India’s Financial Sector – Defies the Global Trend – Continues to Emerge Stronger

Author: Manoj Kumar Vijai, Partner, KPMG India

India has witnessed an excellent growth over past two decades. Indian economy has expanded at a CAGR of 6.9% during this period. Besides economic growth, the country has prospered in a number of other areas as well. Its professionals have made significant contributions in the areas of medical science and business globally. A number of multinational companies today are headed by people of Indian origin. India’s influence in various international forums has increased significantly. While the country’s claim for a permanent seat in the United Nations Security Council is still debated, it continues to be an active contributor to the peace and rehabilitation efforts in many countries.

After the balance of payment crisis in 1991, the Indian Government embarked upon the road of economic liberalization and globalization. The economy expanded at a CAGR of 7.8 percent during the last ten years. India has globalized at a faster rate with its gross capital inflows and outflows growing five times during the last 30 years. The country also witnessed strong savings and investment rates of 32.3 percent and 35.1 percent respectively, in 2011 (quick estimates) which has helped in attaining high per capita income. The services sector grew exponentially especially after the economic liberalization in early 1990s and emerged as the prime driver of this growth. Its share in GDP has consistently increased from 42.7 percent in 1990-91 to 59.0 percent in 2011-12 (advanced estimates).[1]

The pace of the economic growth could be imagined from the fact that while it took nearly 40 years for the real per capita income to double from the level achieved in 1950-51, it increased 2.5 times in the next 20 years in the post-reforms period. More importantly, the per capita income crossed the crucial level of USD 1,000 in FY11, which is considered to be the level beyond which an economy grows exponentially.[2]

A glimpse of increasing investments over the last decade

# FDI for April 2011-February 2012; FII for April 2011-November 2011 Sources: DIPP, SEBI

This growth story has made India an attractive investment destination. India’s share of foreign direct investment (FDI) and foreign institutional investment (FII) has been increasing consistently since the last decade. FDI equity investments during April 2000-February 2012 were pegged at USD 246.6 billion and net FII investments (both equity and debt) were USD 111 billion during April 2000-November 2011.

India’s increasing investment attractiveness was also acknowledged in the World Investment Prospect Survey – 2010-2012 by the United Nations Conference on Trade and Development (UNCTAD) which placed India as the second top destination to receive foreign investments.

However, the last couple of years have witnessed a slowdown in the economic activity in India due to a combination of global and domestic factors. The global financial crisis in 2008 and the subsequent trouble in some of the European countries have impacted the foreign inflows into the country which, in turn, affected the equity, currency and exports markets. These global factors resulted in a slowdown in investment activity and exports which increased the cost of capital and declined capital expenditure.

The country’s high fiscal deficit, accentuated by the governments’ profligacy, could also impact the growth in medium term. Allegations of corruption against the Government, weakening business confidence, delay in many of the reforms process and weak infrastructure have made the macroeconomic environment look gloomier. All these have resulted in Indian economy growing at much below its potential during the last couple of years.

During the global financial crisis, India got impacted primarily due to a decline in FII and exports but financial services (FS) sector remained insulated from any direct impact of the crisis. However, there was an indirect impact due to the economic slowdown and NPAs.  Some of the foreign banks also deferred their growth plans in India due to turbulence in their home country. The equity markets witnessed a sharp decline due to a decline in foreign investment.

However, the impact on the FS sector remained temporary. Though the growth rate of bank credit marginally declined from a CAGR of 22.8 percent (during 2000-01 and 2009-10) to a CAGR of 20.4 percent (during 2009-10 to 2011-12), it was still one of the fastest in the world. [3]Domestic demand for loans, insurance, mutual funds and other FS offerings helped the sector avert any significant downfall due to global turbulence. Besides a strong domestic demand, strong regulatory landscape and conservative approach to economic integration and financial innovation helped India avert a crisis in the sector.

The Indian FS sector is a unique blend of Government and private partnership. On the one hand, the Government ownership of a significant portion of the Indian FS sector provides the sovereign guarantee and keeps people’s trust in the system. On the other hand, private sector participation and private savings, which are increasingly becoming more important, are fuelling the growth of the FS sector. Private players run some of the well-managed financial institutions and are driving innovation in the sector.

As stated above though there has been a bit of overall slowdown off late due to uncertainties/delays on the passage of crucial pending reforms bills, corruption charges against the Government, coalition politics’ compulsions, there is definitely a scope for the individual sub sectors of the financial sectors to grow eventually. The following paragraphs highlight the key aspects of each sub sector.

Banking

The banking sector has registered high growth rates and has supported the growth of the Indian economy during the past two decades. Although there was a marginal decline in bank credit CAGR to 20.4 percent between 2009-10 and 2011-12, it was still one of the fastest growing across the world. The sector also faced headwinds with increased NPAs due to an economic slowdown.

Although faced with these short-term challenges, the sector holds huge long-term growth potential. With a population of approx. 1.2 billion, India has one of the largest and fastest growing middle class. India is also one of the youngest countries in the world with an average age of 25 years and is likely to get younger. Further, the country’s working-age population is expected to increase by 240 million over the next 20 years. All this coupled with increasing income levels and high savings rate is expected to result in a huge demand for retail banking services.

Besides a strong middle class, India also has a strong population of high net worth individuals (HNWIs). Its population of HNWIs registered a strong increase of 20.8 percent in 2010 and figured among the top 12 countries in the world.[4] All this is expected to result in a high demand for wealth management and portfolio management services.

India also boasts of a buoyant corporate sector. On one hand, big industrial houses require huge funds to increase their operations both in domestic and overseas markets. On the other hand, a large number of growing small and medium enterprises (SMEs) are gaining significance and contribute more than 40 percent of exports and 17 percent of GDP in 2011.[5] All this would translate into a huge opportunity for banks to increase their retail and corporate lendingbusiness.

Insurance

The insurance sector is hugely underpenetrated with a penetration of 6.72 percent during 2009-10 (measured as total premiums as a percent of GDP). The sector witnessed significant changes after the regulator Insurance Regulatory and Development Authority (IRDA) allowed the entry of private sector players. The sector was completely transformed and today features 48 players offering a variety of products through multiple channels. The life and general insurance sectors witnessed robust growth of 35.9% and 19.0%, respectively, in total premiums during 2001-02 and 2010-11.[6]

However, the growth of the sector was affected during the last 3-4 years, primarily due to some regulatory directives and guidelines including the gradual detariffication in motor insurance, capping agents’ commission, curb mis-selling and promote traditional insurance over unit linked insurance plans (ULIPs). Though these steps have affected the growth of the sector in short-term, unarguably, these are expected to become the basic groundwork on which the sector will witness a long-term growth. Further, some of the intrinsic factors such as under-penetration of insurance products, a young population and increasing workforce and the Government’s emphasis on micro-insurance will enable the sector to sail through.

Asset management

Similar to the insurance sector, the asset management sector also witnessed a robust growth during the last decade which was stifled by some high handed regulations during the last couple of years. While the sector’s total assets under management registered a robust growth at a CAGR of 23.7 percent during 2000-01 and 2009-10, it witnessed a growth at a CAGR of only 4.1 percent during the subsequent two years.[7] Some of the regulations such as removing the entry load, removing the exit load on investments of more than a year and capping companies’ expense ratio have proved to be detrimental to the growth of the sector.

However, the asset management sector is quite small in India and is in nascent stage. The companies’ reach have been primarily limited to top 20 cities. With an increasing disposable income and equity investment culture, the country offers immense potential to bring in innovation (both at the product and channel level) to take mutual funds to masses in a profitable manner. With a little more policy impetus, the sector is bound to witness huge growth.  The ratio of AUM to India’s GDP called as MF penetration was 11% in 2009, up from only 6% in 2005.[8] Though the AUM in India is expected to increase by 57.2% by 2014 but it remains significantly lower than western countries where the AUM accounts for 20 – 70 percent of GDP.[9]  So though we may witness some consolidation in the near term, again no one can deny that there is significant potential for this sector to grow.

NBFCs

Efficient, competitive and deep financial markets are a pre-requisite for any economy to prosper. The Government along with the capital market regulator Securities and Exchange Board of India (SEBI) has been at the forefront of taking timely decisions to protect investors’ interests. While India has done well on equity, commodities and derivative markets, its debt markets still lack the depth and breadth. Equity markets with nearly 100 percent dematerialization and T+2 settlement system compare favourably with those of many developed countries. India was the first country to launch a demutualized stock exchange, National Stock Exchange, in 1992. Increasing foreign investments have been a testimony to the performance of equity markets. However, the debt market which is dominated by government bonds, still lack long term bonds and participation of private and retail sectors. The Government has been taking various steps to further deepen the equity markets and develop debt markets.

The country has a significant parabanking sector through non banking finance companies (NBFCs). These NBFCs adopt flexible business models to offer loans, distribution of insurance and mutual funds, wealth management, retail and institutional brokerage and investment banking services. These entities have been instrumental in extending the reach of the FS sector in far flung areas and have contributed immensely in the inclusive growth agenda of the country.

Overall, the global and domestic factors have impacted the growth rate of Indian economy during the last couple of years. Though there has been a delay in implementing some of the key reforms, the Government is fast progressing to implement key reforms like deregulation of diesel prices, implementation of Goods and Services Tax and Direct Tax Code. The Government constituted the 11-member Financial Sector Legislative Reforms Commission (FSLRC) in March 2011 to examine and harmonise more than 60 regulations governing the FS sector and arrive at the most appropriate means of oversight over regulators and their autonomy from the Government. The commission is expected to submit its report by March 2013. Meanwhile, we may see action on a number of key bills including the amendments to the Banking Regulations Act, amendment to the Insurance Act and a bill to empower the pension regulator in the coming days.

Regulators for the FS sector continue to be supportive of the growth. Recently, the banking regulator Reserve Bank of India decreased interest rates in order to boost the economy. IRDA and SEBI are considering ways to balance the customer interest with the sector’s growth.

Despite strong headwinds and global downslide of the FS sector, India’s FS sector defies the global trend and is expected to emerge stronger.

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[1] The Economic Survey 2012

[2] The Economic Survey 2012

[3] Reserve Bank of India

[4] World Wealth Report 2011

[5] “Empowering SMEs for Global Competitiveness,” by SME Chamber of India

[6] Insurance and Regulatory Development Authority

[7] Quarterly bulletins of Association of Mutual Funds in India (AMFI)

[8] KPMG Mutual Fund report, 2009

[9] AMFI, CSO and “Indian Asset Management Profitability 2011,” released by Cerulli