besides this, the fundamental reason for such low credit growth is the higher leverage of Indian corporate borrowers. The credit metrics of India’s 500 largest borrowers are at their worst since FY04 with an FY14 median leverage of 4.7x against the historically strongest leverage of 2.3x to 2.5x observed between FY05 to FY08, says a report by India Ratings & Research. Nonetheless, there are two strong reasons why we may see this factor subsiding for most of the corporates who will soon start their borrowing cycle.

First, improvement in economic activity will lead to an increase in cash inflow for these companies that can be used to lower the leverage and boost credit expansion. That apart, the equity markets are currently trading at an all-time high and therefore many of the companies will seize this opportunity to issue shares and lower their leverage. This is evident from the number of qualified institutional placements (QIP) done from the start of this year. In CY14, till November, on yearly basis the total number (29) as well as the money raised (Rs 31,025.28 crore) through QIP has increased by 290 per cent and 380 per cent respectively. This will help them to improve their leverage ratio and offer leeway to increase the borrowings.

What will also lift credit growth are project clearances and the revival in infrastructure investments. More than 230 projects have now received environment clearance by the Union Ministry of Environment and Forests (MoEF) since May 2014 as compared to only 73 projects getting cleared from January 2013 to December 2013. However, as per MoEF’s data, over 320 projects are still awaiting clearance from the ministry. Efforts to put the stalled projects back on track will also help in infusing new investments and provide a much-needed stimulus to aggregate demand. The likely fall in the interest rate will also help spike up credit growth.
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Falling Interest Rate to Favour PSBs

Any fall in interest rate not only increases the credit growth of banks but also helps them post good treasury gains, especially in the case of government-owned banks. The prices of government bonds - which account for a huge portion of the banks’ investment portfolio - will rise as bond prices and interest rates moves in opposite directions. In the last six months, the 10-year benchmark bond yields have come down by more than 80 basis points and are currently at 7.9 per cent - a low of 16.5 months. This is currently lower than the repo rate of 8 per cent, which signals future rate cuts. We have seen this earlier during the period of January-March in 2012 before the succeeding April rate cut. The 10-year benchmark yield was trading at about 20-25 basis points, lower than the repo rate at 8.50 per cent then.

Movement of 10-Year Bond

Once the rate cycle turns, state-owned banks, which have a substantial portfolio of securities held under the available for sale (AFS) category, will need to sell them; else they will have to book a loss on these securities. Hence, PSBs are likely to gain more in the event of any softening of interest rates. We believe that going forward there will be a benign interest rate regime on the back of lower inflation. With the adaptation of inflation as a target by the central bank and increased credibility of the fiscal policy framework, as reflected in the hike of minimum support price (MSP) for rabi crops that was lower than the FY09-13 average, gives us the confidence that inflation will come down and will be sustainable at a lower level. High food prices remained one of the reasons for the elevated inflation level and higher MSPs were feeding an increase in food inflation. The softening of crude oil prices was the icing on the cake that now provides hope of lower inflation, and hence lower interest rate.

Capital Requirements: An Uphill Task

The only point at which the picture is still not yet clear with regard to improvement in the conditions of the PSBs is their huge capital requirement and the way to raise them. The banking system in India requires almost Rs 3 lakh crore by FY18 to fulfill Basel III capital requirements. Out of this almost 80 per cent will be required by the PSBs for the enhancement of capital by end of FY18. The owner of the banks i.e. the government has not yet laid down a clear roadmap as to how this capital will be raised. The state-owned banks command almost three quarters of the domestic non-food credit market and if the government fails to come up with a clear plan on PSB recapitalisation, it will hamper credit growth and hence the GDP growth rate.

In response to a query about how public sector banks are going to meet their capital needs, Siddhartha Khemka, Head - Research (Equity), Centrum Wealth Management, says, “For FY15 the government has allocated Rs 11,200 crore for bank capitalisation. Further, in an effort to help the PSBs raise capital from the primary market, the government plans to allow its stake to come down up to 52 per cent from its earlier set limit of 58 per cent. While the target appears difficult, if the banks are able to achieve this, it would improve their book value.” Nevertheless, we believe that by the next Union Budget that is due by the end of February 2015, we may get a credible plan in place to recapitalise PSBs either through capital infusion by the government or through bringing down the government’s stake in these banks.
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Valuation and Outlook

The CNX PSU index is currently trading at a price to book value (PBV) of 1.3x, which is lower than the average of 1.42x of the last five years. Says Khemka: “PSBs are currently trading in the range of 0.8-0.9x their one-year forward-adjusted book value. The valuation gap between private and public banks has lowered in the last few months. The PSBs are currently trading at an average discount of 30 per cent to their private peers. However, the gap is wider in the mid and small-sized banks with some trading at as high as 45-50 per cent discount.” This discount is largely due to concerns of the NPAs in the balance-sheets of the PSBs, which raises doubts about the actual size of the book value of the PSBs.

Nonetheless, as explained earlier, as the NPA cycle turns around, this valuation gap will taper down. Elaborates Khemka: “The valuation gap between the PSBs and private banks could possibly narrow down further provided there is an improvement in the economic environment and softening of the interest rate scenario. This would potentially help banks report higher income from treasury gains and could lead to improvement in their RoAs. In anticipation of such improvement in RoAs, the PSB stocks have already seen some re-rating in the last few months. In the next one year we may see some more returns from the PSBs if the NPA cycle reverses.” The above factors lead us to believe that the chasm between the performances of the PSBs as compared to their private counterparts in the last few years is going to fill up and the PSBs will be a good bet for long-term investors as of now. Our top picks are SBI, Bank of Baroda and Canara Bank.

State Bank of India | BSE CODE: 500112 | FACE VALUE: Rs.1 | CMP: Rs.316

SBI’s, the largest lender will defi nitely be the primary benefi ciary of improvement on economic growth. Bank’s asset quality has been improving since the last three quarters and asset quality woes have reduced to some extent. All this will help bank to improve its return ratios. Th e bank’s core strength has been its high CASA and fee income, which has supported its core profi tability in challenging times. Its strong capital adequacy of 12.3 at the end of Q2FY15 also provides the much-needed comfort. SBI’s share is currently trading at PBV of less than 2x.

Bank of Baroda | BSE CODE: 532134 | FACE VALUE: Rs.10 | CMP: Rs.1072

Bank of Baroda has one of the best asset quality among its peers. Over the last few quarters, it has delivered better-than-industry performance in terms of asset quality and have either maintained or improved strength of balance sheet by increasing provision coverage ratio, which is one of the best in industry. Expected improvement in economic growth, along with strong tier I capital of around 9.5 per cent, relatively better return ratios are the key positives for the bank. Stock is currently trading at PBV of 1.04x.

Canara Bank | BSE CODE: 532483 | FACE VALUE: Rs.10 | CMP: Rs.414

One of the strongest and largest bank from southern India, has aggressive plans of having more thatn 6,000 branches by FY2015 from 5,514 branches at the end of Q2FY2015. At CMP, the stock trades at price to book value of less than one, which is cheap, considering likely improvement in liability mix, due to increase in branches leading to expansion in net interest margin.

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