Morgan Stanley
India: Cutting Exposure, Banks,NBFCs To Suffer Big Time
What is the impact of the move to replace notes of high denomination, in current usage, on banks? Tough to predict. Longer term this is a clear positive as the sector should benefit from reduced usage of cash in the economy (good for bank deposit growth). For instance, currency in circulation in India is 12% of GDP or 16% of bank deposits - this is too high (in China this is ~4% of bank deposits).
It will also give meaningful fillip to electronic transactions in the longer run implying further market share gains for banks with strong technology based offerings (primarily private banks & SBI among SOE banks). However, in the near term, this move could hurt economic activity, potentially causing banks to have another leg of NPLs. Key in the near term will be how quickly do cash/ payment flows go back to normal.
Only hindsight will tell us the real impact that banks will face for next few months. But as payment flows slow (even for a short period) banks can see NPL's. This move will likely cause a pickup, possibly for a short time period, in retail NPL's (especially in rural areas where large part of transactions are in cash). Smaller businesses (SME / MSME), which were struggling, may also find it difficult to meet bank payments on time. Also banks will likely to have to relook at their underwriting processes for retail / rural lending for next few months (given uncertainty in cash flows), implying potential slowdown in retail growth.
Hence, for Indian financial stocks the near term impact (2-3 months) is likely to be negative. In our recent note, Asia Financials: Model Portfolio – Cutting India after Recent Run Up (22 Sep 2016), we had reduced India exposure. The reason was that valuations were high and the market was disregarding weakness in underlying trends. This was driven by willingness to pay up for longer term growth. While longer term growth outlook is still good - this move could cause stocks to decline given elevated multiples and negative earnings headwinds. NBFC's will be under greater pressure in the near term and will be very volatile both due to near term and potentially structural impact ahead.
The obvious negative impact will be on banks / NBFC's which have a high share of direct / indirect collections in cash - This is especially the case where lenders have relatively larger value loans in rural areas. In these areas, borrowers receive the bulk of their payments in cash. Given the size of the businesses / individuals, quite a few of these borrowers would be paying back from regular cash flows and not savings - in our view. If cash flow stalls, we will likely see a pickup in defaults from these borrowers. Ultimate losses may remain low (as the economy digests this disruption) but NPL formation will increase.
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