India started 2013 on an optimistic note, due to signs that fiscal control was high on the agenda, moves were on to open up foreign direct investment and some freedom in diesel deregulation. A sharp fall in precious metals and crude oil prices for a short period also raised hopes that macros would be on the mend soon. We saw a continuous surge in foreign institutional investment flows in the early part of the year. The Reserve Bank of India, too, seemed encouraged by this and gave signs that cost of funds in the economy were on their way down.
In hindsight, it seems premature. Capital formation on the ground has shown no signs of pick up. While infra-sector was facing hard times, consumption demand, has taken a hard knock, too. Real credit demand continues to falter, mirroring the economy. With most agencies and brokerages now indicating five to 5.5 per cent kind of gross domestic product growth expectation for FY14, it is dawning that the expected V-shaped recovery is a mirage and we have to brace ourselves for a patient U-shaped recovery. With the US showing tepid signs of recovery and the Federal Reserve hinting at QE tapering, it had a disastrous effect on currencies of the emerging economies, including India.
As if on cue, on July 23, RBI announced measures to curb volatility in the dollar-rupee exchange rate and protect the rupee from further depreciation. This indirectly increased the cash reserve ratio requirement of banks and squeezed liquidity from the system but gave a temporary reprieve to the rupee. While the recent RBI decision to keep rates unchanged, even hinted at the measures being temporary to be withdrawn in a calibrated manner, the message was not lost on market participants. For the rest of FY14, further rate cuts seem all but ruled out. In fact, some key private sector banks have raised deposit rates on short tenures and it is likely that more will follow suit.
This puts the banking sector, facing considerable pressure of slowing credit offtake, deteriorating asset quality and rising cost of provisioning, in a dilemma. So while cost of funds, expected to go down not so long ago, is now beginning to go in the opposite direction, credit growth continues to be sluggish and could continue to put pressure on their yield on advances. This could raise further pressure on NIMs (net interest margins).
We are hit by macro developments; our banking system faces an asset quality challenge, which seems likely to continue at least till the end of this financial year. Also, we are heading towards the election season. Keeping all these factors in mind, it will be tough for the Indian markets to break new highs and sustainably stay there in the medium-term. That said, the current volatility will offer some amazing opportunities to long-term investors.
The author is senior VP and head, research, IDBI Capital Markets
