Buy These Banks to Bet on Rate Cuts in India

The Reserve Bank of India (RBI) has maintained a tight monetary policy throughout 2013 to fight inflation. Consequently, the expensive credit stalled new projects and dampened India's GDP growth. Heading into 2014, however, there is reason to believe credit may become relatively cheaper and, eventually, boost the financial performance of ICICI (NYSE: IBN  ) and HDFC Bank (NYSE: HDB  ) .

Possibility of a rate cut
According to last week's data, Indian retail and wholesale inflation rates eased -- for the first time since May 2013 -- to their respective three-month and five-month lows. And with vegetable prices currently below their November peaks, the retail inflation rate during January is expected to dip even further.

The Director General of Confederation of Indian Industry believes the easing inflation and contracting Indian industrial output will encourage the RBI to cut interest rates and revive economic growth. Madan Sabnavis, Chief Economist at CARE Ratings, agrees and estimates the RBI can slash interest rates by 25 basis points in March.

If these estimates prove accurate, the Indian banking industry might be in for a boost. Falling interest rates lower the borrowing costs of banks, and unlock capital for lending purposes. This, in turn, boosts loan growth and results in higher interest income for banks. And I believe investing in ICICI and HDFC Bank, in light of this expected growth, is a good investment decision.

Premier banks
HDFC Bank and ICICI are two of the fastest-growing mature banks around the globe. HDFC has consistently posted net income growth in excess of 25% for the last 43 consecutive quarters. In the recent quarter, with interest rates kept high, several Indian banks including Kotak Mahindra and Yes Bank witnessed a sharp drop in their asset quality. HDFC, however, managed to post a year-over-year net income growth of 25% while maintaining its asset quality.

Fiscal Year 2012-13 

ICICI

HDFC

Citibank India

Net Income* (millions)

$1,387

$1,121

$453

Net Income Change

29%

30.2%

41%

Loan Growth

9.3%

22.7%

16.7%

Non Performing Assets

0.64%

0.96%

1.47%

Net Interest Margin

3.11%

4.5%

NA

Source: Live Mint and HDFC and ICICI annual reports.
*Original figures converted to U.S. dollars where applicable, assuming $1 = 60 rupees.

As shown in the table above, HDFC and ICICI have delivered exceptional financial growth over fiscal year 2013.

ICICI is the largest private-sector bank in India, with operations spanning 19 different countries. Its overseas operations result in a balanced growth, hedge its operational risks, and add stability to its overall business.

In spite of its large size and diversified geographical footprint, ICICI Bank has delivered fantastic financial growth over the recent years. While maintaining top-notch asset quality, the bank has managed to grow its net income by 245% over the last five years.

Moody's recently affirmed its bullish ratings on ICICI and HDFC, noting:

[Both banks have] relatively strong asset quality, which benefits from diversification into the retail sector. ... HDFC and ICICI have had better credit selection and monitoring of its exposures to mid-sized corporates, and have better asset quality experience in this segment relative to public sector banks.

Citigroup  (NYSE: C  ) has also shown exceptional growth over 2012. However, its Indian segment represents only 6% of Citigroup's overall net profit. With limited exposure to India, the much-awaited rate cut won't have a significant impact on Citigroup's overall earnings. So, investing in HDFC Bank and ICICI, in my opinion, is the best option available.

Foolish final thoughts
Investors looking to invest in the Indian banking sector, in my opinion, should dollar-cost average their positions rather than jump in all at once. The new RBI chief, Raghuram Rajan, has developed a reputation of being unpredictable. For that reason, efforts aimed at market timing will be particularly difficult.

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