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Interest rates: Banking dilemma

Aug 25, 2004

Rising interest rates are a concern to any economy's growth prospects. In the Indian context, the specter of rising interest rates is troubling the government, as well as the investor community. In the last three months alone the benchmark 10 yr bond G-Sec (Government Security) yield has risen from 5.8% to 6.3% indicating the upward bias of interest rates. While the Reserve Bank of India (RBI) has refrained from raising the bank rate, the next monetary policy statement may indicate a change in the stance in order to quell this rise in interest rates. Higher prices for commodities like crude, steel and cement have led to the rise in inflation and consequently the rise in interest rates. In this backdrop we asked our viewers their view on which sector is likely to be the most impacted by the rise in interest rates. The result is depicted in the form of a pie chart below.

The opinion among the sample investor community is clear and they point out that the sector most likely to be impacted by the rising interest rates is the banking sector (63% of the votes). The commodities sector was next in line (26% of the votes), while the power and engineering sector was the last with 11% of the votes.

While rising interest rates impact all sectors in an economy, in the Indian context, the negative outlook towards the banking sector is justified to an extent. In the last three years, banks have had a windfall from profits they booked on their G-Sec portfolios and this was mainly due to a rapid fall in interest rates. For instance, between January of 2001 and 2003 the yield on the benchmark 10 yr G-Sec fell from 10.8% to 5.8%. Due to this windfall, banks were able to report strong growth in earnings even while providing significantly for their Non Performing Assets (NPAs). Due to this, almost all banks (especially public sector banks) reported healthy balance sheets in the given period.

In contrast, the last few months beginning June, have seen yield of the 10 yr paper rise from nearly 5.8% to 6.3% till the week ended August 15th. There the situation is now reverse. Banks are now facing diminution (or fall) in value of their G-Sec portfolio. This means that banks had to book large losses on their profit and loss accounts and this has led to a significant (negative) impact on their profitability. Investor sentiments are precisely reflecting this fact and rightly so. However, now that interest rates have started rising what is the likely effect on the banking sector going forward?

Banks with a large (and with longer maturities) portfolio of G-Secs are likely to be hit badly by the rising interest rates. These banks may even witness a decline in profits for FY05. Examples of these are large PSU banks. On the other hand, banks, which have a shorter maturity for their G-Secs, are likely to weather this storm in a better way. These include smaller yet efficient private sector banks. Investors need to shift their focus to the core operations of banks. What this means is that investors need to identify banks, which have a proven track record of growth mainly in terms of their advances. Investors also need to focus on the other income of these banks and identify banks that have a lower reliance on profits from G-Sec portfolio.

Over the long-term, investors need to realise that the banking sector is very susceptible to the vagaries of interest rates. This has been amply highlighted by the way the fortunes of banks have changed in the matter of just a few months after nearly three years of very strong performances. Only banks with strong core operations (which includes both income from lending as well as fee based income) are likely to weather these vagaries with strength.

As far as commodities and power/engineering companies are concerned, the impact of the rise in interest rates will be in the form of higher debt servicing costs. Consequently, this may lead to a slow down in the pace of investments or capex plans.

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