Companies & Sectors
Financial services can deliver significant returns

As economic growth picks up, India’s currently under-penetrated financial services sector could deliver significant and out-sized returns, says Morgan Stanley

For India, a growth of 6.75% per annum is achievable over the next 10 years, which would translate to a $5 trillion economy by 2025. According to Morgan Stanley, financial services will be an integral contributor – and hence beneficiary – of this growth. "In our view, for this GDP growth to be achieved, the financial services sector will need to grow in the high teens over the decade," it said in a research note.



Morgan Stanley, in the first part of its 'The Next India' series, said India now has a government with the strongest mandate in 30 years. "However, to fix the banking system and therefore to give economic growth the greatest chance of success, the new government will need to use that mandate to act decisively in the next months and years. These are not going to be easy steps, but with the right policy choices from the government and prudent financial management from the banks, earnings growth averaging in the high teens is possible," the report says.

 

According to the report, past three years have not been kind to the India financials. The persistent economic slowdown and high interest rates caused default levels to rise meaningfully – impaired loans in Indian banks are now at almost 12% compared to less than 5% three years ago. This has caused profitability and capital levels of a large part of the system (state-owned enterprise-SOE banks are 75% of the system) to come off sharply. The risk is that banking sector problems may cause the next slowdown in the economy as more banks are unable to dispense credit.

 

"In our view, one of the first steps the new government should take is to break this vicious cycle of ‘weak economy => weak banks => weak economy’. SOE banks need capital – lots of it – and this will have to be provided quickly to ensure the Indian economy is able to move ahead," Morgan Stanley said.

 

To turn this vicious cycle into a virtuous one, the reports says, there needs to be substantial loan growth to multiple parts of the economy. That requires a recapitalization of SOE banks of around $50 billion and private lenders of around $15 billion. It also requires deposit growth with appropriate maturities, a willingness to lend to the small and mid-cap sectors and access to credit for the vast unbanked population, it added.

 

Morgan Stanley said, another factor in favour of Indian banks is that they are the only banking sector in emerging Asia that is coming out of a bad loan cycle. It said, "As the economy normalizes, lower credit costs should also provide support to earnings. This is a significant opportunity for investors, in our view. India offers a material growth opportunity with a large and liquid financial sector. On our estimates, Indian financials are likely to be among the best performers across EM banks over the next five years."

 

The report estimates large private lenders to deliver 18-24% CAGR in returns over the next five years. "Public sector banks or SOE banks, on the other hand will do less well- the positive impact on earnings from a stronger economy will likely be negated by the large dilution that we expect to occur over the next five years. The big winners, in our view, will be the large private lenders – HDFC Bank, ICICI Bank, Axis, Kotak and HDFC," Morgan Stanley said.


Over the next five years, Morgan Stanley’s macro team expects India’s economy to keep improving, with GDP growth estimated to average 6.4%. At the same time, inflation is expected to come down to an average of 6.4% by F2019 compared to 9.5% in F2014, which would in turn bring interest rates down. This improvement in the economy will help banks see better revenue progression and lower non-performing loan (NPL) formation.

 

Morgan Stanley expects this improvement in the economy to help drive higher credit demand. At the same time, banks will likely be more open to giving loans. This should help drive loan growth in India at 16.5% CAGR over the five years to F2019. India’s financial sector is materially under-penetrated compared to other Asian countries. As the economy picks up (higher per capita income), loans to GDP should increase to about 75% in five years and around 85% in 10 years, still one of the lowest penetrated banking sectors in Asia, the report added.
 


Morgan Stanley sees five challenges, capital, PSU banks, infrastructure financing, MSME financing and financial inclusion for the growth of financial services sector in India.

 

Capital– We believe that banks will need $65 billion of capital over the next five years and $130 billion over the next 10 years. This is the biggest constraint to banking sector growth, in our view, and in turn economic growth. We need to see a government solution to SOE banks capital quickly. The continued dilution will likely cause ROE trajectories for the private and SOE banks to remain significantly apart over the next few years.

 

PSU banks – Apart from capital and weak balance sheets, the banks are facing problems associated with human resources. In the past, public sector banks had large numbers of staff. However, in the wake of hiring freezes implemented during the 2000s, middle management is now retiring with no replacements available with equivalent skills or experience. At the same time, the cost base of SOE banks remains very high, driven by higher employee expenses – as retirement related provisions are very high. To improve profitability on a sustained basis, manpower related issues need to be resolved at these banks.

 

Infrastructure financing – According to the planning commission, India will need to spend about 9% of GDP on infrastructure on a sustained basis to achieve its growth potential. Of this about 50% will need to be funded by debt. The planning commission expects the bulk of the debt to be financed by banks, but this will be difficult to achieve, in our view. After the problems faced by banks related to infrastructure loans in the last four years – investors have been worried about NPL’s in the sector - we expect them to be averse to lending to infrastructure. Moreover, banks do not have large amounts of long maturity liabilities, which will impede their ability to grow exposure to the infrastructure sector meaningfully. Hence, the government will need to find new ways to fund infrastructure – take-out financing, better bond markets and easier access of foreign capital to fund this sector. Banks are unlikely to be the solution, we believe.

 

MSME financing– There are large parts of the Micro Small and Medium Enterprise (MSME) sector that have been struggling to get credit. This situation has become more acute recently, as NPLs on these loans have increased and banks have increased spreads on these loans materially. Cyclically, there will be a pickup in lending to this sector as the economy improves, which should mean NPLs reduce and banks become more amenable to lending. However, to lend to the smaller sections of MSME, we would need to see more NBFCs / smaller (or targeted) private banks which should focus on ensuring steady credit flow to this sector.

 

Financial inclusion– India has large swathes of the population that are ‘unbanked’. One of the biggest goals of the RBI is to ensure credit availability to these people. This implies that banks will have to find cost effective ways to provide banking to the masses. We would also expect new banks to be set up, with the specific purpose of meeting the credit needs of the less affluent sections of Indian society – an example being the recent grant of a bank license to Bandhan Financial, a micro finance lender.

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COMMENTS

Yerram Raju Behara

2 years ago

A good futuristic analysis. But all depends upon the ability of the financial sector to harness risk appetite for growth oriented healthy credit market to be in its lap. The future is now and here. However, the human resources in financial sector is way behind. People risks and systemic risks are preventing growth of risk appetite among banks in India. Financial Sector CMDs should have a retreat with a progressive facilitator and should upfront leave the legacy behind and start unlearning.

Sumitra Mahajan, the next Speaker of Lok Sabha?

Sumitra Mahajan has never lost the Lok Sabha elections since 1989 and was elected from Indore for the eighth time in the recently-held polls by a margin of 4.67 lakh votes

Bharatiya Janata Party (BJP)'s senior leader and one of the most experienced Parliamentarians, Sumitra Mahajan is likely to be the next Speaker of the Lok Sabha.

 

The 71-year-old leader from Madhya Pradesh has been sounded by party chief Rajnath Singh about the new assignment, say reports.

 

The election for the Speaker will take place on Friday and the party is likely to make the formal announcement about the nomination anytime now.

 

If elected, Mahajan will be the second woman to hold the key position after the outgoing Speaker Meira Kumar.

 

Mahajan has never lost the Lok Sabha elections since 1989 and was elected from Indore for the eighth time in the recently-held polls by a margin of 4.67 lakh votes.

 

She was a minister of state in the Atal Behari Vajpayee government from 1999 to 2004.

 

The week-long first session of the 16th Lok Sabha started Wednesday on a sombre note with the House paying homage to Union Minister Gopinath Munde who died in a road accident Tuesday. The House adjourned for the day after paying homage to the departed leader.

 

President Pranab Mukherjee will address a joint sitting of Parliament on 9th June and the week-long session will end on 11th June.

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Supreme Court refuses to release Subrata Roy from jail

Modifying its earlier order, the apex court allowed Sahara to sell its immovable properties from nine cities to garner Rs10,000 crore for Subrata Roy's bail.

The Supreme Court on Wednesday once again rejected Sahara chief Subrata Roy's plea to release him from jail and put him under house arrest. The apex court, however, modified its earlier order and allowed Sahara to sell its immovable properties situated across nine cities in India.

 

The Court also directed market regulator Securities & Exchange Board of India (SEBI) to release title deeds of the properties to be sold by Sahara in favour of purchasers for arranging the money. However, the apex court made it clear that Sahara can neither sell properties to related parties nor below the estimated value and circle rates. While allowing encashment of fixed deposits and bonds, the apex court also directed Sahara to deposit the proceeds in a bank account maintained by SEBI.

 

Meanwhile, according to reports, the Supreme Court has appointed senior advocate Fali S Nariman as amicus curiae in the Sahara-SEBI case. Coincidently, Adv Nariman earlier represented Sahara in its dispute with SEBI.

 

Sahara chief Roy has been in jail since 4th March after failing to appear at a contempt hearing in a long-running legal battle between his group and SEBI.

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