High Growth, High Valuations

After infrastructure, banking is the sector that the maximum number of fund managers are bullish about today. As the economic recovery gathers speed, credit demand from corporates will rise. Moreover, when an economic expansion is underway, banks tend to suffer less on account of bad loans. For these reasons the banking sector is in a sweet spot today. The positives Strong credit demand. In this credit cycle, credit growth is expected to rise above 20 per cent (according to RBI's recent policy review, it has already touched 19.4 per cent y-o-y). The government's emphasis on infrastructure development; high demand for funds from corporates to meet their working capital needs and to fund their capex plans; and high demand from the retail segment, especially housing and auto loans are factors that are expected to result in high demand for credit. At present the repo rate is at 6 per cent. This is still a low rate in absolute terms. Interest rates are expected to rise by another 25-50 basis points this financial year as inflation remains a concern. But even if rates are rising, the demand for credit is unlikely to be affected, provided they rise gradually. (Corporates will not mind borrowing money at a slightly higher cost in an environment where their business is expanding.) What happened during the last credit upcycle between FY06 and FY08 supports the contention that rising rates will not affect credit demand. Between January 2006 and June 2007, SBI hiked its prime lending rate (PLR) from 10.25 per cent to 12.75 per cent. Nonetheless its credit growth remained strong at 27-34 per cent. Since liquidity conditions are tight at present, this gives pricing power to banks, enabling them to raise loan rates without fear of contraction in credit demand. In particular, those banks which have mostly given out floating-rate loans, will be able to re-price their loans and thus maintain their net interest margin. Investment portfolio unlikely to take a hit. Public sector banks have reduced their exposure to interest sensitive high-duration bonds. So even if interest rates rise their investment portfolios will not take a big hit. NPL-related concerns are declining. A few banks suffered high slippages during Q1FY11, leading to concerns about asset quality. However, after Q3FY11 NPLs (non-performing loans) are likely to decline as relapse of restructured assets will have peaked by then. Slippages from the normal portfolio are also expected to come down because of better corporate earnings and improving balance sheets. In fact, NPL recoveries may even pick up because of improving cash flows of corporates. (Between FY04 and FY08, when economic growth was robust, banks' slippages as well as recoveries had improved.) Many banks will soon migrate from manual recognition of NPLs to system-based recognition based on CBS technology. Initially it was feared that this might lead to higher NPLs. However, Siddharth Teli, analyst at Religare Capital Markets, says in a recent report that this is unlikely to be the case. Capital position is comfortab