What would the Indian bond inclusion in the JP Morgan Global Bond Index mean for the money market and the flows? How meaningful could it be for the interest rate environment in India?
Pranav Gundlapalle: I think this whole bond inclusion would be a bigger factor for the liquidity environment. This has been one of the events that the central bank was waiting for before easing liquidity because they did not want to ease before seeing the impact of these flows coming in. So, from a liquidity perspective, this would be positive and it has been one of the biggest overhangs on the banking sector and easing of that would be a positive for the banks.
On one hand, the private banking space has been doing phenomenally well. If you talk of pure growth in the top five names, the way they have managed their NIMs as well as asset quality, phenomenal work has been done by some but they have been on the receiving end of the FII outflows. How do you think things will change from here? We have got two blowout days by the private banking space in the last fortnight or so. Is it a sign that things are changing?
Pranav Gundlapalle: On the operational metrics, the private sector banks have done phenomenally well. Even from here, we expect them to outperform the public sector banks, both in terms of the EPS growth numbers or even the fundamental metrics as well. What has not helped them from a stock price perspective has been the foreign outflows. And given the high ownership in the private sector banks, I think they have naturally been at the receiving end.
So, with inflows potentially coming back, they would stand to benefit the most. I think from a foreign investor perspective, the private sector banks remain the favorites. Any inflows from there should benefit them more than the public sector banks.
The debate in the market is whether things are looking up for the private banking space or if the market just looking at it as a valuation play because some of these have not gone anywhere in the past year, a year-and-a-half.
Pranav Gundlapalle: A couple of things here. For the public sector banks, two things have worked over the last two years. One was that there was a nice asset quality improvement or rather the credit cost declines, which made their profitability, at least from an ROE perspective, quite comparable to that of the private sector banks.
Second. a couple of years ago, they were sitting with a significant amount of excess liquidity, and therefore, even on the growth front, despite their deposit growth trailing the private sector banks, they have been able to deliver loan growth which is almost on par with their private sector banking peers I think that is kind of run its course. Where we are looking at today is both on the profitability and the growth front we expect a greater divergence from here. For example, on the deposit side, the public sector banks are still growing at about 10% compared to about 17% for the private sector banks. Once you have that and there is no excess liquidity, then you will naturally see a growth outperformance from the private sector banks.
On the profitability front, too, credit costs are expected to normalise. For example, a 30 bps increase in credit cost across the board will hit the public sector banks much harder from ROA perspective and that, again, will lead to an EPS growth divergence. So, overall, we believe that the outperformance will look even more stark for the private sector banks and that should lead to an outperformance from a stock perspective as well. In light of this view on the private banks versus what you expect from the PSBs, also highlight why this bull case for HDFC Bank wherein you believe that in the next four years, it is going to return to industry-leading profitability and parameters.
Pranav Gundlapalle: What is now well understood is that few factors have led to a lower ROA for HDFC versus its peers and most of these are one-off or because of deliberate actions from the bank. And as those reverse or normalised, we do expect the profitability to improve.
The three key factors here are one, loan mix improvement for HDFC. The bank has seen a shift towards lower-yielding corporate segments and therefore, they have developed a significant gap in yields versus peers. Now, as that normalises, we do expect an improvement in their loan yields versus their peers.
The second is, of course, the well-understood increase in the cost of funds because of the merger with HDFC Limited. Now, as long as the bank can deliver deposit growth of about 18% to 20%, which means that they maintain their incremental market share of around 16% in the industry, they should be able to normalise their liability franchise, which is their LDRs come down to less than 90-91% in a three-year time frame and that will again lead to a significant improvement in ROA.
The last one would be an operating leverage. Now, the combined entity used to have an opex to assets ratio or operating cost to assets ratio of about 1.7 versus today they are at about 1.85%, 1.9% simply because of the aggressive branch expansion. Now, once that starts to moderate, that again becomes ROA accretive. So, this is a unique story in the sector where you have these clear levers for profitability improvement, whereas, for most of the others, the idiosyncratic ROA improvement story is non-existent. That’s what makes us quite bullish on HDFC Bank.
You also look at some of the NBFC lenders beyond the banks, some gold loan companies, and some larger NBFCs. How are things looking over there? The regulatory glare seems to be ebbing. That dip was completely bought in the gold loan side. Which are the names you are most bullish on there?
Pranav Gundlapalle: We are most bullish on Muthoot. The gold loan space is something we like within the NBFCs for a couple of reasons. One, we do see a long growth runway in the segment just given the amount of gold ownership in the households and more importantly, the uniform distribution amongst households, which means that these lenders can keep going deeper and deeper down the income pyramid and second is there is a very clear differentiation between an NBFC model versus a bank model, both in terms of the operating model, the target customers, the kind of products they provide, etc. This means that this is one of the few segments where the risk of banks jumping in to provide the same product is quite low.
Now, the regulatory actions have largely been around operating practices rather than on the product itself. Unlike some of the others where you had an increase in risk weight or changes to the pricing or product offerings. Here, I think the regulatory action has been limited to a few players and also around well-established guidelines being flouted. Therefore, we are quite bullish on well-established players like Muthoot, who have been doing this for a long time and have managed the regulatory expectations around operating practices.
What is your take then on the regulatory impact on PPBL and what that could potentially mean for other players entering the space? What could be the long-term impact? As the dust settles what is going to be the residual impact?
Pranav Gundlapalle: Our view is that the risks for an emerging product or a new product are much higher and the cycle seems to be a bit longer than what we have seen in the past. So, almost every new product that has come in, be it microfinance, gold loans, or consumer durables, all of them have gone through a bit of fine-tuning from the regulator. This time it seems to be a bit more stretched out. So, we would be a bit more cautious on newer segments and more bullish on well-established models where the regulator has become comfortable over a long period.