**[investwise]** Credit Suisse: Will ECB Issuances Cut Into Lending By Indian Banks?

 

Credit Suisse Banking: Making Out With A Bear Case Indian Banks could lose 30 to 40 per cent of their market cap over the next few months, as ECBs undercut domestic lenders and their NIMs. In our report, ECBs – a threat to pricing power, published on 21 July 2010, we highlight how the rising differential in domestic and international rates is driving a surge in external borrowings and this is likely to limit the pricing power on corporate loans for banks as domestic rates rise. ● The widening spread between domestic and international rates, and step-up in overseas activities of Indian corporates pushed up ECBs by 3x in 1H10. We estimate corporates are already meeting 35% of their credit needs externally. The interest rate differential (400-500 bp) should expand further, with rising domestic rates and our conversations with CFOs confirms their growing preference for ECBs. ● While ECBs' share in corporate credit is likely to continue rising, we do not expect it to derail the overall credit growth momentum, as large corporates account for only 31% of system credit. ● However, potential substitution risk from ECBs will depress banks' pricing power on domestic corp. loans. Banks like SBI with a larger share of top corporate lending may face margin headwinds. External borrowings up 3x The widening spread between domestic and international interest rates, and step-up in overseas activities of Indian corporates have pushed up external commercial borrowings (ECBs) by 3x, aggregating more than US$12 bn in the first six months of 2010. ECB outstanding is now more than US$75 bn, accounting for about 28% of India's total external debt (19% of GDP). We estimate 35% of corporate (large and mid) credit needs are now being met from external markets. Demand for external debt from the corporate segment has seen a 31% CAGR in the past four years, compared with 18% growth in their domestic borrowings over the same period. Rising domestic rates will further raise ECBs' attraction The growing preference for ECBs by corporate India is not surprising, given the wide interest rate differential. The spread between domestic and external rates is already 400-500 bp, and is likely to expand further. Our conversations with CFOs of some large corporates across a spectrum of industries confirm the growing preference for ECBs. They are finding ECBs cheaper than domestically available funds of similar tenors, particularly where they can match it to their foreign currency revenues.  It is also noteworthy that some infrastructure companies are also keen on ECBs, despite the long tenor of ECBs and difficulty in getting the approvals. Corporates are willing to keep their currency exposures open, as they expect the INR  to appreciate or as their forex revenue streams provide a natural hedge domestic rates to move up.  This will further whet the appetite for ECBs. A large part of the rate differential though is offset by hedging costs on forex loans.  Can ECBs derail the loan growth story? Access to the ECB market owing to the RBI's cap on borrowing costs is primarily limited to large corporates that account for only 31% of total bank lending in India. Thus, while the share of ECBs in corporate credit is expected to continue rising, we do not expect this to derail the overall credit growth momentum in the economy.  Even the previous peaks of the ECB cycle had coincided with the peak in domestic credit cycle, and in those years it is estimated that corporates were meeting 35-40% of their credit needs from the external market. Corporate loan profitability to come under pressure Even though the ECB market activity is unlikely to impact 70% of the domestic credit market, potential substitution risk by ECBs will depress banks' pricing power on domestic corporate loans. Banks such as SBI where top corporate lending forms a larger share of loan book may thus face stronger margin headwinds relative to SME, infrastructure and retail focussed financiers.  Many large Indian banks are also active lenders in the ECB market, given the growing preference of corporate customers for forex debt. However, as banks have to fund these through wholesale funds, margins on these loans are wafer thin (0.5-1.5%) versus 3%+ margins they enjoy on domestic loans.  Our top picks in the sector remain Axis Bank, HDFC Bank, PNB, BOB, and IDFC, and we have an UNDERPERFORM rating on SBI and Yes Bank. Safe Harbor Statement: Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.   Nothing in this article is, or should be construed as, investment advice.

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