Sudden optimism

Is there a good reason for bank shares to shine now? The BSE Bankex has risen by 13""14 per cent over the last one month at a time when interest rate worries should have made investors wary. Has anything changed to make the outlook rosier?

The current state of the banking system can best be summed up by the following set of numbers: credit growth has been 8.4 per cent this fiscal compared to 0.6 per cent over the same period last year; aggregate deposits have increased by 5.6 per cent this fiscal as against 7.4 per cent over the same period in 2003; and bank investments have grown by 6.3 per cent this fiscal compared to 14.8 per cent over the comparable period of 2003.

These numbers show why banks' credit-deposit ratio, especially the incremental credit-deposit ratio, is steadily rising, indicating a turnaround in credit growth. This change obviously leaves less money to park in investments ""and is one reason why bond yields have been rising, apart from fears of inflation and rate increases.

Anecdotal evidence also suggests that the rise in credit may be largely due to the continuing surge in retail lending. Corporates are still flush with cash, thanks to years of good profits without any capacity expansion, and it will take time for that cash to be used up.

It's also noteworthy that, despite the strong credit growth, there is still a lot of liquidity available, as seen from the amounts parked by banks in repos.

Nevertheless, although it may take some more time, there's little doubt that, if current trends in deposits and advances continue, liquidity with banks will steadily diminish, and they will be forced to raise interest rates.

Bankers estimate that this could happen six months down the line, as the promises of increased capital expenditure by corporates get translated into performance and they start borrowing for projects.

Higher credit growth will, of course, benefit banks, particularly if loans are re-priced at higher interest rates while deposits are re-priced partially, as and when they mature.

But that growth will be offset by the absence of profits on sales of securities and the depreciation that banks may have to take on their investments.

The hit will probably be taken despite the recent RBI relaxations that allow banks to shift investments to the "held to maturity" category. This is because any such shifts will still have to be effected at market rates.

Further, the hike in the cash reserve ratio earlier this month will impound bank resources; the emphasis on agriculture will do likewise and probably raise non-performing assets; and the wage settlement in public sector banks will hit their bottom lines.

Bankers say that, at least in the current quarter, the gains from increased lending are unlikely to offset the losses on the investment portfolio.

Yet bank stocks have been sparkling, undimmed by all the negatives. One reason could be the anticipated rise in mergers and acquisitions, as the government puts through its plan for consolidation in the banking sector.

Another could be that most of the negatives are already priced into bank stock prices. A disaggregated view of bank stocks underlines that perception.

It is the public sector banks, which were most beaten down after the election results were out, that are gaining now. In other words, the market seems to be taking the view that there's value in them at current levels.