In Focus: Fluid Situation | Value Research Trend of rising call money rates depicts beginning of pressure on liquidity
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In Focus: Fluid Situation

Trend of rising call money rates depicts beginning of pressure on liquidity

The banking stocks have delivered superlative returns in recent past and the rally in them pushed the BSE Bankex up from 4,348.79 on June 30 to 6,102 on October 23, a gain of 40.31 per cent.

With US Federal Reserve putting off hike in interest rates for the time being, speculation of expected downfall or stabilisation in Indian interest rates prevailed in the market leading to falling bond yields. The 10-year benchmark government bond yield has fallen from a peak of 8.4 per cent in mid July 2006 to 7.6 per cent in the first half of October 2006, a drop of 80 basis points. Fall in bond yields gives banks opportunity to earn easy treasury profits on their investment book. Huge marked-to-market provisions made earlier due to rising yields are no longer required and banks can be expected to write back the same in the coming quarters leading to higher profitability.

Higher interest income on the back of strong credit growth increased the prospects of a good second quarter for banking stocks. Most of them have announced robust results for the second quarter. Greater than 20 per cent credit growth as anticipated by RBI and higher earnings growth visibility due to all the above factors made the banking stocks more attractive. However, major public sector banks and large private sector banks have surged a lot and prices seem to have already factored in all the positive news and upsides. However, the party may not last forever. The banking stocks may lose sheen if interest rates are hiked again.

Interest Rate Hike
Rising call money rates may put pressure on liquidity. Demand for money is rising and the government's second half-yearly borrowing programme of Rs 64,000 crore will also put pressure on liquidity. Inflation for week ended October 27 was at 5.26 per cent on account of rising prices of goods and services, putting further pressure on interest rates. In July, the RBI governor had said that the central bank intends that credit growth be restricted to 20 per cent. The growth rate in credit is 31 per cent at present.

Incremental credit deposit ratio continues to be high at 73 per cent. The Reserve Bank hiked the repo rate by 0.25 per cent to 7.25 per cent in its monetary policy review on October 31. This is likely to raise the cost of funds when liquidity tightens. Repo rate is the rate at which the central bank provides liquidity to banks. The central bank, however, kept the reverse repo rate unchanged at 6 per cent. The central bank also announced measures to enable banks to raise funds overseas to help them meet the rising credit demand. The RBI Governor also hinted to banks that liquidity from the central bank may not be as smooth as before. As per finance minister P Chidambaram, the hike in repo rate is an act towards curbing credit growth.

What to do?
Investors would do well if they go for safe picks like HDFC Bank (Idirect Code: HDFBAN), Centurion Bank of Punjab (Idirect Code: CENBN), ICICI Bank (Idirect Code: ICIBAN) etc. Case in point is IDBI Bank (Idirect Code: IDBI), which has rallied a lot and delivered 47 per cent return on account of merger of United Western Bank with it. IDBI Bank will still take some time to reflect the gains from the merger of UWB. UWB has a long saga of mismanagement, poor asset quality and negative capital adequacy. Investors are therefore advised to book profits at current levels.

Source: Idirect

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