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Indian banks appear to have sidestepped the economic slowdown
surprisingly well, with gross NPL levels virtually unchanged over the
past year at 2.7% of loans. Stress, though, is visible in rising
restructured assets, including which total problem loans jumped to 6%
in March 2009 from about 3% in March 2008. Our stress test indicates
that banks’ balance sheets are strong enough to weather this slippage.
Credit costs, though, are likely to rise 30-50 bps over the next two years.
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The central bank responded to the slowdown with aggressive rate cuts
and is now keen that banks also rapidly lower their lending rates. This
is likely to put banks’ margins under pressure, as their loan books are
floating rate while their deposit base is fixed rate. This, coupled with
rising credit costs, could dampen ROE progression for the banks.
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Easing asset quality concerns and expectations of financial sector
reforms have driven an 80% rally in Indian banks over the last three
months, and valuations are no longer inexpensive with the sector
already trading at 1.6x book, given the 15% ROE generation, and we
recommend a MARKET WEIGHT stance on the sector.
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We prefer banks with strong earnings visibility and those that are well
placed to absorb rising credit costs and margin pressures. We assume
coverage with OUTPERFORM ratings on HDFC Bank, Axis Bank, Bank of
Baroda, Bank of India, Axis Bank and Punjab National Bank; NEUTRAL
ratings on HDFC (fully valued), ICICI Bank (weak profitability, asset
quality risks); an UNDERPERFORM rating on SBI (low profitability).
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