This article first appeared in The Edge Malaysia Weekly, on February 1 - 7, 2016.

It’s going to be a challenging year for Asean banks, but from an investment standpoint, several regional analysts are betting that Indonesian banks — or at least the Big Four — will outperform peers in Malaysia, Thailand and possibly Singapore.

“We believe Asean banks will likely continue to face slower loan growth and higher credit costs in 2016. However, attractive valuations, together with a favourable change in the direction of interest rates, could lead to a stronger share performance for the Indonesia and Singapore banks.

“We believe an interest rate cut in Indonesia could signal a stronger growth trajectory and, together with improved infrastructure spending, could ignite investor interest in a banking sector that we think can still deliver some of the strongest growth and profitability in Asia. Our top pick is Bank Mandiri,” Jaj 

Singh, Nomura Holdings Inc’s head of research on Asean banks, says in a Jan 15 report.

At the time of the report, Indonesian banks were trading at a 20% discount to their five-year trading history. Jaj has an “overweight” call on the Indonesia and Singapore banking sectors, and is “neutral” on Malaysia and Thailand.

While a weaker economic environment is expected to slow down lending among Asean banks this year, analysts see loan growth coming in relatively stronger in Indonesia, at 13% to 15%, compared with under 10% in Malaysia, Singapore and Thailand. 

And the Indonesian sector’s net interest margin (NIM), the margin between lending and deposit rates, is still one of the highest in the world, despite it coming under pressure. The NIM ratio stood at 5.32% as at August 2015.

In a telephone interview with The Edge, he points out that Indonesia still has much growth potential as it is a relatively underbanked market compared with Malaysia or Thailand.

UOB Kay Hian Research, meanwhile, has an “overweight” call on Indonesia’s banking sector and counts it as one of three sectors — the other two being construction and consumer — that are likely to deliver more than 20% annual earnings growth in 2016 and 2017. The research house has a “market weight” call on Thailand and Malaysia.

There are 118 banks in Indonesia, but the Big Four — Bank Mandiri, Bank Central Asia (BCA), Bank Rakyat Indonesia and Bank Negara Indonesia (BNI) — account for about 40% of the sector’s total assets.

Nomura forecasts that the four will see a 24% increase in year-on-year earnings this year, compared with a decline of 3.8% in 2015. Indonesian banks under its coverage were down by an average of 12% in 2015, underperforming the stock market by 0.3%, due to concerns about asset quality, growth and external vulnerabilities.

Indeed, asset quality concerns have weighed on banks not just in Indonesia, but also increasingly in Singapore and Malaysia.

Based on the latest data provided by the Indonesian central bank, the banking sector’s gross non-performing loan (NPL) ratio deteriorated to 2.8% as at August 2015 from 2.3% a year earlier. Jaj is not overly concerned, saying the increase does not suggest a systemic risk.

He says based on banks’ earnings for the first nine months of 2015, and guidance from managements,  NPLs, while rising, don’t look to be a serious threat to earnings.

“We haven’t seen a meltdown or anything like that. The increase in provisions or the increase in NPLs is ... part of the business cycle,” he tells The Edge.

On whether asset quality concerns in Indonesia are finally abating, Jaj points out that the situation for the Big Four and the rest of the banks could be different. The Big Four have much stronger balance sheets, control about half of the sector’s deposit franchise — putting them in a better liquidity position — and tend to have the first pick of the more blue-chip, stable customers.

“The likes of BCA and Bank Mandiri have said they think their NPL could probably peak by the middle of the year, but that doesn’t necessarily hold true for everyone,” he says. The mid-sized banks might take longer, possibly six months or nine months, to recover from NPLs, he adds.

UOB Kay Hian’s top banking picks are Bank Mandiri and Bank Pembangunan Daerah Jawa Barat dan Banten.

In its Jan 15 report, Nomura points out that a fall in commodity prices had led to concerns that companies’ falling margins could easily lead to loan defaults. “We believe the risk from commodities is real but one has to make a distinction between hard and soft commodities. For instance, coal is still witnessing a fall in both its prices and export volumes. Therefore, a bank with exposure to this sector is vulnerable to higher credit costs.”

It notes that Bank CIMB Niaga — a subsidiary of Malaysia’s CIMB Group Holdings Bhd — is one such example, with close to 5% of its loans to the coal sector. The Big Four banks, on average, have only 2% of their loans linked to the coal sector. Nomura has a “neutral” call on CIMB Group.

“Our least preferred [Malaysian bank] is CIMB Group because we think its Indonesian exposure could continue to be a source of high provisioning, and its lower capital ratios could limit dividend payouts,” says the report.

While Nomura sees the operating environment in Indonesia in the first six months of 2016 to be similar to 2015, it expects potential interest rate cuts to excite bank stocks.

UOB Kay Hian, in a Jan 18 report, says interest rate cuts is the game-changer for banks there. 

Bank Indonesia had cut the interest rate by 25 basis points (bps) to 7.25% on Jan 14 — its first cut since March 2015. Nomura thinks there could be another 25bps cut within the first quarter as inflation remains low and the currency is relatively stable.

“Historically, interest rate cuts have provided a strong stimulus for Indonesian bank stocks. In 2005 and 2008, when interest rates were cut by 250bps within six months, bank stocks rallied by 34% and 131%, respectively. While we forecast only a 50bps interest rate cut in 2016, we believe that this, together with attractive valuations and infrastructure spending, could lead to a rerating of Indonesian bank stocks,” it says.

Commenting on other banking markets, Nomura says Singapore offers lacklustre loan growth — possibly just 5% — but potentially higher interest rates there could help deliver stronger earnings growth. It believes there is room for interest rates to move up on the back of higher US rates depreciating Asian currencies. However, there are market concerns about asset quality that centre around the property market, the banks’ exposure to China and commodities. Around 43% if Singapore banks’ loan portfolio is exposed to the property market.

As for Thailand, it thinks the banking outlook will be clouded by moderate growth momentum and earnings pressure from continued high credit costs. Asset quality may improve in the second half of the year. “Most Thai banks indicate that the worst has passed, but it could still take at least three to six months for a full recovery.”

Meanwhile, Nomura says it is cautious on Malaysian banks despite their strong balance sheets and attractive valuations. “We think earnings in 2016 would be contained by a combination of lower loan growth, NIM compression and high provisioning.”

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