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March 26, 1997


Bank on banking

The 1997-98 general Budget of the federal government has turned a weak economy into a potentially buoyant one. This was immediately reflected on the stock market which expects a strong year ahead.

And here comes a tricky question: What segment of stocks will beat the market? I say this point is tricky because over the last couple of years a number of industries which were doing well struggled to beat the downtrend on the stock market.

Which is why industry selection becomes important. In my opinion investors would do well to look at broad industry segments that stand to benefit directly from the reform process. The companies belonging to such an industry would need to have credible balance sheets tied in with the prospect of robust growth in the years to come.

An industry which could well lead the rebound of the secondary market in the country could be banking.

There is a fundamental reason behind the long-term bullishness in banks. Assuming that India's annual population growth continues at 1.7 per cent, real GDP growth per year is 7 per cent and inflation is pegged down to 5 per cent up to the year 2022 AD, experts have estimated that the size of India's domestic credit market would grow at a shade below 16 per cent per year.

Even if loans and deposits grow at 15 per cent per year over the period, the ratio of credit to GDP would only be a little over 130 per cent - less than some of the ASEAN countries like Thailand.

Besides, banking is the best place to be in a growing economy as credit markets outstrip the growth of the nominal GDP.

Now for a technical view of things. The shares of the Indian banking industry have taken a severe hammering over the last year; most banking stocks were quoted way below their highs registered over the last 52 weeks and the P-E ratio for private sector banks, based on their performance for the first half of 1996-97, stood at a shade below six around the time the Budget was presented.

Interestingly, public-sector banks with a corresponding P-E of around 9.5 fared better. Meanwhile, in the developed countries of the world, bank stocks command high P-E multiples.

There are a number of reasons why banks stocks have fallen out of favour. One, the scandal in Indian Bank exposed the threat of bank loans being given out for reasons other than financial.

Two, the feeling that this is a real threat facing just about every branch of every bank in the country which makes it impossible to estimate the risk factor inherent in banks.

Three, most investors understand 'visible product' companies better because it is always possible to put a finger on how much of cement or sugar was sold, but investors feel that in bank stocks it is difficult to put a finger on the money coming in and going out, hence the insecurity.

Four, bank stocks had no track record which resulted in low visibility; as a result, a bank's balance sheet is usually Greek and Latin for most investors.

Five, the reported profit is often not the actual profit because of a number of provisions, prompting the feeling that it is the deceptive fine print which holds the real key.

Six, one bank's income profile may differ considerably from that of another bank. This has induced the feeling that a general rising of the tide may not improve the level of all bank stocks.

Hence, the need for a deeper insight into the company or privileged information with regard to current working. The end result: wherever investors realise that the visible may be illusory, they tend to stay away.

Banks by themselves have done little to address this critical situation which has resulted in poor market capitalisation (Global Trust Bank may be an exception).

The annual reports of most Indian banks are low on operating information. I will go a step further: Most Indian banks make no attempt to 'market' their stocks by creating annual reports that make their operations easier to understand.

Operations statements of most banks are opaque. Investor-management in the industry is near non-existent.

One finds this highly relevant because one is convinced that the banking industry is poised for a sharp rebound in the coming financial year and beyond. My reasons:

* Banking growth will lead the anticipated robust economic growth of the next few years. In fact, economic growth is only possible if there is adequate banking growth in the country.

* The expansion of the economy will be accompanied by increased velocity of money as well, benefiting banks more than any other industry.

* The inflow of GDR funds will buoy banking funds.

* Banks will increasingly access international funds at libor cost (or lower) and deploy the same in the Indian market, earning a windfall gain in the process.

* A reduction in the tax rate will strengthen bottom lines.

* With the interest rate expected to drop over the coming months, bond prices will rise. As a result, all those banks holding a huge amount of government securities and incurring losses by marking to market their portfolios, will now to stand to gain. As a result, the provisions needed to be made fore the losses will now disappear and banks will show their true earnings potential.

* Banks are funds-rich and one expects a substantial loan growth in the coming financial year. This will spur interest income for banks and strengthen profits.

* The economic recession has taken a toll on banks in the form of loans which have not been returned on time turning non-performing asset in the process - or those which may not be returned at all. Provisions against these NPAs will be high in 1996-97 but one expects them to drop in the coming financial when the economic engine has moved into gear. There is also the possibility of loans being returned leading to a draw-down in the NPAs as a result.

* Banks are required to keep a certain portion of their deposits either in cash (CRR) or in government securities (SLR) as a buffer. The interest income that they get on the government securities is much lower than what they would be able to get if they deployed the same in their active business. An interesting thing has transpired over the last few months: the percentage of deposits (as denoted by the CRR and SLR) that must be parked has been lowered by the RBI, resulting in more cash in the hands of the banks. More cash will lead to more loans given out by the banks (at market rates) and a higher income. Result: higher profits.

* The RBI governor had indicated in a recent interview that the cash reserve ration is likely to be brought down below 10 per cent over the coming months. If this transpires, there will be a greater ammunition for credit growth in the country.

There are a couple of other reasons why bank stocks are becoming safer with reference to their profit reporting. Prior to RBI's reforms in the banking industry, a number of banks overstated their profits. With more stringent provisioning norms, banks have identified their bad loans, written them off from their profit and loss account and more importantly, have also provided for the depreciation in the value of the government securities held by them (under SLR).

As a result, banks represent a picture which is closer to reality than ever before. What one sees in the balance sheet can therefore be trusted more than ever before.

The stock that I fancy is State Bank of India. It is the premier bank of the country and therefore must be considered one of the purest proxies of the country's fortunes. It has a large float on the market and affords an easy entry and exit for the bigger players. Profit for the last financial year was Rs 8.31 billion after a major write-off on account of the depreciation in the value of securities.

For the first half of 1996-97, SBI registered a profit of Rs 6.4 billion after writing off Rs 4 billion after marking to market the value of its portfolio - in what is being acknowledged as a bad year.

If SBI's accountants do not permit the write-back of the gain on government securities from the next financial year onwards, then the bank's hidden reserves will increase. In case they do, we could see a phenomenal increase in its bottom line over the coming two years. I am not going to be greatly surprised if SBI posts a bottom line of Rs 20 billion on its present equity of Rs 5.26 billion and its stock strengthens to around Rs 700 from its present level of Rs 300.

If you think this is just a dream, remember that no one visualised that 1997 would be bullish when 1996 ended.

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