Worrying signals from the markets
Investors are getting increasingly concerned about the extent of capital issuance in the financial sector
As has now been spoken about ad nauseam, investors are worried about the long-term growth outlook for India. What is India’s true structural growth rate? How quickly and to what level will growth rebound in FY22, after the pandemic shock? Was Indian growth truly overstated as Arvind Subramanian seems to imply?
The debate on growth is an important one, and depending upon what comes out of this debate, India seems either very attractive or not interesting at all.
The growth dynamics affect most of our long- term macro variables. Debt sustainability being the most critical. If India does not get back to at least 10-11 per cent nominal gross domestic product (GDP) growth, then the country will have real issues in trying to stabilise public debt ratios.
Similarly, without stronger growth, one does not see how the tax revenues will be in place to permit greater public investment and maintain fiscal sustainability. Even from the narrow lens of the stock market, there is a correlation between economic growth rates and corporate profitability (both growth and level).
Unless we get growth to accelerate over the coming years, it is unlikely corporate earnings will meet expectations. In the absence of an earnings acceleration, the outlook for market returns is bleak. Just take a look at the last five years. Between FY15 and FY20, the Nifty delivered a compound annual growth rate (CAGR) of only 1.7 per cent. This modest number was derived from an earnings CAGR of 2.7 per cent, dividends of 1.4 per cent and a valuation derating of 2.4 per cent (source: Motilal Oswal). Valuations are procyclical and multiples also move up or down with growth rates and confidence in the growth outlook. If we don’t see economic growth and earnings pick up in the coming years, we are destined for another period of mediocre market returns.
It is now a consensus view that for growth to pick up in India, its financial system needs to be fixed. We have undergone a series of shocks to all segments. The asset quality review forced the banks to disclose and provide for all bad assets. Frankly the public sector banks (PSBS) never recovered. Then we had the IL&FS crisis, which effectively wiped out the business model of non-banking financial companies (NBFCS) and housing finance companies. No longer able to access debt markets, their structural funding weaknesses and asset liability mismatches came to the fore. After the Yes Bank fiasco, the smaller private banks are running scared, some have got beaten down to below book and have to pay a large risk premium for deposits.
Unfortunately, the way markets are behaving, investors seem to have given up hope of the financial sector recovering from the Covid-19 shock anytime soon. Price action does not indicate that investors believe that the financials will lead us out of this economic slump. Current valuations seem to imply that we are in for an extended period of weakness on both asset quality and earnings for the vast majority of the financial system. This does not bode well, for without a recovery in the financials, I do not think the economy can bounce back.
This is for the simple reason that the financials have been the worst-performing major sector year-todate. Most of the major banks are down between 30 per cent and 45 per cent and all the laggards in the BSE-200 index are financials. There is not one major financial stock that is up for the year.
One can understand why the financials led the way in the Covid-related sell-off. The sector was overowned by foreigners, who did all the selling in the market meltdown. It was natural that they would sell what they owned. This is where the bulk of their profits were. The sector accounted for almost 42 per cent of the Nifty, and was thus ripe for a correction. What has been worrying is the inability of major banks to claw back their losses, as the markets and economy have started to normalise.
Investors are getting spooked by the extent of the capital issuance in the space. Every major financial institution is raising equity and the ticket size for each is between ~10,000 crore to ~15,000 crore. What do these banks know that we don’t? Is the rise in credit losses going to be so severe that they all need to raise capital at the same time? That too at not the best prices for most. Some are issuing such deep discounted rights, that they are literally forcing their shareholders to subscribe.
Are the non-performing assets once the moratoriums end, expected to surge to such an extent? Rather than comforting investors, the surge in issuance is worrying many. There is another associated concern of the relevance of the numbers being reported. If we continue to have most loans under moratorium, what is the relevance of the earnings number being reported? How to value a bank, if one does not know what its asset quality and profitability are truly?
The markets are saying that we don’t think the banks will rebound quickly. Their growth and profitability is unclear and too difficult to model. This has implications for the market’s view on the economic recovery as well. In fact, the markets’ price action is consistent with a weak economy and the lack of confidence in a strong V-shaped recovery. The best performing sectors year-to-date are Pharma and IT services, both export-oriented and classic defensives. The worst sectors, besides financials are, real estate, autos and capital goods. All domestic cyclicals. Such sectoral rotation, is consistent with a lack of confidence in future growth prospects.
The government has done a lot to stabilise the financial sector and address the risk aversion— from huge liquidity infusions to credit guarantees for small and medium enterprises to targeted longer-term refinancing operations. The time has now come to address the elephant in the room. The PSB model is clearly not working. Except the State Bank of India, no PSB can raise external capital. Most seem either unable or unwilling to compete. We need to fundamentally reform their governance, incentive structures and improve their competitiveness. The NBFC business model is broken, it will not come back in a hurry. We cannot have only five or six banks fund our growth aspirations. The system has to be deeper and stronger. PSBS are important and have to be a part of the solution to reviving the economy. They cannot be a permanent fiscal drag on the government.
Yes, we will have to recapitalise them. However, this time the recap must be accompanied with genuine reform as to how the banks are run. Privatisation may be politically too difficult, but surely we can reform their governance without privatisation. Markets are convinced the PSBS have little hope. More broadly, the markets are negative on the entire financial system. The government must prove the markets wrong.