A bleak future for Indian banks?

Nov 7, 2008

In this issue:
» Indian banks could lose almost a sixth of their net worth
» The Japanese lessons
» From offense to defense
» ...and more!!

 Asset allocation is the key
In the midst of the turmoil in stock markets across the world, you might have thought that investing in gold was a good idea. Even we have received innumerable queries from readers of this newsletter asking our view on the yellow metal.

Well, gold prices have been pretty volatile this year. It started the year at around US$ 850 an ounce. As crude oil prices started to climb and experts began predicting that oil might hit the ominous US$ 200 a barrel mark, gold quickly shot up to over US$ 1,000 in March. Post that, the metal retreated and began bouncing around in a trading range of US$ 850 to US$ 950 before dipping back below US$ 750 in September. Currently, the metal is trading at US$ 732 an ounce, almost 28% down from its peak this year.

All in all, price of the metal has been pretty volatile over the past few months. However does this take the shine away from the metal being a safe haven investment? Not really. There is always a case to have gold, even though a small proportion, in one's portfolio. In fact, investing a small amount of your assets (maybe 5% to 10%) in gold is a good way to diversify your portfolio.

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However, whatever you choose to buy as an investment - equities, gold, bonds - make sure that you have already covered yourself with an emergency fund (6 to 12 to 18 months' worth of living expenses) to meet your necessary expenses. The money you are investing for longer-term goals like child's education and marriage, or your retirement should be invested in a blend of stocks and bonds that are appropriate to give you risk tolerance as you have time on your side.

 In the meanwhile...
Asian markets ended mixed today. Major gains were seen in the indices of Hong Kong (3%) and India (2%). While losses were seen in the benchmark indices of Japan (down 4%) and Malaysia (down 2%). These markets seem to have fallen in line with the weak performance of the US and European markets yesterday. While the US Dow Jones index closed almost 5% down, European indices traded weak within a range of 4% to 9%. Quite a few of them are however trading in the positive territory currently.

Weakness in European stocks yesterday followed the spree of interest rate cuts announced by three key central banks in the region. While the European Central Bank (ECB) lowered its benchmark lending rate by 0.5% (to 3.25%), the Bank of England reduced it by 1.5% (to 3%). The central bank of Switzerland followed suit, lowering its lending rate by 0.5% (to 2%). What is more, these central banks have not ruled out a further reduction in interest rates on concerns of a deeper economic slump.

Selling pressure across Japanese markets today was also on the back of some weak earning numbers reported by large corporations like Toyota. The Japanese automaker, for instance, halved its annual profit forecast yesterday. The company now expects its profits to fall almost 68% YoY during the current year.

 Nearly 16% of Indian banks' net worth may get eroded
High interest rates, prolonged economic slowdown and global recession are not things that Indians banks have never encountered before. But the last time they did, the outcome was not something they are proud about.

Despite the fact that lending policies in India are more refined and relatively conservative (loan against borrowers' income) than in the Western world (loan against borrowers' assets), banks may once again see higher slippages in their loan quality. This means that more number of borrowers (corporate and retail) will default on their repayment schedules, leading to higher NPA levels. Having managed to bring down the gross NPA levels from the highs of 7% to 8% of advances in 2002 to nearly 2.5% in 2007, the NPA levels have sequentially risen in the past few quarters. Bankers believe that while the may not head back to the historic highs, a further slippage of 1% to 2% is certainly not deniable. Our calculations (based on certain base assumptions) show that banks may see up to 16% of their net worth getting eroded in the next few fiscals due to the incremental NPAs. Here we have assumed the banks' leverage ratio at 15 times, CRR, SLR ratio to remain static at the current levels, minimal accretion of non fund profits and no further equity dilution.

While this does not mean that the future of Indian banking sector is bleak, what investors need to be aware of is that the risks are not unforeseen. Having said that, given the high rate of savings and prospects of growth in the Indian banking sector, an attractive valuation can certainly discount the risk of slippages.

How a bank's net worth can erode - Hypothetical example
Particulars Rs Explanation
Bank's networth (A) 2.0  
Borrowings 30.0 Assuming a leverage of 15 times networth
Total funds available with bank 32.0  
Less: CRR (5.5%) + SLR (24%) 9.4 Mandatory deductions
Net funds available (Rs) 22.6  
Investments - 30% 6.8  
Advances - 70% (B) 15.8 Funds to be lent
Current gross NPA levels (% of advances) 2.5%  
Future gross NPA levels (% of advances) 4.5% Assumed
Additional slippage (C) 2.0%  
Absolute slippage (Rs) (D) 0.32 B multiplied with C
Erosion of bank's networth 16.0% D divided by A

 Learn from the Japanese
A nation of craftsmen and manufacturers, Japan long looked down on finance because its wealth was not fueled by the sweat of the brow. This helped the nation get minimally impacted by the crisis that engulfed almost every large and mid sized economy globally.

For years, Japanese households poured money into overseas assets, where they could earn better returns than in Japan with its near-zero interest rates. But Japanese households have been smart and quick in recognising value in their home-grown companies. Especially, when they became available at an attractive discount. According to a Japanese consulting company, Nomura Research, in October 2008, net investment in domestic stock mutual funds surpassed investment in foreign bond funds for the first time in 27 months.

Sitting atop US$ 15 trillion in personal savings, Japanese households are snapping up equities, particularly blue chip stocks. The ones with higher risk appetite are also opting for riskier investments like currencies and index futures. They have managed to, an extent, replace foreign investors and boost the market capitalisation at Tokyo's beleaguered exchanges. To put things in perspective, in the month of October, the Japanese individual investors were net buyers of US$ 10 bn worth of stocks on the Tokyo Stock Exchange while the FIIs were net sellers of equities to the tune of US$ 7 bn.

Indian households that are themselves one of the best savers globally, have lessons to learn. Instead of worrying about the movement in interest rates, short term liquidity and possible ban on foreign money; they could concentrate on more lucrative opportunities. Can Indian households pick up some cues about long term investing from their Oriental neighbours?

 Indian banks see liquidity problems easing
"There is no problem of liquidity at this point of time", said the chairman of India's largest bank, State Bank of India in a press meet yesterday. However he further added that there will be some pressure on liquidity next month on account of the busy season and the fact that government borrowings typically increase during this time of the year.

SBI announced a 75 basis points (0.75%) reduction in its lending rates, which will be effective from 10th of November. The bank's management does not see the rate of growth in credit off-take slowing down during the second half of the year, as it expects the government and central bank to inject substantial cash into the financial system. SBI is one of the many public sector banks that have reduced their lending rates, after being arm twisted by the finance ministry to do so. The other banks that have reduced their lending rates by 0.75% include Bank of Baroda, Bank of India, Corporation Bank, Canara Bank, OBC, Allahabad Bank, Union bank and PNB.

The impact of reduction in lending rates will also be seen in the deposit rates, which are expected to come down as well. This is ironically considering that while domestic savers will have their deposit rates slashed, the government and central bank are leaving no stones unturned to attract non-resident deposits by way of increasing interest rates on their accounts.

 From offense to defense...
Lafarge and Holcim, two of the biggest cement producers in the world, are suddenly finding themselves in a very uncomfortable situation. Just a while back they were busy with a global race amongst themselves to claim market share in faster-growing emerging economies. For this, both companies were aggressively building plants and acquiring local producers. Lafarge now finds itself encumbered with 17.3 bn euros of debt after buying an Egyptian company's cement assets. Similarly, Holcim has invested over US$ 3.5 bn in India for acquiring stakes in ACC and Ambuja Cement. The sudden onset of the financial crisis and a slump in housing markets in the US, Britain and Spain has now compelled them to step on the brakes in a hurry.

Global cement demand has now weakened considerably, and at the same time, the global capacity is set to spike in 2009 as a result of the industry's expansion projects that are due for completion. Not a very favorable situation for a cement company to be in. All these unanticipated chain of events have spooked Lafarge into dropping its 2010 earnings targets. Its priorities have indeed taken a complete U turn. They are now 'cash flow-generation', 'cost-reduction' and 'de-leveraging'.

 China is feeling the heat
How good is a GDP growth rate of nearly 6%? Well, the answer depends on what country of the world one is talking about. Developed economies that are working overtime to avoid a recession would be willing to give their arms and legs for the GDP growth of that magnitude. But what if a 6% growth is severely looked down upon? There are few chances that one could be talking about anything else than the People's Republic of China. Accustomed to years of double-digit growth rates, the Chinese are finding it hard to fathom that their economy could slow down to a growth rate of the order of 5%-6% during the fourth quarter of the current year. But this is exactly what most economists are predicting, based on the macroeconomic data that is coming out of the country. Factories are closing down, real estate projects are being halted and local consumption boom is also on the wane. In short, all the three pillars of its economy viz. consumption, investment and exports are not giving a very encouraging vibe. However, there are a lot of people on the other side of the debate who believe that stimulus packages from the government would prevent things from spiraling out of control. It should be noted that the country needs a GDP growth of atleast 8% to create jobs for its huge workforce and prevent any social unrest.

 Today's investing mantra
"My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks." - Warren Buffett

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