A late cut too many?

With expectations of yet another policy rate cut in upcoming monetary policy, one of the major concerns for investors is the earnings outlook of Pakistan banks.
The local banks are already facing margin compression due to 350 bps cut in discount rate and 100bps rise in minimum deposit rate in less than 1.5 years. “We believe that contrary to common perception if discount rate is cut by 50-100bps, banks annualized earnings will be negatively affected by 3-7 percent,” said Topline analyst Farhan Mahmood.
The analyst said if the central bank cut the discount rate by 50bps, the 2013 estimated profits of his sample banks would increase by 3 percent now compared to earlier projection of 6 percent.
He said his side had downgraded earnings growth to 6 percent from 14 percent on August 13, 2012 after the SBP surprised the market by slashing rate by 150bps. Last time in 2011 when SBP reduced discount rate by 200bps, banks lending rate reduced by approx 40-50bpps only because banks increased floor rate.
Assuming the same trend to continue, we might see lending rate falling by approx.10-12bps. Moreover, banks on the other hand will opt to shun expensive deposits to mitigate the impact of cut in discount rate and will increase their advances.
In case of higher discount rate cut i.e. 100bps, banks 2013 earnings to dilute by 6- percent7. Thus, in that case, 2013 earnings will remain flat as we have also assumed fall in deposit rate and increase in lending. In fact few banks have aggressively started marketing consumer financing.
On the flip side, 50-100 bps reduction in discount rate may lead to 2-3 percent improvement in earnings in short run. According to accounting rules in Pakistan any gain and losses on re-measurement for held for trading (HFT) is included in profit and loss account while the impact of revaluation in all other categories of investment is taken in profit and loss account when actually realized upon disposal.
Thus, there is only a small portion of those gains will be reflected in Income Statement and major portion of that revaluation gain will go into the equity thereby increasing the book value of the banks and thus reducing PBV marginally. In arriving the revaluation gain, we have also assumed that banks will realize 20-25 percent of the investment portfolio in available for sale (AFS) and Held to Maturity (HTM) in short-term.
Incorporating a 100bps cut, Pakistan banking sector is trading at one year forward PE of 5.9x and P/BV of 1.1x with average ROE of 17 percent. This is 35 percent and 38 percent discount than last 5 years average PE and PBV of 10.7x, 1.8x, respectively. “We believe that market has already priced in the impact of 50-100bps cut as banking stocks plunged by 8 percent in last 2 months while KSE 100 index is up 6 percent,” said Farhan.