The Bubble in Indian Banking Stocks
As research director of a top brokerage in Mumbai, I am astonished by the performance of Indian banking stocks. The Bank Nifty, the sectoral index, is up four times since last March, from 3200 to 12400. The Bank Nifty index is showing more momentum and performance than the Nasdaq in 1999, during the peak of its speculative blowout ! Note that the Bank Nifty is an index, and therefore, an average. If we consider individual bank stocks, most are up six times in a little over a year. Axis Bank 270 to 1580, Uco Bank 20 to 120 etc. The list goes on.
(This is important because the banks make up about 27 % of the Indian stock market currently - the largest sector . Any sell off in them will almost certainly bring about a market selloff.)
All this reminds me of the good old days of 1999, during the dot com bubble when local speculative favorites like Himachal Futuristic and Global Tele moved up five times in their last year of up moves. The banks, like their IT counterparts in 1999, are up as much, if not more, in a year! Astonishing.
To put things in historical perspective, Chrysler a speculative favorite in Wall Street’s golden age – the Roaring Twenties – was up four times over two years and that became the subject of myth and legend. The banks are up even more in a year, and India with its ahistorical nature takes it for granted.
Indian banking stocks are in the last stages of a massive speculative bubble. A collapse is imminent and could happen anytime.
The basic question is how in a country like India, with an old fashioned public utility form of banking based on acceptance of deposits and lending of money, that banks have managed such good profits and stock returns over the past year ? More importantly, how does the Indian central bank (the Reserve Bank of India or RBI) survey indicate that credit growth has risen from 16 % to 19 % in 2010, a rise of 3 %, while banking profits are higher by up to 40 %, and banking stock prices are up 400 to 500 % on average ?
Bear in mind that three quarter of the Indian banking sector – the public sector – is not even run by bankers, but by banking bureaucrats. Note also that none of them have brilliant traders manning trading desks, and generating “black box” trading profits. Finally, some of them are trading between three and five times book value , and 30 to 35 times earnings, many times more expensive than the best banking franchises in the world like JP Morgan and Wells Fargo. This, in the face of four successive rate hikes by the Indian central bank this year. Also, advance tax numbers for the September quarter (a portent of corporate profit growth) that are up just 10 % for the sector as a whole.
What is going on here?
Part of the answer lies in the nature of the Indian monetary transmission mechanism.
Banks in India make money because of massive inefficiencies in Indian monetary transmission mechanisms. More particularly, there is hysteresis, a sexy economic term with a common sense explanation – (ie) the delay, or lag, between a cause and its effect. Thus if the US Fed reduces its policy rate the Fed funds rate (the cause), other interest rates throughout the economy reduce as well (the effect). Consequently, there is no hysteresis in the US.
In India, by contrast, the monetary transmission mechanism by the RBI’s own admission, is bust. Thus the RBI, during the Lehman crisis reduced its policy rates, the repo and reverse repo, by 400 basis points ( 4 %) . The banking system essentially kept its lending rates (its income source) virtually unchanged, and slashed its deposits rates ( which is its cost). Their net interest income (NYSEMKT:NII) margins, - the difference between their lending and borrowing rates - soared. Essentially, the banks did nothing, and made money. The earnings growth was so large that second rate public sector banks like Uco Bank reported 270 % growth rates in March 2010 over the same period in the previous year. The market is mindlessly projecting these inflated rates into the future. Note also that the very same Uco Bank looks cheap at 8 times earnings because the earnings have been so inflated.
Note however, that this is a one time effect. With the rate cycle on an upswing due to soaring inflation in India, they will not be able to do that this year. More importantly, the RBI has recognized that the monetary transmission mechanism is basically broken and has switched banks to a base rate system from the earlier Benchmark Prime Lending Rate (BPLR) system. The earlier BPLR system was rendered nonsensical anyway by its practice. The BPLR is, by definition, the rate the bank gives to its best customers, and consequently most of the lending to “non best customers” - who are riskier- , should be at rates above that. Instead 80 % of Indian bank lending was at rates below the BPLR, - an absurdity. The new base rate system, - essentially a “cost plus” pricing regime - will eliminate the opacity of the earlier system, and improve monetary transmission considerably.
Further NII expansion will therefore depend less on systemic efficiencies, and more on credit growth. The problem is there is not much of it. In every quarter of last year, we were told that credit growth will pick up in the next quarter, but so far this has been a credit less recovery. RBI’s survey figures of August 27, show that credit growth was essentially flat. Banking stocks have increased so much, that even with 20 % to 25 % credit growth, let alone flat credit growth, the sector would be overvalued.
Second, the long bond yield has crossed its “ lakshman rekha” (or key threshold in Hindi,) of 7.8 %. Till that level, banks are protected from any treasury losses. The yield is now at 8 %. From now on, the previous benign environment for treasury profits will change. Banks will now suffer treasury losses. The absence of treasury profits will now change to the presence of treasury losses. Also fee based income the last source of revenue is rising well, but is too small a category to compensate for falls in NII and treasury profits, noted above.
Third, note also the extremely stretched valuations of the sector, particularly the heavyweights. HDFC Bank at 35 pe and 5 times price/book. ICICI Bank at 30 pe and 2.5 times p/b. SBI at 21 times pe. No margin of safety at all at these levels. As noted earlier, at these prices, some Indian banks are trading at many times the valuations of the best banking franchises in the world, which anyway have substantial emerging markets growth exposure. The public sector banks at 9 to 10 times earnings seem cheaper but note that the earnings have been artificially inflated due to the one time effects of hysteresis. ( The Uco Bank example from earlier). The market is mindlessly projecting the one time earnings growth of last year due to the hysteresis, into next year, and finding the stocks cheap.
Fourth, everybody and their grandfather are overweight Indian banking stocks. Every fund manager in India it seems, has put the maximum amount he can put in a stock - 5 % -, into HDFC Bank, ICICI Bank and SBI. This is similar to the IT mania in 1999. When the last buyer at the margin has come in, there is no one left to buy, and the sector sells off.
Fifth, the technicals. Personally, I don’t do technicals but keep an eye on them. Stocks in the banking sector are parabolic. The long term chart for all banks, looks like a straight line upward over the past year. I note that the gap between the current stock price and the 200 day moving average (DMA) is the highest it has been since January 2008, when the Indian market collapsed. RSIs are pushing 90, again as high as in February 2000, for IT stocks when that bubble burst. The sector is massively overbought in the short term.
Sixth and finally, the most important reason to sell the sector has to do with the deregulation of the last administered interest rate in India, the savings bank (NYSE:SB) interest rate. Banks have the God - like power to pay only 3.5 % on SB accounts. Hundreds of millions of poor and middle class Indians – especially in rural areas - have SB accounts as their basic – and only - financial instrument. With CPI inflation running at 13 to 14 % banks are robbing millions of 10 % of their capital every year, by offering negative rates of interest, a staggering 10 % below the inflation rate.
Both the RBI and the government recognize this absurdity, and will free the SB interest rate. Most probably the current level of 3.5 % will be the floor, and the rate freed above that. Both Dr. C. Rangarajan, the Chairman of the Prime Minister’s Council of Economic Advisors and the RBI Governor have publicly stated that it will be done (googling the issue will show the interviews) . When both government and central bank, are in agreement on Indian banking issues, one can be sure that it will be done, and quickly.
This will forever change the economics of the Indian banking sector. Banks have been maximizing their current and savings account (OTCPK:CASA) deposits because they are absurdly cheap for them at these administered rates. Now banks will be forced to pay market rates for SB accounts, thus losing their low cost deposit status. There are Rs 950,000 crores (about USD 225 billion) in SB accounts in India. Even if banks have to pay half percent more, that means an increase in their costs of Rs. 4500 crores (about USD 1 billion) ! They can raise lending rates and pass on the costs, but as said earlier, where is the credit growth for them to raise lending rates ?
For all the above reasons, I conclude that Indian banks are in the final stages of a speculative mania, and are headed for collapse. The market is extrapolating the one time gains of the previous year into the future, and ignoring the factors I have outlined above. The stocks should collapse 50 % or so from these levels.
Full disclosure: Exited Indian bank stocks.
Disclosure: Exited all Indian banking stocks
Disclosure: Exited all banking stocks