Boston, MA -- (ReleaseWire) -- 09/17/2012 -- BMI View: Liquidity constraints, margin pressure and asset quality concerns are all indicative of a challenging banking sector environment in India over the coming months. Ultimately, despite scope for a gradual recovery in H212 in line with the broader economy, we expect sector profits to disappoint this year and equity market performance to remain muted. We continue to believe that the outlook for Indian commercial banks remains challenging over the coming quarters, despite the potential for a gradual improvement in macro conditions from H212 onwards. From our viewpoint, there are three main factors that are likely to weigh on bottom line performance in the months ahead; liquidity constraints, margin pressure and asset quality concerns. Liquidity constraints: As one might expect, weakness in India's economic growth story has seen demand for new loans cool substantially. Commercial credit growth came in at 15.6% year-on-year (y-oy) in February, marking the slowest pace of expansion since January 2010. What may come as more of a surprise, however, is that India's commercial banks continue to operate in a tight liquidity environment. Indeed, with deposits growing at cyclical lows of 13.4% y-o-y, the banking system's loan-to-deposit ratio currently stands at an all-time high of 78.1%. Given that such tightness usually occurs during times of an expanding (and overheating) economy, the disconnect between liquidity scarcity and economic activity points to a more structural issue afflicting the country's banking sector. To be sure, the Reserve Bank of India (RBI) has been forced to bolster short-term liquidity by increasing the amount of funds available via its repo window. Since the turn of the year, commercial banks have regularly borrowed around 3-4% of their deposit base from the RBI, well above the central bank's comfort zone of 1%. We expect recent cash reserve requirement ratio cuts of 75bps (to 4.75%) and the fall in inflation (which has sent real deposit rates back into positive territory) to help mitigate liquidity concerns. However, with inflation expectations likely to remain elevated, not least due to the government's heavy borrowing schedule, we suspect that banks will continue to operate in a tight liquidity environment.
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