>Further Tightening Ahead? Banks: Sector Update

We believe that there is a high probability of a further tightening by the RBI through either a 25bps reverse repo rate hike or moderate CRR hike over the next few months. Our premise is that the core inflation (ex food and energy) is rising, CPI inflation at 7-7.3% is high and the recent CRR hike is unlikely to dampen the "excessive credit expansion" to levels within the comfort zone of the RBI. The fourth quarter of last year had seen an abnormal situation of stretched liquidity, panic borrowing on the back of rising interest rates and a curtailed government spending due to stretched government finances. In the current year, all these factors are working in the opposite direction and will foster a comfortable liquidity environment, which will tend to be inflationary and support the strong credit expansion. We believe that the recent statements made by government (post the CRR hike) are indicating that a further tightening could be in the offing.

"Inflation should be below 5% and toward 4%. We will take more measures as and when necessary to moderate inflation."
Finance Minister on 11th Dec 2006 after CRR hike

"India's interest rates are not directly linked to moves made by US Federal Reserve. Every central bank has to take its policy decisions.
"Rakesh Mohan - RBI Deputy Governor on 12th Dec 2006

"We have to be ahead of developments and take pre-emptive action rather than fall behind and take corrective action. It is too early to say that inflationary expectations have come down. Credit growth and money supply are still too high."
Finance Minister on 19th Dec 2006

However, over the medium term we expect inflation risks to moderate driven by falling food and fuel prices and hence don't expect a sustained and rising interest rate scenario; such a hike could be near to the end of a tightening cycle.

While the tightening will temporarily hurt the sentiment for banking stocks, there will not a sustained P&L impact. The hike will not significantly impact government bonds as there is a huge demand for SLR and hence bond losses for banks will be restricted. However it will impact deposit rates (both bulk and retail) and will pave the way for the PSU banks to push through a PLR hike. Although there may be temporary pressures on bank's NIMs due to lag effects is passing on the higher costs, sustained margin pressure is unlikely. In this environment, we would continue to favour banks that have either strong pricing power in lending market or have a high quality liability profile and sensible growth strategy. ICICI bank, Centurion bank, SBI, PNB and Andhra Bank remain our top picks in the sector.