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Markets have over-reacted to Moody's downgrade of Indian banks
November, 11th 2011

It is the ultimate irony. But such is the hold of rating agencies that despite their decidedly unimpressive track record, they still have the ability to make markets dance to their tune (read: lose all sense of perspective and proportion). We saw that happen in August this year when markets briefly lost their head after international rating agency Standard and Poor's (S&P) downgraded long-term US debt.

And we saw it again on Wednesday when rival rating agency, Moody's, lowered its outlook for the Indian banking sector from stable to 'negative'. In the context of the downgrade of US government debt, markets recovered once they realised the rating was almost irrelevant in a scenario where US Treasuries remain the most-sought-after asset. Likewise, it is only a matter of time before Indian markets realise their folly in reacting as they did to Moody's announcement.

This is not to deny that Indian banks, especially the state-owned ones, are in worse shape than they were a year ago. They most certainly are. But there is a reason for this. They continued to lend aggressively during the downturn at the behest of their owner, the government, even as their private sector counterparts operating on commercial lines, cut back on lending.

It did not need rocket science to predict that when rates reversed or economic growth slowed, banks would see a rise in their non-performing assets (NPAs). The rise in public sector NPAs is a consequence of deliberate policy choice; of opting to keep bank lending going (against commercial sense) in the hope that it would help shore up economic growth. In the event, economic growth has slowed and the chickens have come home to roost. But it is one thing to acknowledge worsening of banks' financial health.

It is quite another to assume the worst; which is what markets seem to have done. Hopefully, the intervening holiday on Thursday will restore some sense and the Indian banking sector will be assessed more correctly - as no better or no worse than the broad economy - when trading resumes on Friday. If we have faith in the India
story and we have no hesitation in saying we do, there is no reason to doubt the story of the Indian banking sector either

 
 
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