Exclusive Interview | Expect back-to-back rate hikes of 25 bps taking the policy rate to 6.25% by March 2023, says Morgan Stanley’s Sumeet Kariwala

Sumeet Kariwala, Executive Director, India Banks Analyst, Morgan Stanley

On 6 June, the Monetary Policy Committee (MPC) began its three day meet to decide the course of interest rates and broader steps for the next leg of inflation fight. For Indian policymakers, inflation has emerged as the biggest concern with the steep price rise hurting even the poorest of poor already fighting the double whammy of a pandemic.

A rate hike this time is widely expected.

In an interview with Moneycontrol on June 7, Sumeet Kariwala, India Banks Analyst of Morgan Stanley said he expects back-to-back rate hikes of 25 basis points (bps) taking the policy rate to 6.25% by March 2023.

That apart, Kariwala also spoke on a range of issues including the ongoing HDFC-HDFC Bank merger, bad bank proposal among other issues.

Edited excerpts:

What is your outlook on Indian banking sector for this year?

We remain constructive on India’s banking sector. NPL cycle has turned driving positive surprise on credit costs. Further, gradual macro recovery along with rate hikes will drive higher revenue growth for Indian banks. This should drive banks’ profitability to levels not seen over past 10 years. Near term, we would closely monitor the potential impact of higher commodity prices. So far, high frequency indicators have behaved well and in-line with our expectations. Having said that, inflation has remained sticky and could impact demand with a lag. Another key trend to watch would be the competitive intensity on retail deposits. We expect competition to intensify given higher rates, stronger growth, LCR regulations as well as rising consolidation. Our view is that retail deposit growth would be key to profitable growth and a key differentiator between Indian banks over next few years.

According to your assessment, what is the estimated capital requirement for PSBs?

Indian banks’ balance sheet has improved significantly over past two years despite the COVID crisis. This is helped by a turn in corporate NPL cycle at Indian banks. Indeed, CET 1 ratio at SoE banks has improved to 10.7% in F22 vs. 9% three years back. Within SoE banks, SBI is ~10% and non-SBI SoE banks at >11%. The improvement in balance sheet is much higher if we adjust for higher coverage ratios. Going forward, we believe the capital needs will be a function of growth outlook. Based on our current growth and profitability estimates, we expect capital raise of USD 3-4bn at SoE banks over the next few years. The positive here is that a lot of SoE banks have raised capital from the public market, and this will help manage potential requirement adequately unlike history.

What is your view on bad bank implementation so far?

NARL or bad bank is a relatively differentiated idea that being implemented in India and we have noted some operational delays. To be fair, the formation of bad bank, by itself has lagged. A lot of bad loans that will be transferred to the bank are over five years old, and are fully provided. However, we expect some recoveries as well as balance sheet improvement to benefit banks. That said, we expect much greater benefit of the bad bank architecture in the upcoming cycles.

Some banks have said the government isn't repaying ECLGS compensation on time. Will this be a risk factor for banks considering rising defaults in this segment?

The ECLGS was a strong and timely measure by the government, and it helped provided necessary funding to MSMEs at the peak of COVID crisis. In our view, a number of small businesses were able to survive and rebound owing to this scheme. As moratorium ends, we expect some of these accounts to turn delinquent given multiple COVID waves, which would have weighed on their cash flows. Its early days as yet, but the delinquencies have been in-line with expectations so far. We would closely monitor this portfolio over the next few quarters. ECLGS has been a major scheme by the government, and there could be some operational bottle-necks which should get resolved over time. Further, we note that certain formalities had to be also full-filled by banks for the guarantee cover to get activated.

What is your view on broader reforms in Indian banking?

(Kariwala declined to answer this question)

The government's inability to progress on privatisation is evident. Your views?

I think there are two ways to this about this. We agree that the pace of stake reduction at state owned banks has been slower than expected. However, if we look at the pace of private banks loan market share, there has been significant acceleration in recent years. We note, that private banks have increased loan market share by >10%pts to >35% over past five years ending F22. This compares to an increase of ~7%pts during the preceding five years.  We expect the pace of private sector market share gains will continue to remain high - this will be helped by a number of new differentiated bank licenses as well as the technology led innovations in the private sector.

What is your view on RBI rejecting 6 out of 11 banking applications recently?  

(Kariwala declined to answer this question)

What is your take on HDFC Bank-HDFC merger?

The proposed HDFC bank merger with HDFC benefits both entities and we believe is a timely one. While HDFC bank gets access to long tail loans, HDFC will benefit from HDFC bank strong retail franchise. The merged entity, once approved, will have a balance sheet of US$330bn on a pro forma basis. The loan book of HDFC Bank will increase 41%, to ~US$230bn (~15% of banking system loans). We expect the loan growth for merged entity to accelerate post this, given improved cross-sell potential particular in the mortgages segment. One of the key success factors for the merger would be execution on retail liabilities and that would be a close monitorable.

Will Indian banks and NBFCs need to undergo another round of AQR post RBI withdrawing Covid support measures for borrowers?

We expect credit costs for Indian banks to moderate over the next few years, even as restructured and ECLGS loan book come out of moratorium. There will be increased slippages from these loans, but banks have improved coverage ratios and that should suffice. Note, unlike the previous cycle, we believe the restructuring in the current cycle was more prudent and much smaller than that of the previous cycle.

There are rising instances of borrower harassment by digital lenders. Should RBI introduce a fair practice code here?

(Kariwala declined to answer this question)

Are Indian banks adequately capitalised at this point? If not, what's the overall gap?

We believe Indian banks have been much more proactive in build capital in the current cycle, partly also helped by RBI guidance. This coupled with lower than expected credit losses from the crisis has resulted in very strong balance sheet for Indian banks. Indeed, we believe private banks in aggregate, are very well capitalized and we don’t see any deficit as such.

What is your outlook on interest rates?

We expect the RBI to front-load rate hikes as we build in an increase of 100 bps combined in the June and August meetings, moving the policy rate close to the pre-pandemic rate of 5.15% over the next two meetings. Thereafter, we expect back-to-back rate hikes of 25bps, taking the policy rate to 6.25% by March 2023. Banks would tend to pass this in lending rates, unless loan demand slows sharply. With respect to deposit rates, we expect proportionate increase, though private banks could raise deposit rates by a higher quantum to accelerate retail deposits market share.

Your take on crypto currencies and RBI warnings on private VCs?

(Kariwala declined to answer this question)

Do Indian fintechs lack adequate regulations?

Fintechs are transforming financial landscape globally at a fast speed, and this would require RBI widen the scope of potential regulations. Given this backdrop, RBI or any regulator for that matter could take time to respond. Fintechs have transformed the speed and delivery of financial services, and have the potential to accelerate financial inclusion at a wider scale and lower costs. We believe regulators would want to achieve a fine balance between innovation and potential systemic or concentration risk. The regulations will continue to evolve, and we believe the guidelines so far have helped both banks and fintechs to collaborate and drive better synergies with limited systemic risk.

Do you believe RBI as an institution needs to revisit it's structure and infrastructure to catch up with change in the composition and character of banking sector?

(Kariwala declined to answer this question)