A bad time to be a bank

Higher bond yields and liquidity spell double trouble

The Bombay Stock Exchange Bankex has risen about 6 per cent from early June, lower than the 8 per cent or so rise in the Sensex. This underperformance comes after a fall of 20 per cent during the June quarter, compared with a Sensex decline of 14 per cent over that period.

This disenchantment with bank stocks is, of course, the consequence of higher yields in the bond market and the worry about what it means for banks' bottomlines.

But between early June and today, the ICICI Bank scrip is up around 15 per cent, the HDFC Bank stock is up about 5 per cent, while SBI is down 4 per cent and Bank of Baroda is flat.

The point is that PSU banks and the new private sector banks will be affected differently by the rise in bond yields, and the market reflects that.

PSU banks buy and hold large amounts of government securities and the impact of marking to market will hit them the most.

On the other hand, not only do banks like HDFC Bank and ICICI Bank churn their portfolios, the duration of their portfolio is much lower, so the hit they take will also be less.

Also, ICICI Bank also has a large number of floaters in its portfolio, protecting it from a rise in interest rates.

As Dipankar Choudhury, vice president of ICICI Securities points out, this is a bad time for banks, because of the peculiar situation where long bond yields are rising on inflation fears, but, at the same time, there's a lot of liquidity which prevents any increase in loan interest rates.

As a result, while banks will bear the brunt of the lack of treasury profits, they will not be able to reap the benefits of higher net interest margins.

With about a third of banks' liabilities in the form of savings and current accounts, and with interest rates rising only on new deposits, banks can benefit from rising interest rates on loans.

But in the current quarter, if loan interest rates do not rise, higher lending will not make up for the lack of treasury profits or, in some cases, a depreciation in their gilts portfolio.

Cement demand

The good times in the cement industry are expected to continue at least for the next 12 - 15 months, thanks to the better demand-supply situation.

One indication of that is that, for the first time in years, current prices in the all-important consuming regions of the North and West are equal, if not higher, than during the peak December period.

Current cement prices in Delhi are at Rs 133 per bag vis-a-vis Rs 129 in December, while in Mumbai they are pegged at Rs 162 per bag as compared to Rs 160 - Rs 160 six months earlier. These strong prices should help companies to neutralise to a large extent the recent increases in diesel and coal prices.

Strong demand conditions resulted in cement consumption in the north growing 9 per cent year-on-year in Q1 FY05 and 7 per cent in the western region.

However, in the south there was a deceleration of 11 per cent, and analysts point out that it was largely due to curtailed purchases from the public sector, due to change of governments in key consuming states of Karnataka and Andhra Pradesh. It is understood that from the first week of July, cement sales in the south have shown signs of normalising.

The 1995 tightening

In the two weeks to July 30, 2004, forex reserves fell by $2.7 billion as the RBI bought dollars in order to prop up the rupee. One fallout of that has been lower liquidity in the bond markets.

Perhaps it's time to recall what happened in the second half of 1995-96 when the rupee depreciated sharply from about Rs 31.50 in April, 1995 to about Rs. 35.60 per US dollar in October, 1995.

Following intervention by the RBI, the rupee stabilised in the Rs 34-36 range until January 1996. In February 1996, the rupee again suffered a bout of depreciation and touched a low of about Rs 38 per US dollar.

The RBI intervened massively to prop it up, in the process withdrawing liquidity from the markets. Call money rates reached stratospheric heights. That savage tightening of monetary policy led to a severe credit crunch for corporate India.

The CMIE database of manufacturing companies showed a rise of 100 per cent in profit after tax in 1994-95, a rise of 21.1 per cent in 1995-96 and a fall of 38.8 per cent in 1997-98. While the clampdown did succeed in reducing inflation, (as the table shows), it resulted in borrowing rates for most corporates to rise to around 17 per cent, while real interest rates moved up to 12 per cent.

Many commentators, including the authors of the 1997-98 Economic Survey, felt that the RBI's tightening was too sharp, stifling growth.

The RBI needs to keep the lessons of 1995-96 in mind while deciding its current policy.

With contributions from Amriteshwar Mathur