India Strategy - Peak of NPA cycle still not behind us - Emkay

We revisit our banking theme "Slippage not the only thing, new risks are emerging, May 2012" to assess the endurance of the rising NPA cycle and conclude that structural (and also cyclical) factors that sustained decline in NPA ratio during 1994-2008 are now receding, leading way for longer and structurally higher GNPA ratios. Inclusive of GNPAs and restructured asset, the stressed assets for the banking system have risen to 9% of total lending or equivalent to GNPA ratio seen during early 2000s. We see the ballooning GNPA cycle rooted to an overleveraged banking system and weak macro conditions. Sustenance of higher elasticity of GNPA/Credit growth at 3.4x post 2008 and decline in credit growth in response to credit risk concerns will imply GNPA growth sustaining at 40% implying GNPA/Advance rising to 4-6.5% in the next two years.

Ballooning NPAs rooted to the lack of countercyclical buffer

In our view, the fulcrum of the current NPA upsurge, steeper than in the late 1990s, can be attributed to overleveraged banking system reflected in renewed weakening of counter cyclical buffer which reversed the readjustment for the credit boom during FY04-07 instilled by decline in credit growth during FY08-FY10. The deleveraging process was cut short by the lagged impact of liberal credit restructuring and fiscal & monetary expansion in FY10. Phases of overleveraged banking is followed by multi-year moderation in credit growth and cyclical upsurge in GNPA (FY86-FY89, FY97-FY00, FY008-FY10 and FY12).

Rising NPA also reflect weakening in macro conditions

The linkage of the macro economic conditions to the elevated leveraging in the banking system is embodied in multiple variables including decline in domestic saving rate (public, household and private), impairment of productivity growth due to persistently high inflation, commodity prices & revenue deficit and decline potential GDP growth.

Dominance of long term lending creates backdrop for longer NPA cycle

Higher long term lending at over 57% of total loans vs. 22% during FY96-FY03 has created a backdrop of longer NPA cycle, particularly in the context of lower structural GDP growth. Unlike the earlier phase where long term lending was primarily the domain of development financial institutions (DFI's), the predominance of banks in project lending now implies absence of option to transform, as DFI's had by converting into banks in response to high NPAs.

Sector concentration risk is far more elevated

Exposures of banking sector to sectors that are highly cyclical or exposed to structural problems have increased to 20 year high. Within industrial credit, the proportion of allocation in Iron & Steel, Power, Chemicals, Infrastructure (including telecom) and engineering reach a high of 54% in FY11 before declining marginally to 53.1% in FY12. At these levels, the sector exposure to these high risk sectors is significantly higher than the FY97-FY01 average 40%.

Aggressive Agri lending exposes PSU banks to high credit risk

While this rising intensity of agricultural credit has resulted in elevated level of indebtedness for the agri culture sector, it has also resulted in steep rise in NPAs for the banks as their contribution to Agriculture lending has risen to 65% by FY11 compared to 25% in FY00. As per RBI, the agricultural NPAs rose by 47% in FY12. Of the estimated Rs240bn NPAs in FY12 on direct agri lending nearly 90% belonged to PSU banks. We believe NPAs on agri credit could rise back to early 2000 levels.

GNPA cycle unlikely to peak before corporate profit cycle bottoms

Rise in GNPA growth since FY08 has been much steeper in response to decline in profit growth than it was during the FY06-FY08 period. PAT growth for non finance companies declined from the peak of 70% in FY04 to around 5% in FY12, GNPA growth rose from -15% in FY06 to 60% in FY12. Importantly, peaks and troughs of the GNPA cycle lags profit growth cycle by 12-18 months. In line with our earlier strategy theme and limited scope for macro policy stimulus we expect profit growth to remain under stress for at least four quarters, on the back of sharper decline in sales growth. Hence, we believe it will be several quarters before the GNPA cycle peaks out.

Banks exposed to credit risk and limited trading profit potential

During the previous NPA cycle (FY97-FY02) allocations to SLR and non-SLR papers were higher and rising, which implied that banks made significant trading profits from interest rate easing, to compensate for high NPAs. Contrastingly, credit/total asset is higher now at 65% while allocations to SLR lower at 25%. Hence, pains from higher provisioning costs will dominate potential trading gains from rate easing. Going forward, balance sheet rebalancing will shift towards SLR and high-quality non-SLR investments, even as banks rationalize credit lending in response to credit concerns. This will imply lower balance sheet & credit growth and decline in returns on assets.

Corporate debt restructuring: Moral hazard problem and source of vulnerability

The 60% rise in restructured asset in FY12 and a CAGR of 43% since FY09 is a reminder of evergreening during the earlier episode of rising NPAs. The risk of willful default from such regulatory concessions and banks attempting to camouflage asset quality deterioration is high now. This backdrop exposes the banking system to unanticipated and disproportionate risk in the context of potential external shocks. PSU banks top the list with higher FY09-FY12 CAGR at 48%. Restructured credit/advance for public sector banks is higher at 5.7% vs 1.6% for private banks.

PSU Banks: Concurrence of slippage and provision cycle

We believe seasoning of NPAs will become increasingly important with Indian banks, especially PSU banks, having seen significant rise in the sub standard (SS) and D1 category of NPAs over FY09-11. Over time a substantial proportion these NPAs will migrate towards D2 and D3 categories. Liberal provisioning by PSU banks in the recent past portend elevated provision costs. Over the next two years, the migration of advances into lower categories itself would require 40-60bps of (20-30bps each year).

New underwriting for PSU banks not helping profits & capital adequacy

The not so drastic decline in RoEs of PSU banks needs be contextualized against the quadrupling of stressed assets/total loans to 5%. New underwriting needs to be seen in backdrop of decline in RoEs adjusted for the additions to gross NPAs to single digit. While the reported Tier I capital adequacy of the PSU banks is at 8%+, in most cases the sharp rise in NPAs also means that the overall networth has been impaired significantly (UNBK, SBI and BOI the impairment ratios have risen to 24.7%, 23.2% and 20.2% respectively).

Outlook: Peak of NPA cycle is still not behind us

Overall, we believe the peak of the NPA cycle for the Indian banking sector is still some time away. We expect GNPA growth to average around 40% in the coming couple of years compared to the 30% seen during FY09-FY12. Effectively we do not rule out GNPA ratio rising from the 3.1% in FY12 to 4-6.5% in the next 12-24 months. Sustenance of high commodity prices, further weakening in fiscal conditions and extension of regulatory concession will likely elongate the NPA cycle while tighter regulatory framework, correction in global commodity prices and aggressive fiscal consolidation would shorten the cycle.

Given that balance sheet constraints and asset quality issues are more pronounced for PSU banks, our analysis strengthens our conviction on remaining underweight PSU banks and our preference for private sector banks.

Source : Equity Bulls

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