Updated March 06, 2004



The market posted marginal gains on each of the three trading sessions during the shortened week and the index gained 1.24 percent WoW to finish at 4,900.43. We had indicated in last week's article that announcement of a lower dividend by Hubco had the potential to have an adverse impact on the market. However, this prediction did not prove to be correct. 





While the company did declare a decreased dividend, it did not cause much damage since the market had already adjusted the company's price downwards in accordance with the lower expectations. Moreover, the actual amount of dividend paid out lay in the middle of the analysts' forecasts, further reducing the shock value of the announcement. Overall, the market remained generally directionless during the week and witnessed relatively low volumes. These are natural outcomes of lack of news that can steer the market in any particular direction.


With the bulk of the earnings-reporting season behind us, little news is expected from the corporate front to drive the market during the coming week. Moreover, the political scene is anticipated to be quite as well. Thus, the index is likely to remain range bound during the next few trading sessions. Furthermore, while the index has steadily inched up to reach the current mark, the market does not appear to be willing to cross the 5000 points mark without strong positive news. This is an interesting example of a "psychological barrier" since the 5000 mark is just a little over 2 percent higher than the closing index value for each of the previous three weeks, yet investors appear to be waiting for a strong reason to take the index over this level.


An increase in interest rates and a rise in demand for advances, accompanied by increased reliance by banks on core earnings to increase profits, are likely to be the key factors driving the banking sector in 2004. Rising inflation leads us to believe that the State Bank will be forced to increase interest rates in the next few months. While this should help banks in improving their net interest income, it has the potential to harm their earnings from investment holdings. However, the impact of the latter is likely to be dampened by actions by banks to minimize any damage cause by a rise in rates. Furthermore, while increases in advances given out by banks have lagged increases in deposits during the past two years, this trend is likely to reverse during the current year due to an addition in products being offered by banks and increased acceptance of consumer financing among the general public. We maintain a NEUTRAL stance for the sector due to the valuations of the players in the industry.

The banking industry in Pakistan has witnessed very drastic changes over the past few years a rapid fall in interest rates, a tremendous rise in the deposit base and a decrease in demand for advances to name a few. These changes led a large number of banks to shift their focus from core earnings to capital gains, from both fixed-income and equity markets, to boost their bottom lines. Moreover, the managements of the banks were forced to reconsider their traditional practice of primarily lending to high quality borrowers, which now yield very low interest rates. This in-turn led to the introduction of consumer financing by banks. Given these developments, the factors likely to most significantly effect the banking sector in the current year are: the direction of the interest rates and an increase in demand for advances, accompanied by increased reliance on core earnings to increase profits.

The tremendous inflow of capital into the country after the events of September 11 drove down the interest rates to their lowest levels in history. However, results of recent T-bill auctions by the government clearly indicate that the interest rates have finally bottomed out. While the State Bank has repeatedly insisted, through both the Monetary Policy and various statements, that it intends to maintain interest rates at these levels for the foreseeable future, we are of the opinion that the rates will experience a rise in the next few months. A key reason for this assertion is the rapid rise in inflation, a problem which the Governor of the State Bank recently recognized publicly as well. Rising interest rates will have a dual effect on the banking sector. On the one hand, an increase in rates will help banks improve their core earnings since lending rates on advances generally rise at a faster pace, and by a bigger margin, than payments on deposits. On the other hand, analysts forecast that investment holdings, which have been the key source of profits for a large portion of the sector in 2003, will be adversely affected by a rise in interest rates. We, however, expect the latter impact to be lesser than is generally being anticipated since banks are likely to take necessary steps to minimize the damage to their bottom-line. In fact, after uninterrupted growth in total investment throughout 2003, the banking industry as a whole reduced its investment holding in January 2004. This is evidence of the fact that banks are well aware of the impact of a possible rise in interest rates and are taking steps accordingly.

As indicated above, the events of September 11 led to an enormous inflow of funds, which swelled the deposits at banks. While the total deposits in the sector increased by 16.25 percent and 17.97 percent between Jan-Dec 2002 and Jan-Dec 2003 respectively, advances increased by 1.24 percent and 16.93 percent over these periods. With the introduction of numerous consumer financing scheme by banks, and their rapid acceptance among the general public, this trend is likely to reverse in 2004. In fact, while deposits rose by 0.84 percent between Dec 2003 and Jan 2004, advances experienced an increase of 4.32 percent over the same period. Moreover, the bulk of the increase in advances in 2003 can be attributed to the last few months of the year. The fact that these loans yield significantly higher interest rates should further help the banks in bolstering their net interest-income.



Although higher interest income should help the banks in continuing good fortunes from the previous year, there are a couple of threats that could harm the industry. Firstly, if the banks fail to take adequate actions in a timely manner to deal with the adverse impact of a rise in interest rates on their investment holdings, the profits of the industry could be considerably reduced. Secondly, considering that this is the first time such loans (consumer loans) have been introduced, there is some doubt over whether there are sufficient regulations in place, such as foreclosure rules, to properly handle defaults. Moreover, even in cases where such rules are in place, they have not been "tested" and consequently banks and regulatory authorities are as yet unaware of any loopholes in these laws.

Overall, we maintain a NEUTRAL stance for the sector due to the valuations of the players in the industry.

While making investment decisions in this sector, investors need to focus on banks that relied mainly on core earnings in 2003 to maintain or grow their profit line, since these banks are likely to benefit the most from a rise in interest rates in the economy.






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