DeMo impact: Cashless habits gain traction
DEMONETISATION AFFECTS CREDIT DEMAND, BENEFITS RETAIL PAYMENT SYSTEMS

The Indian government’s decision on November 8, 2016 to immediately withdraw all Rs 500 and Rs 1,000 bank notes — approximately 86 per cent of currency in circulation by value — has led to a slowdown in economic activity that weighed on demand for credit among companies and retail borrowers during Q3 FY2017. Trends in asset quality have been mixed, with lower collections for various Indian asset backed securities (ABS), while the agricultural segment, which is heavily reliant on cash as the medium of transaction, has seen stability in non-performing loans (NPLs). The quarter ending March 31 is expected to show more adverse trends.
Nevertheless, the impact on asset quality from demonetisation should be manageable for the banking sector. Banks experienced significant inflows into their deposit base after customers deposited demonetised notes. However, the level of bank deposits will increase by only around 1-2 per cent in the near term, given the substantial role of cash in the Indian economy as a medium of transaction. It must, however, be said that while usage of retail payment systems to conduct transactions has increased, the transition to a cashless environment will take time.
Economic activity in the country dropped in November and December 2016 as households and businesses experienced liquidity shortages following the announcement of demonetisation.
Loan growth for 14 of the 15 Moody's-rated banks declined in December 2016 from the previous quarter as demand for credit slowed. The slowdown in loan growth may also have been in part due to loan repayments using the demonetised Rs 500 and Rs 1,000 notes during the quarter.
When auto sales dropped after November 2016 it was consistent with the slowdown in economic activity as highlighted by falling loan growth. While commentary from the banks pointed to a rise in economic activity in January 2017 compared to the prior two months – a point corroborated by the slight increase in auto sales in January 2016 – it was below the levels seen in October before demonetisation. As such, we expect the slowdown in loan growth to continue through to the next quarter.

IMPACT ON ASSET QUALITY HAS BEEN MIXED SO FAR

The performance of Indian ABS has
deteriorated following demonetisation with microfinance ABS, small-and medium-sized enterprise (SME) ABS and tractor ABS most severely impacted, indicating
that demonetisation led to some stress in repayments in the
retail sector.
However, the impact of demonetisation has not been uniformly negative across sectors. In the agricultural segment, which is heavily reliant on cash as the medium of transaction, NPL ratios have stayed relatively stable across most of the rated banks.
Asset quality in the last and final quarter ending March 2017 is expected to show more adverse trends as the quarter ended December 2016 may have benefited from the fact that only two of the three months were affected by demonetisation. Nevertheless, it seems that the impact on asset quality from demonetisation will be manageable for the banking sector.
While the banks' retail segment has seen some weakness, its biggest part — home loans — has shown a stable performance. More importantly, economic growth seems to be recovering from demonetisation, although gradually, which should cushion the impact on the banks' asset quality.

INCREASE IN CASH IN CIRCULATION will RESULT IN MODERATION IN DEPOSIT BASE

Deposits at the 15 rated banks grew by 13 per cent in December 2016 compared to 6 per cent in the previous quarter. However, as cash availability increases and current restrictions on cash withdrawals come to an end, a moderation in the deposit base will occur in the next few quarters.
About three weeks ago, on February 3, total currency in circulation was around Rs 9.8 lakh crore, which is about 58 per cent of the level seen before demonetisation. More significantly, the amount of currency in public circulation continues to increase steadily, indicating that the limiting factor is the supply of currency rather than the demand for it.
The level of bank deposits will increase by 1-2 per cent because of demonetisation. This means cash in circulation will be 10-20 per cent lower, as a proportion of nominal GDP, compared to the pre- demonetisation levels.

ASSET QUALITY TRENDS FOR PSBS MORE BENIGN

On a positive note, the pace of asset quality deterioration at public sector banks (PSBs) slowed in the past two quarters from the FY2016 levels. These banks are coming towards the end of the NPL recognition cycle. Nonetheless, IDBI Bank stood out among the rated PSBs, as the spike in net NPL formation in Q3 signals that asset quality pressure may persist longer than expected for the bank.

Surge in usage of electronic payment systems for retail transactions

Demonetisation has been positive for electronic payment systems, with the lack of cash pushing users to adopt electronic channels. Growth rates for consumer payment channels, such as cards, mobile wallets (m-wallets) and immediate payment services (IMPS), saw very strong growth.
On the other hand, the rise in growth rates for real-time gross settlement (RTGS) and national electronic funds transfer (NEFT), which are by far the two biggest electronic payment channels, was much more muted. A sustained increase in the transaction volumes for these channels would largely depend upon how much of the previously unbanked population comes into the formal financial system post demonetisation.
The growth in transaction volumes for electronic retail payments is expected to remain high, but from a low base. Payments through cards, mobile wallets and IMPS, the channels that have seen the strongest rise post demonetisation, formed only 1 per cent of the overall transaction value for the fiscal year ending March 2016. Use of cards to withdraw money from ATMs itself was around 4 times more over the same period. Hence, given the relatively low share of these transaction methods, cash transactions will remain the dominant part of retail transactions for the foreseeable future.
Usage of credit and debit cards at point-of-sale (POS) as well as the usage of prepaid payment instruments (PPIs) fell in January 2017 compared to the previous month, which indicates that a part of the growth in volumes will normalise as cash availability increases.

INTEREST MARGINS TO COME UNDER PRESSURE AS BANKS ADOPT MCLR TO PRICE LOANS

In December 2015, the Reserve Bank of India released guidelines for the banks' calculations of their lending rates. Under the new guidelines, the banks will gradually adopt the marginal cost of funds lending rate (MCLR) to price new loans approved after April 1, 2016. So far, less than 20 per cent of the banks' variable-rate loans have been repriced to MCLR as opposed to their base rate.
Before the new guidelines, Indian banks were allowed to set their base rates on either their average cost of funds, or marginal cost of funds. However, because the marginal cost of funds would result in a lower cost of funds — amid declining policy rates — the banks have not used it.
On average, the differential between the base rate and MCLR is quite large, with the MCLR around 85 basis points (bps) lower than the base rate. In this regard, we expect the downward trend for the net interest margins of the rated banks to continue as the rest of their variable-rate book gets repriced to MCLR over the next few quarters.
Source: Moody’s Investor Service
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