Citibank: Banks: India: Macro Shines Stronger than Valuation Clouds

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Macro Shines Stronger than Valuation Clouds
 Outlook for 2011 — 2010 was a great year for Indian banks and the sector
outperformed the benchmark by 15.2% - supported by a strong economic
recovery, a sharp reduction in asset quality pressures, rising Net Interest
Margins and healthy loan growth. We believe the overall macro environment
continues to be supportive for banks – GDP growth is likely to be over 8.5%,
loan demand should stay healthy and profitability will be relatively high. While
there is some pressure on the banking system’s liquidity, the RBI has
provided enough indications of keeping it within manageable limits. In sum,
while an encore might be challenging, given relatively higher valuations, the
sector should still be a beneficiary of India’s continued economic momentum.

 Key trends to take advantage of — We believe the key trends in 2011 will
likely be: a) Infrastructure led growth – an oft repeated one – but still likely to
provided the maximum delta in loan growth for the sector (larger banks are
likely positioned better to participate in the growth); b) Deposit mix – a turn
from excess liquidity to a bit of a squeeze, is likely to increase competitive
intensity and push up funding costs (private banks typically manage liquidity
better; large PSU counterparts also are competitive); and c) Asset quality –
we expect private banks, having taken higher credit costs over the last 18
months, to start showing bigger reductions in credit costs than government
banks.
 Key risks to watch for — We believe the key risks could come from: a)
Inflation – has proved to be more stubborn than expected, could force RBI to
raise rates faster/higher than expected; b) Lower funding growth – deposit
growth will likely remain a laggard and could cap growth/pressure NIMs; and
c) Asset quality concerns – recent weeks have thrown up increasing
regulatory / environmental risks to asset quality – will firmly remain on the
watch list for now.
 Top Picks — While we remain slightly overweight on the sector vs the local
market, we would be selective in stock picking and not chase very high
valuations. We maintain a bias towards large private sector banks and those
with strong deposit franchises. Our top picks in the space would be SBI and
Kotak. We would avoid stocks with higher interest rate sensitivity and
relatively expensive valuations (BOB). We also remain watchful of higher
capital market exposures / sensitivity – (Edelweiss, Reliance Capital).