We are calling the bottom and upgrade the sector to Neutral. After years of pessimism, it is time to call the bottom for the sector, as we believe incremental stressed asset formation will slow down. Our channel checks coupled with better liquidity, falling interest rates and recovery in the economy, give us confidence that NPLs (non-performing loans) will peak out in a couple of quarters and FY14 is likely to be a better year.
Our internal analysis also suggests that Ebitda (earnings before interest, taxes, depreciation and amortisation) margins of corporates have bottomed out and that falling commodity prices coupled with a benign rate cycle should result in a reduction in SME sector NPL formation.
Also, in the overall pall of gloom, the market has failed to recognise structural changes like lower reliance on bulk deposits, less funding of short-term unsecured corporate advances and movement towards system-based recognition of NPLs. Indian banks over the past three years have also reduced their concentration risks—a fact that has been largely unnoticed.
We upgrade State Bank of India (SBI) to ‘Outperform’ from ‘Neutral’ and Punjab National Bank (PNB) to ‘Neutral’ from ‘Underperform’, as these are the two banks that are most leveraged to the SME/mid-corporate NPL cycle. We rate 'Outperform' on Axis Bank now that it has come off the restricted list.
So what has changed and why the upgrade?
Two main aspects led to the upgrade. Our view on the asset quality cycle—which we believe is close to the bottom. Further, loan growth and margins have also bottomed out.
Liquidity and interest rate scenario: Interest rates are set to come down with inflation moderating (we expect a 100 bps points cut in benchmark rates which may translate into a 50 bps cut in lending and deposit rates). The liquidity situation also has improved and is set to further improve, driven by RBI OMOs (open market operations) as well as government spending. Short-term rates are already down 250 bps from the peak.
Bottoming out of growth: Needless to say, there is a strong correlation between economic growth and the NPL cycle, and with GDP growth expected to bottom out in FY13e and recover 100 bps, we expect cyclical-related stress to come down. A recent stress analysis by Fitch revealed that more than 50% of the stress is contributed by cyclical sectors. Sectors like SMEs are very leveraged to the interest rate cycle and demand revival and hence they would be