Banks are a reflection of the economy. The government's recent push for reforms has not only opened up the key sectors to foreign investments, but has also sent a message that tough decisions will be taken despite political opposition. Foreign investors may expect more reforms and the government might just escape a downgrade in sovereign rating next month. If India retains its investment grade, banks will continue to have access to cheap funds.
The hike in diesel prices and the cap on the number of subsidized LPG cylinders per family will reduce subsidies and rein in ballooning fiscal deficit. A rise in deficit forces the government to borrow more money from banks. This impacts interest rates and crowds out private investment. On the contrary, lesser the deficit, lower the government borrowing and higher the money available for banks to lend.
Turnaround in rate cycle: Though the Reserve Bank held rates for a fifth straight month, the commentary suggests a reversal in the rate cycle may not be too far despite an unexpected rise in August inflation. Falling rates would give a push to credit off take, which has stagnated around 16 per cent, leading to higher profitability for banks. The 25 basis point cut in the cash reserve ratio will free nearly Rs 17,000 crore for banks to lend. Interest rates for consumer loans may soften marginally.
"This is a remarkable departure from the first quarter review of 31 July, where dovishness was conspicuous by its absence. When the Review says growth is weak, government is taking measures towards fiscal consolidation and that monetary policy "will reinforce the positive impact of these actions" it means the RBI is shifting rate action from today till a future date," Joydeep Sen, senior VP - advisory desk - fixed income, BNP Paribas Wealth Management said.
Valuations and risks: Public sector banks have been beaten down because of rising bad loans and the resulting restructuring. A pick up in the economy will reduce the quantum of bad loans. Many smaller PSU banks are trading at attractive valuations after a sharp correction in share prices.
Re-rating: The push to reforms and the global liquidity easing has led leading investment banks to raise their Sensex targets aggressively. Banking stocks, which are treated as cyclicals because they tend to do well when economy turns, have started finding favour in the portfolios of global brokerages. Citigroup and UBS have turned "overweight" on banks. Deutsche Bank says Axis Bank, Yes Bank, ICICI Bank, and SBI are among its preferred stock picks.