India: bank credit picks up finally; concerns overstated : JP Morgan

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India: bank credit picks up finally; concerns over rising lending rates overstated

With investment and bank credit strongly correlated, credit growth remained largely sluggish in the last two years as private investment failed to turn on Credit growth has now begun to rise although it is still largely in infrastructure An upturn in non-infrastructure investment is key to credit growth, but investment is a lagging not a leading indicator of credit—it has to happen before credit picks up We expect a broader based recovery in credit staring around 3Q11 after the investment cycle resumes This would eventually be good for banks, offsetting any squeeze in net interest margins due to rising cost of funds reflecting the continued monetary tightening Concerns over higher interest costs hurting credit is overdone as lending rates have almost always risen only in the context of rising credit demand in India Bank credit finally picks up…. One of the well documented disappointments of 2010 in India was the failure of the non-infrastructure investment cycle to take-off. Despite strong public-sector led domestic demand and increasingly strained industrial capacities across several sectors, repeated global shocks through 2010 increased economic uncertainty and ostensibly depressed the desire of corporates to undertake large fixed investments at home. One of the unsurprising casualties of this phenomenon was the growth of bank commercial credit. In a developing country such as India, with a highly underdeveloped corporate bond market, credit growth is strongly driven by private investment growth, but typically lags the investment cycle by 2-3 quarters. With almost no meaningful non-infrastructure private investment growth since the onset of the global financial crisis in 2008, it was no surprise that credit growth would suffer. To put some numbers to this, growth of bank credit fell sharply from a pre-crisis average of about 30%oya (2004-8) to 20% in 1Q09, to 15% in 2Q09 all the way down to 10% by the end of 2009. Since then, however, credit growth has gradually begun to rebound. Credit growth rose to 16%oya in1Q10, inched up to 19% in the second and third quarters (though, admittedly, some of this was attributable to borrowing by telecom firms to pay for the 3G licenses and to acquire foreign assets) and then rose sharply to 23%oya in the last quarter of 2010. And even if one takes out the loans for telecom asset purchase, credit growth still rebounded and instead of being around 23% it is somewhat lower at 18%. This momentum increased sharply towards year end and credit off-take in 4Q10 exceeded the combined off take of the two previous quarters. …..but it is still infrastructure The question that therefore naturally arises is what’s driving this credit growth and whether the pick-up has been broad based across sectors? One could conjecture several hypotheses. Consumer durable growth has surged over the last two years and with real-interest rates negative for the most part of 2010, has credit growth been driven by a sharp surge in consumer loans? Or has demand for credit been driven by the increase in crude prices through the year, particularly in the last quarter? Alternatively, has the increased lending been directed primarily towards the real estate sector, underscoring concerns of a real-estate bubble in several micro-markets? Finally, is the increase in credit off-take disproportionally directed towards industry suggesting that, contrary to conventional wisdom, the private investment cycle did show some momentum in 2010? As it turns out the answer is none of the above. Instead, consistent with anecdotal evidence from banks, lending to the infrastructure has surged over the last two years, and been a key driver of aggregate credit growth. Specifically, credit to the infrastructure sector has grown more than 50%oya between Sep 2009 and September 2010, about two and a half times as fast as aggregate credit growth. This comes on the back of 45%oya growth the year before, more than three times as fast as aggregate credit growth. What this has done is to significantly increase the share of infrastructure in banks’ loan book from about 9% just two years ago to about 15% currently. In contrast, non-infrastructure growth continues to be anemic, with year-on-year growth printing around 18% in September 2010 up, however, from 10 percent growth in the corresponding period the previous year. Contrary to popular perception, growth of consumer loans (6 % oya) and loans to the real estate sector (10% oya) are significantly below their pre-crisis averages, and credit growth to the real estate sector, in particular, has abated sharply over the last two years. As a consequence, the share of credit to consumers and the real estate sector in banks’ loan book has fallen every year for the last three years. Non-infrastructure industrial credit has picked up to 21%oya after bottoming out to less than 10% oya the previous year, but not enough to suggest a big upswing in the investment cycle. Credit growth needs to wait the turn around in investment The sharp growth in infrastructure investment over the last few years, as manifested by the surge in credit towards the sector, is critical to helping plug India’s gaping infrastructure deficit. But given that infrastructure investment is still only about 7-8% of GDP (a fifth of India’s gross investment needs) it is not enough by itself to sustain the current growth momentum. While growth has been robust in the first half of this year it has been driver primarily by a continued surge of government consumption in the absence of non-infrastructure investment. With government spending expected to wane (in line with the government’s planned fiscal consolidation path), it is critical that the investment cycle turn on soon to sustain the current growth momentum. Were this cycle to turn on sharply, one would expect a sharp surge in bank credit growth, given the strong correlation documented above. This, in turn, could have significant implications. For one, this would be very positive for banks. Prospects of continued tight liquidity in the banking system combined with expectations of significant monetary tightening over 2011 suggest that bank net interest margins (NIMs) could come under pressure over the course of the year. In contrast, if credit growth were to pick up sharply in response to a pick-up in the investment cycle, gains from the volume growth experienced by banks would likely swamp any adverse impact from squeezed NIMs. Beware of telecom refinancing One risk going forward is what happens to the large telecom related borrowing made in 2011 (for foreign acquisitions and 3G license sales). While exact estimates are difficult to come by it is estimated that the short term credit provided by domestic banks was around Rs400-450bn just shy of 0.9 % of deposit. If these loans were not refinanced domestically (i.e., the corporates refinanced the loans abroad given the lower interest rates), then there could be a period when credit off take could turn negative and credit growth could fall on a year-on-year basis (the loans could be up for refinancing starting April). Again, as we discussed earlier even if the telecom credit was discounted, credit has picked up in the last few months. But slow down if it were to happen could again dampen bank stocks. Concerns over rising interest rates hurting credit is overdone When lending rates rise credit demand obviously takes a hit. But in India lending rates have almost always been driven by rising credit demand. Credit has not been driven by low rates, rather rates have risen/fallen when the demand for credit, driven by non-interest factors (growth, global recovery etc), has risen/fallen. The causality runs from credit to rates, rather than the other way around. So in the coming quarters it is clear that the RBI will continue to tighten and this will over the course of the year raise rates further. We don’t expect lending rates to follow in lockstep as they have already risen significantly due to the liquidity squeeze, which is moderate ease in the coming months. If lending rates rise substantially from here, then it will in the context of rising credit growth driven by non-interest factors. Credit growth will pressure bond yields The corresponding outlook on bonds is not so sanguine. Currently the banking sector is holding government bonds (29 % of net time and demand liabilities (NDTL)) far in excess of the SLR requirements (24% of NDTL). Continued tight liquidity in the banking system (which the RBI seems comfortable with, current the current inflationary momentum) coupled with sharp increase in credit demand later this year would result in banks selling off and/or reducing their incremental demand for government bonds, exerting upward pressure on bond yields. Similar to lending rates, bond yields too are driven by credit growth, although the government’s borrowing program has a much larger impact on market sentiment. The government’s borrowing program in FY12 is unlikely to be lighter than in FY11 (see India’s fiscal outlook: flattering to deceive, January 6 2011). To some extent, however, this upward pressure on yields would be countered by authorities through more open market operations (OMOs) by the RBI, a potential increase in FII limits for government bonds and a possible increase in SLR requirements for banks. RBI’s concern of asset-liability mismatch overstated In The January 25 policy review and in subsequent interviews, the RBI warned of a growing asset-liability mismatch in the banking sector. The mismatch has been due to banks borrowing in the interbank market to fund credit growth as deposit growth lagged that of credit. In particular credit has been growing around 23-24%, while deposit growth only 16%. While the RBI’s concern should be noted, the scale of the problem is unlikely to be significant at the overall system level. True the banking system has reduced its bond holdings in the last month, but to a large extent this has been through repos with the RBI rather than sales to nonbanks. Moreover, excess bond holdings (over the 24% SLR requirement) even after declining is around 4.5% of deposits and about 200bps above the “normal” excess holding. In other words, banks still have a lot of space to fund credit growth. Some banks may be regularly using the repo window to fund its credit growth, but this is a supervisory issue that can be easily fixed. That said, the credit-deposit ratio has increased to its highest level in the last 5 years and perhaps this is what may be worrying the RBI. Given the RBI’s general concern with financial stability, some banks could face closer supervision.

With investment and bank credit strongly correlated, credit growth remained largely sluggish in the last two years as private investment failed to turn on Credit growth has now begun to rise although it is still largely in infrastructure An upturn in non-infrastructure investment is key to credit growth, but investment is a lagging not a leading indicator of credit—it has to happen before credit picks up We expect a broader based recovery in credit staring around 3Q11 after the investment cycle resumes This would eventually be good for banks, offsetting any squeeze in net interest margins due to rising cost of funds reflecting the continued monetary tightening Concerns over higher interest costs hurting credit is overdone as lending rates have almost always risen only in the context of rising credit demand in India Bank credit finally picks up…. One of the well documented disappointments of 2010 in India was the failure of the non-infrastructure investment cycle to take-off. Despite strong public-sector led domestic demand and increasingly strained industrial capacities across several sectors, repeated global shocks through 2010 increased economic uncertainty and ostensibly depressed the desire of corporates to undertake large fixed investments at home. One of the unsurprising casualties of this phenomenon was the growth of bank commercial credit. In a developing country such as India, with a highly underdeveloped corporate bond market, credit growth is strongly driven by private investment growth, but typically lags the investment cycle by 2-3 quarters. With almost no meaningful non-infrastructure private investment growth since the onset of the global financial crisis in 2008, it was no surprise that credit growth would suffer. To put some numbers to this, growth of bank credit fell sharply from a pre-crisis average of about 30%oya (2004-8) to 20% in 1Q09, to 15% in 2Q09 all the way down to 10% by the end of 2009. Since then, however, credit growth has gradually begun to rebound. Credit growth rose to 16%oya in1Q10, inched up to 19% in the second and third quarters (though, admittedly, some of this was attributable to borrowing by telecom firms to pay for the 3G licenses and to acquire foreign assets) and then rose sharply to 23%oya in the last quarter of 2010. And even if one takes out the loans for telecom asset purchase, credit growth still rebounded and instead of being around 23% it is somewhat lower at 18%. This momentum increased sharply towards year end and credit off-take in 4Q10 exceeded the combined off take of the two previous quarters. …..but it is still infrastructure The question that therefore naturally arises is what’s driving this credit growth and whether the pick-up has been broad based across sectors? One could conjecture several hypotheses. Consumer durable growth has surged over the last two years and with real-interest rates negative for the most part of 2010, has credit growth been driven by a sharp surge in consumer loans? Or has demand for credit been driven by the increase in crude prices through the year, particularly in the last quarter? Alternatively, has the increased lending been directed primarily towards the real estate sector, underscoring concerns of a real-estate bubble in several micro-markets? Finally, is the increase in credit off-take disproportionally directed towards industry suggesting that, contrary to conventional wisdom, the private investment cycle did show some momentum in 2010? As it turns out the answer is none of the above. Instead, consistent with anecdotal evidence from banks, lending to the infrastructure has surged over the last two years, and been a key driver of aggregate credit growth. Specifically, credit to the infrastructure sector has grown more than 50%oya between Sep 2009 and September 2010, about two and a half times as fast as aggregate credit growth. This comes on the back of 45%oya growth the year before, more than three times as fast as aggregate credit growth. What this has done is to significantly increase the share of infrastructure in banks’ loan book from about 9% just two years ago to about 15% currently. In contrast, non-infrastructure growth continues to be anemic, with year-on-year growth printing around 18% in September 2010 up, however, from 10 percent growth in the corresponding period the previous year. Contrary to popular perception, growth of consumer loans (6 % oya) and loans to the real estate sector (10% oya) are significantly below their pre-crisis averages, and credit growth to the real estate sector, in particular, has abated sharply over the last two years. As a consequence, the share of credit to consumers and the real estate sector in banks’ loan book has fallen every year for the last three years. Non-infrastructure industrial credit has picked up to 21%oya after bottoming out to less than 10% oya the previous year, but not enough to suggest a big upswing in the investment cycle. Credit growth needs to wait the turn around in investment The sharp growth in infrastructure investment over the last few years, as manifested by the surge in credit towards the sector, is critical to helping plug India’s gaping infrastructure deficit. But given that infrastructure investment is still only about 7-8% of GDP (a fifth of India’s gross investment needs) it is not enough by itself to sustain the current growth momentum. While growth has been robust in the first half of this year it has been driver primarily by a continued surge of government consumption in the absence of non-infrastructure investment. With government spending expected to wane (in line with the government’s planned fiscal consolidation path), it is critical that the investment cycle turn on soon to sustain the current growth momentum. Were this cycle to turn on sharply, one would expect a sharp surge in bank credit growth, given the strong correlation documented above. This, in turn, could have significant implications. For one, this would be very positive for banks. Prospects of continued tight liquidity in the banking system combined with expectations of significant monetary tightening over 2011 suggest that bank net interest margins (NIMs) could come under pressure over the course of the year. In contrast, if credit growth were to pick up sharply in response to a pick-up in the investment cycle, gains from the volume growth experienced by banks would likely swamp any adverse impact from squeezed NIMs. Beware of telecom refinancing One risk going forward is what happens to the large telecom related borrowing made in 2011 (for foreign acquisitions and 3G license sales). While exact estimates are difficult to come by it is estimated that the short term credit provided by domestic banks was around Rs400-450bn just shy of 0.9 % of deposit. If these loans were not refinanced domestically (i.e., the corporates refinanced the loans abroad given the lower interest rates), then there could be a period when credit off take could turn negative and credit growth could fall on a year-on-year basis (the loans could be up for refinancing starting April). Again, as we discussed earlier even if the telecom credit was discounted, credit has picked up in the last few months. But slow down if it were to happen could again dampen bank stocks. Concerns over rising interest rates hurting credit is overdone When lending rates rise credit demand obviously takes a hit. But in India lending rates have almost always been driven by rising credit demand. Credit has not been driven by low rates, rather rates have risen/fallen when the demand for credit, driven by non-interest factors (growth, global recovery etc), has risen/fallen. The causality runs from credit to rates, rather than the other way around. So in the coming quarters it is clear that the RBI will continue to tighten and this will over the course of the year raise rates further. We don’t expect lending rates to follow in lockstep as they have already risen significantly due to the liquidity squeeze, which is moderate ease in the coming months. If lending rates rise substantially from here, then it will in the context of rising credit growth driven by non-interest factors. Credit growth will pressure bond yields The corresponding outlook on bonds is not so sanguine. Currently the banking sector is holding government bonds (29 % of net time and demand liabilities (NDTL)) far in excess of the SLR requirements (24% of NDTL). Continued tight liquidity in the banking system (which the RBI seems comfortable with, current the current inflationary momentum) coupled with sharp increase in credit demand later this year would result in banks selling off and/or reducing their incremental demand for government bonds, exerting upward pressure on bond yields. Similar to lending rates, bond yields too are driven by credit growth, although the government’s borrowing program has a much larger impact on market sentiment. The government’s borrowing program in FY12 is unlikely to be lighter than in FY11 (see India’s fiscal outlook: flattering to deceive, January 6 2011). To some extent, however, this upward pressure on yields would be countered by authorities through more open market operations (OMOs) by the RBI, a potential increase in FII limits for government bonds and a possible increase in SLR requirements for banks. RBI’s concern of asset-liability mismatch overstated In The January 25 policy review and in subsequent interviews, the RBI warned of a growing asset-liability mismatch in the banking sector. The mismatch has been due to banks borrowing in the interbank market to fund credit growth as deposit growth lagged that of credit. In particular credit has been growing around 23-24%, while deposit growth only 16%. While the RBI’s concern should be noted, the scale of the problem is unlikely to be significant at the overall system level. True the banking system has reduced its bond holdings in the last month, but to a large extent this has been through repos with the RBI rather than sales to nonbanks. Moreover, excess bond holdings (over the 24% SLR requirement) even after declining is around 4.5% of deposits and about 200bps above the “normal” excess holding. In other words, banks still have a lot of space to fund credit growth. Some banks may be regularly using the repo window to fund its credit growth, but this is a supervisory issue that can be easily fixed. That said, the credit-deposit ratio has increased to its highest level in the last 5 years and perhaps this is what may be worrying the RBI. Given the RBI’s general concern with financial stability, some banks could face closer supervision.