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India’s banks face their biggest test

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Even before the pandemic, India’s banks were struggling. With among the highest ratios of bad loans in the world, at least five lenders have had to be rescued from collapse since late 2018. Several more were in a precarious state. Already creaking under the strain, the sector now faces one of its biggest tests: emerging intact from the crisis.

A strict lockdown in place for several months from March was devastating for the businesses of borrowers big and small. This in turn prompted a historic economic contraction — forecast by the IMF at 10.3 per cent for the year ending in March — that was worsened by the spiralling Covid-19 caseload. But while emergency government relief measures for borrowers helped soften the immediate blow to banks, this support is now being phased out.

“This is like being in the middle of a storm,” said Uday Kotak, chief executive of Kotak Mahindra Bank, one of India’s largest private banks, which like most banks took advantage of the support. “One hopes that most of the boats reach the other side of the shore, but you can’t take it for granted.”

Mr Kotak, who is one of the richest bankers in the world with a net worth of more than $16bn, added that with lockdowns now lifted and case numbers on a downward trend: “For the financial sector players who are able to get on to the other side, there will also be significant opportunity.”

Credit growth to businesses has stagnated

Swords hanging over the system

Pandemic-hit borrowers had until the end of 2020 to apply to restructure debts with banks through a one-off scheme designed to prevent a sharp rise in defaults.

Other measures — including a moratorium on loan repayments in place from March to August, followed by a Supreme Court order instructing banks not to classify loans as defaults — mean the extent of problems will only become apparent in the months to come.

Reserve Bank of India
The Reserve Bank of India expects the ratio of non-performing banking assets to rise from 7.5 per cent in September 2020 to 13.5-14.8 per cent in September 2021 © Dhiraj Singh/Bloomberg

The Reserve Bank of India, the country’s central bank, acknowledged that the relief measures may have masked the extent of the damage, saying in a report last month that “the asset quality of the banking system may deteriorate sharply, going forward”.

By any measure, the ratio of non-performing banking assets is expected to shoot up. The RBI is forecasting an increase from 7.5 per cent in September 2020 to between 13.5 per cent and 14.8 per cent in September 2021. Fitch said last year that India’s banks will need anywhere from $15bn to $58bn in recapitalisation by 2022.

“There are still quite a few swords hanging over the banking system,” said Ajay Mahajan, chief executive of rating agency Care and a former executive at several Indian and foreign banks. “We’ll have to see the outcomes to pass a judgment as to how the system has reacted to the entire pandemic.”

The RBI expects bad loans to shoot higher

Chronic bad debt problems

The country’s banking system is dominated by a dozen state-owned banks that control about two-thirds of assets, the legacy of a 1969 socialist-era bank nationalisation. But private competitors like Kotak Mahindra and HDFC Bank have gained share since the 1990s and 2000s as the economy has liberalised.

Foreign names like Citibank, HSBC and Deutsche Bank have also built up local operations focused on niche markets like retail banking for the wealthy and distressed debt.

The sector’s chronic bad-debt problems have prompted several near-misses. In early March last year, the central bank had to intervene to rescue scandal-hit Yes Bank, one of the country’s largest private lenders, from collapse.

In November it stepped in once again to oversee a takeover by Singapore’s DBS Bank of Lakshmi Vilas Bank, a regional lender whose decline predates the pandemic and had rattled markets.

A customer uses an HDFC ATM on a van in Mumbai, India, in May 2020
Private competitors like HDFC Bank have gained market share since the 1990s and 2000s as the economy has liberalised © Dhiraj Singh/Bloomberg

Some worry that the sector, already weak before the crisis, will burden the financial system for years to come.

Capital Economics, a consultancy, warned in a note that the need to address rising non-performing loans will drain profitability and restrict lending and, ultimately, growth in what had been one of the world’s fastest-expanding economies.

Others hope the pandemic will force a shake-up of a moribund, scandal-prone sector that has been held back for years by the cosy nexus between tycoons, bank executives and politicians that results in the misdirection of capital into expensive vanity projects that often fail.

Analysts said the best-run banks, mostly private but some state-owned, are well placed to gain market share. A recent rally in India equities, which pushed the benchmark Nifty 50 index to an all-time high this month, has helped the likes of State Bank of India and Kotak Mahindra to recapitalise swiftly, raising billions in capital to bolster their balance sheets and increase their cover against non-performing loans.

Private banks have gained market share from state lenders

An opportunity for overseas money

Following the takeover of Lakshmi Vilas by DBS, other overseas banks sense an opportunity to expand if regulators have become more open to foreign capital after years of reticence.

“This whole Lakshmi Vilas Bank, the way the [central bank] has handled it does show some indication of things to come . . . of the fact that there’s a need” for foreign money, said Kaushik Shaparia, Deutsche Bank’s India chief executive. “The [public-sector] banks’ ability to absorb all this is limited.”

Deutsche has invested some $1bn in India since late 2018, Mr Shaparia said.

Foreign investors have also circled other distressed financial-sector assets. Oaktree Capital Group, the LA-based fund, is one of the final bidders for the books of Dewan Housing Finance, a shadow bank that collapsed into bankruptcy in 2019 and is the first financial company to restructure using the country’s four-year-old insolvency code, which aims to speed up the process.

Some hope greater foreign participation in the financial system will address a chronic shortage in domestic capital willing to take risky bets and help speed up the often tortuous process of turning around ailing lenders.

But executives and analysts said it is hard to say how much the ownership make-up of India’s banks will change and, with the impact of the pandemic still unclear, the investment case remains to be seen.

Lakshmi Vilas Bank branch in Connaught Place, New Delhi, India in November 2020
Following the takeover of Lakshmi Vilas Bank by DBS, other overseas banks sense an opportunity to expand if regulators have become more open to foreign capital © Alamy

The later months of 2020 saw improvements in corporate earnings, demand indicators and the daily Covid-19 caseload has fallen to below 20,000 from nearly 100,000 in September. But it is unclear how many borrowers will have viable businesses once the last of the relief measures runs out and they continue repaying their debts.

“One has to look at the ground level reality in terms of return of the small businesses and employment to see what will be the quality of the balance sheets,” said Sanjay Nayar, chairman of KKR India. “The jury is out until at least March if not June to see what’s the quality of the books.”



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Analysis

Large-cap US stocks with high ETF ownership have underperformed

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Visit our ETF Hub for investor news and education, market updates and analysis and easy-to-use tools to help you select the right ETFs.

Large-cap US stocks favoured by exchange traded funds have underperformed the wider market in recent years, raising fears that “crowding” in popular companies is damaging returns.

Analysis of the constituents of the S&P 100 by Vincent Deluard, global macro strategist at StoneX, a New York-based brokerage, found that since 2018 the stocks most owned by ETFs have tended to perform worse that those more lightly held by such funds.

Moreover, this negative correlation “has been getting stronger in the past three years”, Deluard said, “which I find interesting and possibly consistent with the view that a high ETF ownership depresses future returns by pushing up valuations”.

If that thesis is correct, then “the best opportunities to compound wealth should therefore be found outside of popular funds and indices,” he added.

Deluard’s research adds some credence to the arguments of some value investors that the rise of ETFs is just the latest example of “the madness of crowds” and that price-insensitive index funds create “passive bubbles” by piling into the same momentum-driven stocks, only for these bubbles to then burst.

The booming global ETF industry has seen its assets almost double to $9tn since the end of 2018, according to figures from consultancy ETFGI, with the bulk of this money both in the US and in equities.

Simultaneously, there has been a partial shift from broad market capitalisation-weighted ETFs — which pump money into every stock in an index in line with its pre-existing size — to narrowly focused thematic ETFs and those investing on the basis of environmental, social and governance factors.

The assets of thematic ETFs have tripled since the end of 2018 to $382bn, according to ETFGI, while those of ESG ETFs have risen ninefold to $246bn over the same period.

This has fed suggestions that ETFs have evolved from attempting to passively reflect stock markets to actively shaping them, distorting prices of particular companies as an ever larger share of money flows into favoured “ETF darling” stocks.

However, the data from StoneX suggests that the opposite may be happening, with unfavoured stocks seeing stronger gains.

Deluard found that ETFs’ share of ownership ranges from 4.1 per cent to 11.2 per cent for the 100 largest US stocks.

ETF ownership and return

The 10 stocks most lightly owned by ETFs include five that have more than doubled investors’ money over the past three years: Morgan Stanley, T-Mobile US, Deere & Co, Amazon and Tesla, the latter with an outsized 820 per cent total return.

Apple, Alphabet and Facebook are in the same quadrant.

In contrast, the stocks most favoured by ETFs include a disproportionate number of weak performers, such as Gilead Sciences, Chevron, ExxonMobil, Intel and 3M, alongside a smaller number of strong performers such as chip designers Texas Instruments, Qualcomm and Lam Research.

Deluard played down the importance of his findings to some degree, saying the negative correlation between the level of ETF ownership and performance was statistically “weak” and that relative sector performance “has been the main driver” of returns.

Although there has been high profile coverage of some tech ETFs, the ETF industry as a whole tends to be underweight technology stocks, something he attributes to a meaningful block of stock typically being locked up in founders’ stakes and employee ownership, leaving less for outside investors.

Similarly, despite the rise of ESG ETFs, the industry at large is still overweight oil companies such as Chevron and ExxonMobil, which are favoured by value and dividend ETFs.

Comparable analysis Deluard conducted into the 2012-2018 period found a weaker, though still negative, link between ETF ownership and performance.

Nevertheless, even if his findings can be attributed to a statistical quirk, there is at least no evidence that rising ETF ownership is distorting the market by pushing up the prices of ETF darlings at the expense of unloved and overlooked stocks.

Deluard does not, though, rule out the possibility ETFs might be pushing up prices of small or mid-cap stocks that are less able to absorb strong ETF inflows, such as those in popular fields like gold miners or cyber security companies.

“Passive distortions are likely much greater for small caps whose limited float can be overwhelmed by index funds’ relentless buying,” he said.

Peter Sleep, senior portfolio manager at 7 Investment Management, cautioned that Deluard’s findings could vary somewhat if they were based on free-float market capitalisation, omitting founders’ stakes from the calculation.

On this basis, ETFs would own a higher percentage of technology companies’ shares, reducing the tendency for lightly held shares to have performed better.

Overall, though, Sleep welcomed the findings saying “I think it’s a good thing. You often hear people say that the market is only going up because of ETFs,” an argument the analysis undermines.

Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research, said the findings ran counter to what he would have expected, and possibly signified ETF darling stocks first witness an unsustainable rise, followed by a reversion to the mean.

“There have been two narratives out there,” he said. “One is that too much money is going into ETFs and thus they are driving the car, and stock prices are being dragged along with them. This seems to disprove that,” Rosenbluth said.

“The second is that people will pile out of these [ETF darling] securities and the stocks will fall.”

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Analysis

Biden faces tough path to US economic recovery

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Joe Biden is grappling with a messy and unpredictable economic outlook as the twin threats of rising inflation and slow jobs growth shake confidence in the steadiness of the US recovery from the pandemic.

The US labour department this month reported that the pace of job creation slowed significantly in April, fuelling concerns of widespread discrepancies in the labour market.

It followed up that report with figures published last week showing an unexpectedly steep jump last month in its consumer price index, compounding fears of mounting inflationary pressures.

The data have exposed Biden to sharper criticism of his economic management from Republicans and rattled hopes of a smooth rebound from the coronavirus crisis on the back of hefty fiscal stimulus and quick vaccination rollouts.

The US has driven the global economic recovery, with the IMF predicting gross domestic product growth of 6.4 per cent in 2021.

“There are a lot of signs of a resurgence in aggregate demand — an economy that’s recovering, but that recovery is going to be chaotic,” said Wendy Edelberg, director of the Hamilton Project, an economic think-tank at the Brookings Institution. “And yes, really difficult to manage.”

Senior Biden administration officials have cautioned against drawing too many conclusions from one month’s data. They argued that average monthly job creation over the past three months has still been much stronger than in the previous quarter, that the inflation bounce is likely to be transitory and that the recovery remains firmly on track.

But they have also acknowledged high levels of economic uncertainty at a time of big shifts in spending patterns and employment trends, and as health-related restrictions are being lifted across the country more rapidly than predicted — partly because of the pace of the country’s vaccination campaign.

“There’s going to be a period, as supply starts to equal demand and sectors are healing and recovering, [during which] there’s going to be some choppiness,” Cecilia Rouse, chair of the White House Council of Economic Advisers, told reporters on Friday.

“We know that the mismatch between different parts of the economy will show up in unexpected ways until the economy more fully recovers. As the president urged earlier this week, we must be patient,” she added.

Critics of the administration’s economic policies — ranging from former Democratic Treasury secretary Larry Summers to Republicans on Capitol Hill — have seized on the latest data to argue that the Biden administration has recklessly dismissed the risks of excessive fiscal stimulus, and played down the economic warning signs.

“I was on the worried side about inflation and it’s all moved much faster, much sooner than I had predicted. That has to make us nervous going forward,” Summers wrote on Twitter on Friday.

“I think there’s a decent chance that this works out fine. And that we just have a super rapid recovery and a great year,” said Michael Strain, director of economic policy studies at the American Enterprise Institute, a conservative think-tank. “I think there’s also a chance that this could end really poorly.”

Other data releases last week failed to clarify the picture. The University of Michigan’s consumer sentiment index showed rising long-term inflation expectations, while retail sales were flat last month after a big jump in March. On the brighter side, weekly jobless claims out on Thursday dropped to a low point for the pandemic.

Cecilia Rouse
Cecilia Rouse said: ‘There’s going to be a period, as supply starts to equal demand and sectors are healing and recovering, [during which] there’s going to be some choppiness’ © Reuters

At this stage, there were no signs from the White House of any big changes to Biden’s policy agenda to address the emerging economic picture. On the labour market front, the president moved to enforce a requirement that citizens who were offered “suitable” jobs not be eligible for unemployment benefits, and Rouse said the White House was reminding businesses of a tax credit for employee retention set up as part of its stimulus programme.

The White House is sticking by the fiscal support it has enacted with the help of congressional Democrats not only to stoke the country’s recovery but also to help low-income families. It has also pointed to its confidence in the Federal Reserve to manage any rise in inflation.

But Republicans and conservative economists have called for more dramatic action to cool the economy, such as an early end to federal unemployment benefits, which Republican-led states across the country have refused to pay.

Meanwhile, economists whose forecasts were badly wrecked by the data released in recent days warned that any assumptions about the US recovery — let alone policy changes — may well have to be revisited.

“We’re in such an uncharted territory,” said the Hamilton Project’s Edelberg. “When you’re talking about the changes in aggregate demand that we’re experiencing, and changes in supply that we’re experiencing — whatever uncertainty you have about inflation in normal times, increase that by an order of magnitude.”





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Covid rules leave pubs and restaurants in England fearing the great indoor reopening

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Before the pandemic, the tiny Sicilian restaurant Franzina Trattoria was loved by south London locals for its long communal tables. Customers would squeeze in and share food with people they had never met. Two diners, who were complete strangers, ended up getting married.

But as owner Stefania Taormina and her husband Pietro Franz prepare to welcome the first diners since December back into their 4-metre-wide eatery in Brixton on Monday, Taormina fears they may not return.

“We don’t see many bookings inside [and] it’s a bit scary. We think people are thinking differently now and sharing tables is maybe a problem,” she said.

To comply with Covid-19 restrictions for hospitality businesses in England when the government allows them to open indoors from Monday, Taormina has cut the number of guests seated in the restaurant from 55 to 14 and spent £1,000 on plastic dividers to break up the tables.

The saving grace has been the six two-person tables on the restaurant’s outside terrace, which have been booked all hours of the day since restrictions on outdoor eating and drinking were lifted in late April. “We are breaking even just about with the terrace open,” she said. “I think people still prefer to go to places outside.”

The pandemic has left the hospitality industry facing a crisis of historic proportions. Since the pandemic struck, UKHospitality, the trade body, estimates the sector across Britain has lost £80.8bn in sales between April 2020 and this March, compared with the previous 12-month period, equivalent to £9m every hour.

Line chart of like-for-like hospitality sales compared with 2019 (% change) showing pub and restaurant sales have plummeted during the pandemic

More than 8,500 of the UK’s 115,100 licensed premises have gone out of business. And only a third of those operating have the outdoor space that has allowed them to reopen since the government allowed alfresco dining from April 12.

Even as the rest make ready to open inside in the biggest easing of restrictions in England since lockdown was imposed in January, many pub and restaurant owners fear the remaining Covid rules — waiter service only at tables that must be at least 1m apart, with a limit of six people from no more than two households — will make most establishments unprofitable.

“The vast majority of our pubs will be trading on May 17 [but] I expect us still to be trading at levels where we will be making a loss,” said Andy Spencer, managing director of Punch Pubs, which owns 1,100 premises. He said that pubs would run at half their usual capacity and that the restrictions were “challenging, time consuming and expensive”.

Key to profitability for most pubs and restaurants is the removal of all social-distancing rules, and many owners were buoyed by recent comments from Boris Johnson. At the start of this week, the UK prime minister raised the possibility that all restrictions could be lifted over the summer.

But by Friday, Johnson warned that the next state of England’s lockdown easing plans due on June 21 — when all existing rules are set to fall away — may have to be delayed because of a surge in infections caused by the emergence a Covid-19 variant first detected in India.

Opening with extensive restrictions in place has presented other challenges, not least the need to train staff who have been furloughed for months.

Pedestrians walk past a PizzaExpress restaurant in central London
PizzaExpress’s 6,000 staff have had a week of ‘full immersion’ training in both hygiene measures and service © Tolga Akmen/AFP/Getty Images

Zoe Bowley, managing director of PizzaExpress, said the chain’s 6,000 employees had undergone a week of “full immersion” training, both in hygiene measures and service. “Some of our team members, apart from a small gap in November, haven’t worked for a year,” she said.

The sector also faces a labour shortage with a loss of experienced and qualified staff, partly due to the pandemic and partly due to Brexit, with EU workers returning to their home countries.

This will add to the pressure on employees facing customers for the first time in months. “They are rusty after furlough for a year and are heading back to jobs where they will have to cover other roles because there aren’t enough staff to cope,” warned Mark Lewis, chief executive of the charity Hospitality Action.

Another common fear is antagonising guests by insisting they comply with the Covid regulations, such as checking in with the test-and-trace app and wearing a mask when moving around.

Even if reopening goes as planned, the absence of foreign tourists and commuters for at least part of the summer — with international travel still heavily restricted and office staff encouraged to continue to work from home until at least late June — is expected to leave many city-centre establishments short of customers.

Anna Sebastian, manager of the Artesian bar at London’s Langham hotel
Anna Sebastian, bar manager of the Artesian at London’s Langham hotel, said ‘normality won’t be restored’ until tourists return in large numbers © Charlie Bibby/FT

“We’re very dependent on footfall from tourists shopping on Oxford Street and hotel guests, so until they return in large numbers, normality won’t be restored,” said Anna Sebastian, bar manager of the Artesian at The Langham hotel in London.

If there is a positive to have come out of the crisis, the pandemic has forced the industry to accelerate the adoption of technology that has improved productivity: payment and ordering apps allow operators to turn tables faster and employ fewer staff.

Customers using apps also tend to spend more per head having had more time to peruse the menu and the ability to order as and when they want, according to several pub and restaurant owners.

But Bowley warned there was a “fine balance” to strike to make sure that an industry built on personal service did not become “faceless” just as it needed customers to return.

Technology aside, Spencer said he feared that until sports and live music could restart and customers could stand up in crowded bars, the pub experience would be a “sanitised” one. “We have taken out a lot of the soul . . . and a lot of the things that make the pub really special,” he said.

It is the same pre-Covid conviviality that Taormina fears will be lost at Franzina Trattoria. “It was a joy for me because you would see people who you had never seen in your life start to drink together and talk about food together and then sometimes they would go out together afterwards . . . I am scared that it will not happen again.”

Additional reporting by Oliver Barnes



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