How To Capitalize On Economic Reform In India

| About: iShares S&P (INDY)


Economic reform is poised to unlock economic growth in India.

Stronger GDP growth will require substantial loan growth, benefiting financials.

Loan growth will require bank recapitalization, especially for State Owned Banks (SOEs).

Private banks are well positioned to gain loan market share and outperform SOEs.

INDY is heavily weighted to India’s very under-penetrated financial sector.

Economic Reform Poised to Unlock Higher GDP Growth

The emphatic win of the BJP party in May's general election has given the new government a strong platform from which to launch economic reforms. Improved sentiment, gradual rate cuts and some progress on clearing away investment bottlenecks should lift growth over the next few years. The effects of corrective policy measures over the past 12 months in the form of adjustments in the real effective exchange rate and real interest rates, and steps to improve the business environment alongside the steady improvement in the external environment, are beginning to show up in India's macro-economic indicators.

India (NASDAQ:INDY) (NYSEARCA:EPI) (BATS:INDA) (NYSEARCA:PIN) is forecasted to achieve an average economic growth rate of 6.75% over the next 10 years. By 2025, India's economic size is likely to surpass $5Trillion, a feat that has been achieved by only the US and China. If India fails to deliver stronger growth over the next decade it will face a rising unemployment problem. UN data shows that, by 2025, India will contribute 124M people to the global labor pool. In comparison, US will contribute 5M, while Japan's, China's and Europe's working populations are estimated to decline by 6M, 12M, and 28M respectively.

Given a stable political environment and an accelerated pace of reforms complementing the huge surge in working age population, India is well positioned to deliver stronger economic and corporate profit growth.

To Achieve Higher Economic Growth India Needs Loan Growth

  • Deposit growth / GDP growth is running at the lowest level in almost 30 years. India's currently under-penetrated financial services sector could deliver significant, outsized returns.
  • Loans to GDP should increase towards 75% in five years and 85% in ten years, still one of the lowest penetrated banking sectors in Asia.
  • Consumer loan penetration remains low, at about 12% of GDP.
  • Loan growth will require deposit growth, and a willingness to lend to the micro, small, and mid-cap sectors, providing credit for the vast unbanked population.
  • Retail credit is forecasted to rise to 17% of GDP by 2019, up to $600B from $250B
  • Origination practices have improved. The Credit Information Bureau India Limited (CIBIL) is now fully operational, generating more reliable data on credit history, supporting earnings through lower bad loan formation.
  • Home affordability has increased. India's Property Prices to Annual Income Ratio currently rests at 4.6 times, compared to 5.1 times in 2007 and 5.3 times in 2001.
  • Profits are forecasted to grow at an annual growth rate of 20% in the next 5 years.
  • Financial system revenues to grow at an annual growth rate of 16.5% in the next 5 years.

Loan Growth Will Require Bank Recapitalization

  • SOE (State Owned) banks need recapitalization of around $50B, approximately 50% of book value
  • Private banks need recapitalization of around $15B, approximately 12% of book value.

Private Banks Poised to Outperform State Owned Banks

  • Private banks will gain meaningful market share given stronger balance sheets, better credit processes, and an ability to market to small and medium size businesses.
  • SOE banks, on the other hand, will likely underperform private banks as the positive impact on earnings from a stronger economy will likely be negated by the large dilution that is expected to be seen through $50B in recapitalization.
  • SOE banks lag private banks in terms of the compensation they offer employees, which makes it tough for them to attract quality human capital.
  • The average staff cost at SOE banks is close to 25% above private banks, driven by the large retirement provisions that SOE banks have made for employees. This gap has been widening over the last four years and will likely continue to do so over the next five years.
  • Projected annual stock returns of 20% over the next 5 years.

Disclosure: The author is long INDY.

Business relationship disclosure: Accuvest Global Advisors is a registered investment advisor in the SF Bay Area. This article was written by James Calhoun, one of portfolio managers. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.