Indian Banking: Outlook for 2014

Vikas Sharma   Q-45   roll no 1273665

  Indian Banking: Outlook for 2014

Introduction

Raghuram Rajan’s big challenge in 2014 will be building on the gains he’s scored since taking the helm of India’s central bank last fall.

The rupee was among the world’s worst-performing currencies in the summer, losing more than 20% of its value against the U.S. dollar between May and August, reflecting a rush of capital out of emerging markets.

India, which runs large trade and budget deficits, depends on foreign capital to meet its financing needs. When foreign investors sensed U.S. rates were heading higher, they moved out of Indian stocks and bonds.

Mr. Rajan managed to stabilize the currency and buy time by taking innovative steps to attract capital back to India. A program to attract deposits from non-resident Indians, for instance, raised $34 billion in foreign exchange reserves, far more than analysts had expected.

He also took the tough decision of raising interest rates at a time when economic growth was already slowing sharply. The rupee is now trading close to 60 per U.S. dollar, up from lows just short of 69 in August.

But many analysts say India could face new headwinds now that the U.S. Federal Reserve is winding down its $85 billion in monthly bond purchases, pushing U.S. interest rates higher.

Mr. Rajan told reporters in mid-December that India is better prepared now than in the summer to weather the Fed’s moves, though there could be some volatility in the local markets.

Meanwhile, India’s economic health remains precarious. Inflation has been rising, fueled by a spike in food prices and the rupee currency’s fall earlier in the year.

Mr. Rajan has said he’s committed to taming inflation and has raised benchmark interest rates twice since he took over. The central bank held rates steady in mid-December, saying a recent flare-up in inflation driven by food prices could be temporary. Mr. Rajan said the bank didn’t want to react to short-term price increases.

Analysts will be watching to see whether Mr. Rajan will be able to stick to a hard line on inflation and raise rates further in 2014, even if the economy slows.

Economists expect India’s economy to expand by less than 5% in the year that ends March 31, the slowest pace of growth since 2003. The government is also pressing for lower rates to stimulate the economy, ahead of federal elections due before May 2014.

Another thing to watch for in 2014: The central bank is expected to hand out licenses to allow new private banks, a move aimed at boosting competition and bring more financial services to rural India.

Discussion

Rating agency Moody’s has maintained its negative outlook on India’s  banking system, reflecting the effects of the rupee’s volatility, persistent inflation and slowing economic growth.

In a statement, Moody’s said asset quality would continue to deteriorate, particularly for public sector  banks (PSBs), while profitability was likely to remain weak, limiting internal capital generation.

Moody’s rates 15 banks in India— 11 public sector banks and four private sector banks. It also incorporates government support in the ratings of all these banks.

                                                            

Conclusion

 Having already made new highs during 2013, I believe, going into 2014 equity markets are likely to be positively poised on the back of supportive global cues as well as improving domestic outlook. The markets have taken the announcement of moderate tapering of the Fed’s QE3 program in their stride as India’s external sector risks have materially subsided. A gradual tapering of monetary stimulus by policymakers indicates confidence in the economic recovery taking hold in the United States. In the medium-term, a revival of growth in advanced economies is beneficial for export demand from emerging economies like India.

Strong export growth, aided by the sharp rupee depreciation, as well as recovery in external demand, are key factors for improvement of the domestic outlook as it has reduced India’s external vulnerability and is positive for GDP growth. Coupled with this, India’s resilience on the external sector has also stemmed from a compression of imports, driven by restrictions on gold imports. Driven by these aspects the current account deficit has come down sharply at 1.2 per cent of GDP in Q2 FY2014 as against a wider deficit of 4.9 per cent of GDP in Q1 FY2014. I expect improvement in the trade balance to continue with the deficit moderating closer to a more sustainable level of 2.5 per cent of GDP for FY2014 compared to 4.8 per cent in FY2013. At the same time, a pick-up in banking capital, NRI deposits and debt inflows on the back of measures announced by the RBI have rendered financing of the deficit more manageable.

High inflation remains the key overhang on the outlook as WPI- and CPI-based inflation have paced higher. But on the positive side, it is driven largely by a surge in vegetable prices, seen to be temporary in nature. I feel, vegetable price inflation will moderate in the near future. Recently, the Government has indicated at policy prescriptions to combat the rise in vegetable and fruits prices. Going forward, on account of the improvement in agricultural production, food prices are likely to moderate and ease inflationary pressures to that extent.

Markets are hoping for a strong show by the BJP-led Government in the general elections owing to their pro-development and reform agenda. If that happens over the coming six months, then the market momentum would strengthen, benefiting stocks in the cyclical sectors. Given India’s demographics, any new Government would focus on revving up the economic growth engine and creating more job opportunities for the youth. Post-elections, greater policy certainty could drive announcements of new projects and revive the investment cycle, both of which would invigorate GDP growth.

In the light of these positive developments, I expect Sensex EPS to post a robust 17-18 per cent growth in FY2015, higher than the 9-10 per cent growth expected during FY2014. Attributing a 16 times multiple to the Sensex EPS, we arrive at a Sensex target of 24,600 for the coming 12 months. Beyond this, I believe markets are likely to, at least, give returns in line with the expected 13-15 per cent earnings growth.

Despite strong interest evinced by foreign institutional investors, retail investors have shied away from equity investments owing to the market’s underperformance in these past five years. It is only a matter of time before the investment environment in the country strengthens, resulting in a broad-based pick-up in economic activity and rise in market participation.

I would continue to recommend investors to remain positive on the outlook for export-oriented sectors, such as IT and pharmaceuticals. I’m also overweight on select metal stocks, considering the recent capacity additions and under-utilised capacity getting employed for exports as global fundamentals improve. In the light of positive cyclical factors shaping up, I prefer select large private banks, as they continue to remain structurally strong and could benefit from an imminent economic recovery.