The times, they are a changin…

I visited India in February and March 2018. This is an annual trip for the Indian in me. As usual, there was a frenzy of activity everywhere – on the roads, in trains, airports and even hotels. My mind went back to the India I had left behind in the mid-nineties. At that time India was impoverished in material, money and ideas. She was a self-effacing, fatalist, back-bencher nation, having just emerged from near-bankruptcy. The status car was a “Contessa” – a fuel-guzzling boat on the road based on some outdated Vauxhall design. They were driven by chauffeurs wearing peak caps, while their suit-clad bosses read the Economic Times in the rear seat. I was one of those – a pinstripe-suit-clad banker.

In 2018, the Contessa was nowhere to be seen. Instead, all the world’s best luxury automobiles were roaming the streets, skillfully dodging the complete almanac of locomotives known to man – from Harleys to rickshaws to bullock carts and everything in between. I had left India with a billion despondent people in 1996. And now with 1.3 billion,  Indian society looked markedly different. The confidence in the air was palpable. Old Vauxhalls were out. New BMWs were in.

It’s not just cars and bikes. Indians were  spending a lot of money on a basket of things: clothes, food, electronics, and all the material comforts we can think of in the West. Clearly, incomes had risen dramatically. The standard of living, at least for the city-dwelling middle-class who fill up these fancy shopping malls, had clearly gone up. All those rosy numbers we’ve been reading about in the papers seem to be true.

Pundits across the spectrum of “thinking” organizations had just pronounced India as the fastest growing economy in the world. With India expected to hit real GDP growth of 7.4% in 2018, she was leaving China in second place at 6.6% (all emerging economies at 4.9%, all advanced economies at 2.5%, and the world overall at 3.9%) way behind. The IMF thinks that by 2021, India will cross an annual growth rate of 8% and will moderate inflation down from 5.8% now to 4.8%. I also read that based on purchasing power parity exchange rates, China was the world’s largest economy in 2015, with a GDP of almost $20 trillion and India’s GDP was larger than that of Japan, Germany, France, and the United Kingdom. 

Why the sudden acceleration in growth rates? I’ve gone through this in some detail here. My opinion is that “the Indian consumer” is ready to break out and accelerate spending across the board – TVs, Cars, Clothes, Healthcare, Insurance and so on. They want to eat better, live better, and buy cooler things. This isn’t a particularly Indian thing. It’s happened in other countries, and most recently across the Himalayas in China. While I was in India, I could see it on the ground. Despite some volatility, I think the consumer story in India is sustainable – especially because of some factors that are, in fact, particularly Indian. And I think there is an interesting way to play this.

Babies have Bloomed

Looking around, I noticed that the cellphone had become the center of people’s lives across social strata. They talk (loudly), text, WhatsApp, play games, see movies, consume multiple apps and even do business on it. Heads are down staring at the small screen, but heads are not down in any figurative sense. India’s youth is plenty confident, with “the whole wide world in their hands”. There are 900 million cell phone users – gosh that’s 3 times the population of the USA. Nearly 25% of them are smart phone users. The rest will catch up faster than we may think. That implies that there is another USA-sized market for smartphones waiting to take off in the next few years. A big part of the reason is that using a cellphone in India is cheap. Call rates that used to be INR 16 ($0.25) per minute just 5 years ago has dropped to INR 0.60 ($0.01). 40% of all e-commerce is done on mobile phones.

Indeed, India also has the third largest population of internet users worldwide with 190 million subscribers on the internet and growing. I went back to a civilization with a history that goes back to the depths of time,  that has one of the youngest populations in the world. By 2020 64% of the population i.e. 800 million will be of working age – a problem and an opportunity at the same time. The need to consume, with quick gratification appeared to be very strong among the youth, not only in metros but also in Tier 2 towns. Access to the newest and smartest deals on Amazon or Flipkart seemed to be part of many “chai-time” conversations.

The Chinese have noticed this new, spendthrift India, and they are going in big. Chinese consumer brands (especially TVs and smart phones), unheard of in the USA, have started making inroads at very attractive price points into India. A Chinese cellphone company is now the official sponsor of the Indian Cricket Team. In a cricket-crazy nation like India, this is nothing short of a coup. 

So, my next question was – what are these young cellphone addicts with a growing need to consume going to do?  Will they tend to borrow more like the largest consuming nations of the world? And if so, will credit availability and usage increase in India?  I didn’t have to put my banker hat on. I guess I had never really taken it off.

To India’s Credit: Let's Bank ‘Em

Numbers suggest that there is massive headroom in household debt in India compared to most other countries. An OECD report of February 2017 says that based on 2015 data, among the BRIC countries, India had the lowest household debt as a percentage of GDP [Brazil 26%; Russia 16%; India about 10% and China nearly 40%. It seems to me that the party is just about to get started. 

The reality on the ground supports this theory. Here’s why:

• Unique Identity database: Aadhaar literally translates to “Foundation”. It is a 12-digit unique identity number in an identity card issued to residents of India, inclusive of biometric and demographic data. Aadhaar is acknowledged as the world's largest biometric ID system. Run by a Government of India organization known as Unique Identification Authority of India (UIDAI) as of November 2017, 1.17 billion people had been covered by Aadhaar – that’s close to 100% of the population of India. Why is this important? Aadhar is not only a depository of identity but also a payment system using fingerprints or IRIS scans. AEPS (Aadhaar Enabled Payment System) in its basic form is a machine known as micro ATM. This machine is similar to POS (Point of Sale) machines that accept credit/debit cards. The only difference is that instead of any card you need to authenticate your payments using your bio metrics. So imagine that deep in rural India, Ram has opened a bank account with a bank branch situated in the nearest town. Using a micro ATM with a local representative in his village, he can withdraw cash, deposit cash, check balance using his finger print as authentication. Ram does not need to sign anymore – that was his biggest fear with the banking “babus”. Not only that, if Ram’s brother Shyam in his village 50 kilometers away is on the system, Ram and Shyam can now send and receive money on their smart phone. No travel to a bank branch required; no dealing with dismissive babus; no cash involved. Ram and Shyam can go about their productive activity instead of worrying about keeping their money safe. Aadhaar can propagate through peoples’ lives very quickly.
• Active Credit Bureaus: There are 4 credit bureaus functioning in India - Transunion CIBIL, Experian, Equifax, High Mark. Having a credit score is a pre-requisite for a personal loan in India. It is now possible to get default records easily for a potential borrower. So, the system looks and feels very much like what we have in the US – quantitative, standardized, and built for quick loan approvals.
• Digital transactions: In 2009, at the behest of the government, the Reserve Bank of India and a few other banks came together to form the National Payments Corporation of India (NPCI). An umbrella organization charged with setting up a pan India digital payment infrastructure, NPCI has done impressive work in the direction. Between November 2016 and January 2018, just mobile payments have grown from 671 million transactions to 1.12 billion – a 67% rise. Volume of money was up from a monthly volume of $1.5 billion to about $2 billion during the same period. A Boston Consulting Group/Google report states that by 2020, there will be 30 billion transactions a month against 1.12 billion now, with a monthly value of USD 40-42 billion ($2 billion today). How does this compare with the US and China? The exciting and expanding world of FinTech (Financial Technologies), is widely recognized as the route path to financial inclusion. Embracing not only digital payments and receipts, it provides the means to reach out to potential customers at a fraction of conventional costs. It also potentially brings to previously unreached customers, credit, insurance, investment/fund management and other financial products. FinTech developments globally are targeting hitherto excluded sections of the population and/or small businesses. China has been at the forefront of this revolution with transaction volumes 3 times that of USA which ranks a distant number 2. India has been a late starter. In 2015, a Reserve Bank report points to Indian’s Fin Tech transaction volumes at 0.02% of China’s and 0.06% of USA. The headroom is massive.
• Government tail wind: India’s financial inclusion agenda has gained significant momentum at both policy and implementation levels. For example, the government’s introduction of gold monetization schemes, or the launch of Pradhan Mantri Jan Dhan Yojana (PMJDY) in August 2014 that led to the opening of bank accounts for 254 million previously unbanked individuals. Again, I’d like to emphasize the scale we’re dealing with here – 254 million is roughly 80% of the population of the USA.

At the forefront of India’s financial inclusion program, Banks face sustained competitive pressure to increase efficiency and productivity. They are attempting to do so by leveraging on technological developments through partnerships, finding new markets and launching new innovative products. It is possible that in this regard, i.e. banking with the unbanked, Banks may have an edge over other financial intermediaries because of their ability to leverage branch networks and an array of financial product offerings through affiliated organizations. With an inclusion strategy riding on technological innovation, reaching down lower towards the bottom of the pyramid may hold the key to big business opportunities for Banks.

To its Debit: Corporate Loans

The Indian banking system consists of 27 government public sector (government owned) banks, 26 private sector banks, 46 foreign banks, 56 regional rural banks, 1,574 urban cooperative banks, in addition to cooperative credit institutions. Public-sector banks control more than 70% of the banking system assets.

Over the last decade, both bank deposits and bank credit have been growing at a compound annual growth rate of 11%. Within the banking system, asset growth recorded by private banks has been twice that of public sector banks. And Return on Assets among private banks has been much healthier than government owned public sector banks.

However, during the period 2006 –2011, loan assets of Indian banks grew at an annual average rate of 20%. Some of the growth was indiscriminate, especially among government-owned banks. This led to a surge in the growth of stressed assets or Non-Performing Assets (NPAs). From a declared level of about 6% as of March 2011, the figure had climbed to over 12% by December 2017. Comparing the two types of banks – public and private – stressed assets of public sector banks hovered around 16%, while stressed assets of private banks remained below 5%.

Why did this sudden surge in NPAs happen? That’s because the central bank (Reserve Bank of India or RBI) focused on this. In 2015, the RBI conducted a series of in-depth audits and identified stressed assets much more comprehensively than Banks were previously required to report on their own. It became evident that the bulk of stressed assets were a result of lending to large corporates mainly for comparatively longer-duration infrastructure projects. Interestingly, the share of large corporates in total loan assets ranged from about 45% (March 2015) to 42% (March 2017), but they made up over 70% of total stressed assets. The Retail side of balance sheets showed a comparatively better asset quality.

Digging a little deeper, I found that India was among the worst offenders in resolving stressed assets. Granted there were powerful interests involved with political leanings. But part of the reason was also that Bank CEOs hid the seriousness of the problem till RBI got into the act. Another part is that the legal system did not facilitate quick insolvency and resolution. According to the RBI, resolution of stressed assets took 4.5 years on average in India and resulted in about 20% recovery of delinquencies. In China the resolution time is about 1.5 years although the recovery rate is not much higher than India at 30%. The best recovery performance was Norway with average resolution time of about a year with close to 90% recovery. 

Can India ever catch up to Norway? Maybe not. But it’s headed in the right direction.

Sweeping Changes

Two massive changes in the last couple of years point to better days in the Indian banking system.

1. With a view to making it more difficult to own and stock unaccounted money, high value currency notes were demonetized in November 2016. The Government of India announced that Rupees 500 and 1,000 were no longer legal tender. These currency notes would need to be exchanged for a new series of 500 and 2,000 rupee notes. The idea was to flush out “black” or unaccounted money from the system. The execution was highly flawed, and it didn’t quite solve the “black money” problem, which was the government’s stated reason. Maybe accidentally, this was a strong nudge towards “formalization” of an economy that used currency notes at a much higher level than most other countries in the world. Sure, there was an initial disruption, but the controversial move has been generally regarded as a positive step for the long term.
2. Finally, a new Bankruptcy Code has been implemented.

#2 is big. In 2016, India passed the Insolvency and Bankruptcy Code that sought to streamline the process of bankruptcy. Here are some highlights:

• Resolution initiation and timeline: The process may be initiated by either the debtor or the creditors. For companies, the process will have to be completed in 180 days, which may be extended by 90 days, if a majority of the creditors agree. 
• Insolvency regulator: The Code establishes the Insolvency and Bankruptcy Board of India, to oversee the insolvency proceedings in the country and regulate the entities registered under it. The Board will have 10 members, including representatives from the Ministries of Finance and Law, and the Reserve Bank of India. 
• Professionals to manage the process: The insolvency process will be managed by licensed professionals. These professionals will also control the assets of the debtor during the insolvency process. 
• Bankruptcy and Insolvency Adjudicator: The Code proposes two separate tribunals to oversee the process of insolvency resolution, for individuals and companies.

This is a significant step towards resolving NPAs and cleaning up balance sheets of banks. Why? Without the ability to force bankruptcy, banks were left with only the ability to restructure loans. Now there is a clear time-bound process towards insolvency proceedings with punitive measures for owners and management. In addition, the powers of the RBI have been further enhanced to closely monitor Banks and where necessary compel initiation of insolvency proceedings against delinquent borrowers. However, this is a metric to watch.

The combination of #1 and #2 points to this: 

1. On the Liabilities side of the Balance Sheet: Increase in Deposits
2. On the Assets side of the Balance Sheet: Better Recovery Rates in Corporate Loans. 

These should lead to what (as a former banker) I would love to see: much healthier Balance Sheets. Now, as an investor, I would love to see that translate to better Net Interest Margins and a higher sustainable Return on Equity profile. The seeds have been sown.

Net Credit: My Take

• The stage is set for a huge push towards individual lending with Aadhar, Credit bureaus, FinTech firmly in place.
• Consumption will surge – the young working population is eager to move up the ladder. For example, TV purchases are expected to double between 2016 and 2020; by 2020 India will surpass many EU nations for annual car sales; India is the largest 2-wheeler market in the world.
• They will need credit for consumption – Autos, houses, two wheelers, TVs, white goods, cell phones etc.
• Banks hurt by their dismal performance in corporate lending will clean up their balance sheets; the pace of cleaning is a marker to watch.
• Using their branch network and technology, they will gravitate towards retail (personal and household) lending – there is huge headroom here.
• Liquidity with banks will continue to be good on the back of a continued savings rate of 30%+ of GDP.
• Banks that succeed in harnessing technology will be winners; alliances will be forged among banks, technology providers and last mile players as new markets in hitherto unbanked areas are explored and exploited. 

So, what should The Buylyst do?

For American investors, unfortunately there are just 2 hassle-free investable Indian bank stocks. By hassle-free, I mean that they are traded on an American Exchange as American Depository Receipts (ADRs), which means that we don’t need to go through tedious paperwork to buy into these stories. The two companies are:

1. HDFC Bank
2. ICICI Bank

I took a superficial, quantitative look at both, using some ratios that I thought are most pertinent to analyzing banks. These are figures from their latest Annual Reports, which are 3 months apart. HDFCs figures are as of March 31, 2018. ICICI’s are as of December 31, 2017. But three months wouldn’t change the bigger picture. 

Quantitatively speaking, the answer to the question “where should The Buylyst spend its time?” is clear. HDFC is the healthier bank as per these numbers. The qualitative reason for this difference, I believe, is the sum-total of everything I’ve written about. HDFC’s credit exposure is more Retail-oreinted (the Indian consumer) while ICICI’s credit exposure is has traditionally been more Corporate. HDFC’s Retail exposure is 58% compared to ICICI’s at 51%. Don’t let the seemingly small difference fool you. In banking, with its leveraged business models, every basis point makes a difference. And really, ICICI’s Retail exposure was a lot lower last year. To be fair to them, they’ve been improving their numbers. But it takes time to get rid of toxic assets.

Among the two, HDFC clearly deserves time – to dig in and to look for potential pitfalls in its business model. As I’ve discussed, the macro story is tangible. Indian consumers are turning a corner. They need credit. So far, at least, HDFC’s numbers fit into the Worldview. What The Buylyst needs to figure out is this: Can a bank like HDFC harness this inflection point without lending imprudently? Is it a comfortable business? And if so, is it trading at a comfortable price?

Time to roll up our sleeves.