With India's public sector banks burdened by over-stretched balance sheets, the country's more nimble private banks are benefiting from positive demographics and stronger credit demand, says Diego Mauro, Senior Investment Analyst, of Hermes Emerging Markets.
Growing demand for credit
We believe India is one the best structural growth stories within the emerging markets: in the coming decade, more than 100m people are expected to join the workforce from a population of 1.2bn, fuelling a powerful demographic dividend. Furthermore, the percentage of people over the age of 15 who have completed secondary and tertiary education has risen from 23% to 40% throughout 2005 to 2015, and is expected to reach 50% by 2025. This should increase the number of skilled workers in the economy.
With these developments in mind, we believe that retail banking in India will undergo structural growth as economic progress increases both wages and demand for financial services. As disposable incomes rise, tax incentives are enticing more Indians to take up mortgages, and greater personal wealth often creates demand for investment and financial planning services. These favourable economic and social conditions, combined with our focus on high-quality companies trading at attractive valuations, have led us to research India’s retail banking industry for investment opportunities.
Public sector banks are losing steam
At the moment, the environment for retail banks in India is probably the best that we have seen. In the wake of Modi’s election, the national economy is expanding at more than 7% per annum, its current account is becoming more balanced and it boasts $350bn in foreign exchange reserves. Inflation is under control, at about 5%, and positive real interest rates are creating the right incentives for individuals to invest.
India’s financial industry is still dominated by public sector undertaking (PSU) banks, which comprise about 73% of the total system. These entities are currently focused on repairing their balance sheets after the government stopped providing them with capital, and consequently do not have the flexibility to expand and invest in competitive retail banking services.
Private-sector banks operate without these constraints. With robust balance sheets and strong retail franchises, they are poised to rapidly grow market share. This is already happening: while PSUs such as State Bank of India and Punjab National Bank are experiencing single-digit growth, a number of retail banks are expanding at more than 20% per annum. In our research of the sector, we identified two lenders that we believe are capturing the opportunities available to them.
HDFC: market innovator
HDFC Bank is the second-largest private bank in India, with a 35m client base that is growing by 1.5m every year. This uptake is fastest in rural areas, largely due to the bank being one of the few offering digital services outside cities. HDFC has a 15% market share in the retail segment, with very strong positions with respect to credit cards (30% of the market), point-of-sales machines (20% of the market) and e-commerce transactions (more than 30% of the market). Its financial position is also strong: at a time when the loan books of most banks are deteriorating in quality, its non-performing loan (NPL) ratio is beneath its 10-year average, at less than 1%.
HDFC has invested significantly in its digital operations, with the recent launch of a new platform aiming to facilitate faster loan approvals, bring remote access to a larger customer base and make merchant payments faster and easier. Highlights of the strategy include a 10-second personal loan approval for certain clients and a plethora of new apps.
With its focus on digital innovation and improving consumer services, HDFC is well positioned to benefit as rising incomes enable more Indians to take up banking products and the proportion of skilled workers in the workforce grows. As a result, we are confident that the bank can maintain a return on assets of 1.9% to 2%.
ICICI: rapid retail growth, attractive valuation
The retail business of ICICI, India’s largest private sector bank, has expanded at more than 20% per annum in the past two years. It now accounts for nearly 43% of its total loan book compared with 37% two years ago. ICICI has been focusing on growing its retail arm and expanding margins from domestic business as it has significant credit exposure to industries suffering cyclical challenges. We believe, and the bank has indicated, that these levels of NPLs have peaked. However, despite this improvement and the increasing proportion of higher quality retail business, the stock is trading at an attractive price-to-book valuation of 1.6x, which is about one standard deviation below its average over the last five years.
We believe that these banks are best-in-class lenders that should continue to benefit from ongoing economic reforms and growth in India, favourable demographics and a concomitant rise in credit demand.