>>Indian Banking Sector (MACQUARIE RESEARCH)

Bond yields, NPLs in focus

EVENT
We preview the 4Q FY3/09E results for Indian banks.

IMPACT
Decelerating NII: Net interest incomes will decelerate this quarter as a result of slowing loan growth and lower margins, in our view. Systemic loan growth has slowed from the October peak primarily because of disinflation; company revenues (and thus, working capital needs) have shrunk. Cancelled capital projects have emphasised the slowdown. NIMs have also been under pressure, due to aggressive benchmark rate cuts from the banks – the benefits from lower deposit rates will take a couple of quarters to offset this.

Bond profits will disappear: Bond profits are expected to reverse this quarter, as bonds collapsed over this quarter. Bond yields are up by almost 200bp over the quarter, reversing a 300bp fall in the previous quarter. Almost all banks benefited strongly from bond profits in 3Q FY3/09E, and that trend
should significantly reverse over this quarter.

NPLs pushed into FY3/10E: Despite the dramatic slowdown in the economy from October/November, we think it is too early for NPLs to show up in most P&L accounts. The worst period for NPLs is likely to be FY3/10E and FY3/11E, with probably an even spread of provisions. One of the key reasons
for the postponement is the window that the RBI has allowed banks to restructure assets: It allows banks to absorb the losses over a long period.

Revising forecasts: We are revising our forecasts for some of the banks under our coverage, partly due to the strong loan growth and margins that came up in 3Q FY3/09, and our view that the provisions will be postponed to later years.

OUTLOOK
We remain cautiously optimistic on Indian banks, and believe that:
* The valuations, in many cases, factor in an asset quality slippage situation that is too pessimistic.

*The deep interest rate cuts actioned by the RBI since October 2008 will
have a medium-term beneficial impact on the banks.

* We upgrade Bank of Baroda to Outperform from Underperform, given the belief that its core profitability is improving while NPLs will be cushioned by its high provision coverage. Our top picks in the sector remain HDFC (HDFC IN, Rs1,577, OP, TP: Rs1,738) and HDFC Bank (HDFCB IN, Rs1,037, OP, TP: Rs1,106).

To see full report: BANKING SECTOR