India’s Banking Renaissance

Looking back, 2017 may prove to be a dramatic turning point for India’s economy and banking sector. During the year, the country dealt with the fallout of demonetization, a process in which 500- and 1,000-rupee notes were removed from circulation in an attempt to flush out undeclared income, or “black money.” Also in 2017, the government rolled out a national goods and services tax (GST), which supplanted a patchwork of state and local levies and, overnight, turned the $2.4 trillion economy into a single market. And another reform, the Real Estate Regulation and Development Act (RERA), took effect with the aim of improving governance and accountability in the real estate sector.

This trifecta of reform caused significant disruption, weighing on growth. In fact, for the three quarters through November 2017, India’s rate of economic expansion fell short of forecasts. But long term, we believe these and other changes, led by Prime Minister Narendra Modi, could go a long way toward strengthening India’s economy and, in turn, investment opportunities in the country’s financial sector.

Tax Compliance
For one, demonetization is encouraging tax compliance, with 25% more income tax returns filed for the year through March 2017, according to the Income Tax Department. We believe this gradual formalization of the economy is key for the growth of India’s banks. State-owned and private banks must underwrite loans based on income that is reported, not shadow transactions. Non-Banking Financial Companies have historically filled this void, exploiting the informational arbitrage. But as more of the country’s economic output is officially recognized, traditional banking opportunities should expand, boosting bank revenues.

Already, some institutions are identifying growth opportunities. HDFC Limited, a leading Indian housing finance company, notes that mortgage lending to self-employed individuals is likely to rise as more of these workers begin declaring income and paying taxes. The government is also collaborating with builders to increase the supply of affordable housing, while RERA has helped boost confidence around lending to developers. As a result, HDFC believes loan demand could accelerate for the next several years.

Integration & Digitization
Formalization is happening in other ways, too. Until recently, roughly half a billion Indians did not have a bank account. But in 2014, Mr. Modi launched Jan Dhan Yojana, a scheme to provide basic financial services to the unbanked, with the goal of signing up 75 million people by January 26, 2015. By the end of that month, more than 125 million bank accounts had been created, and today the figure exceeds 300 million. Other initiatives for integration have included Aadhaar, a unique biometric identification card, and the development of mobile banking platforms, both of which have simplified and hastened verifiable account opening.

These tools are driving innovation, with the country charging full speed into digital payments. The National Payments Corporation of India, for example, built the Unified Payments Interface (UPI), a digital platform that allows users to send payments from a bank account via a mobile phone. UPI is taking off: Google, for example, adopted UPI for its Tez payment app, launched in 2017, while Uber riders can now remit payment via the platform. Adoption of the platform could quicken as more people acquire bank accounts, as well as advanced devices. Roughly 300 million Indians have a smartphone today, but the figure still represents only about a quarter of the country’s population. With the middle class expected to grow in coming years, digital transactions – and the revenues that accrue to banks – are likely to rise.

Infrastructure Spending
Improving India’s transportation system is also a focus. By 2022, the government aims to reduce the country’s overall logistics costs by approximately 40%. To do so, Mr. Modi is planning to spend $1 trillion over the next several years on improving ports, rail and highways. Should the plan succeed, Indian companies will be able to move goods and services more rapidly and efficiently around the country. This transformation, along with rollout of the GST, should make it easier for businesses to scale, accelerating the pace of growth in the country’s formal economy. For India’s banking and financial services sector, that could lead to more lending and services. Already, we are seeing glimpses of that potential: In 2017, the first life and property and casualty insurance companies went public, with half a dozen initial public offerings during the year. As more Indians seek to protect newfound wealth and businesses with insurance, the growth prospects for financial services will strengthen.

Of course, the path forward is not without risks. Mr. Modi is up for re-election in 2019, and fiscal discipline could become lax in the interest of winning votes. At the same time, in the wake of GST, companies may pass on price increases to consumers, pushing up inflation. Higher oil and other commodity costs could also cause inflation to rise. Taken together, these trends could drive Indian bond yields higher, raising red flags for investors. Even so, we believe the changes enacted in 2017 have set India on the path to rapid growth. Should Mr. Modi win re-election, as we expect, we will likely see further banking reform and consolidation that will help make India an even more appealing growth story for years to come.