Emerging Markets Spotlight – India’s Banking System

“The Reserve Bank of India has asked banks to initiate bankruptcy proceedings against 12 large loan defaulters, accounting for a quarter of nearly [INR 9trn] that the banking system has piled up in bad loans.” — Hindustan Times, August 7, 2017

Our top-down process looks at a broad range of top-down drivers of emerging equity markets. One market on which we have been positive for several years has been India, with a preference there for domestic cyclical stocks. Those views have contributed positively to the portfolio’s performance. Since September 2013, the MSCI India Index has delivered a total return of 56.6% in U.S. dollar terms, well above the MSCI Emerging Markets Index’s total return of 20.0%. That is not to say, however, that all of the drivers have played out as we expected. In particular, we have been revisiting our positive view on the banking and credit cycle in India.

We had expected an upswing in the credit cycle, which would be supportive of economic growth through both consumption and investment. Inflation has come in substantially below expectations, and both private-sector credit/GDP and the loan/deposit ratio of the banking system have declined in recent years, in contrast to the ramp-ups of credit seen in some other emerging markets. Yet despite the apparent opportunity, growth has not come through. In the year to the first quarter of 2017, we estimate system loan growth at 6.2%, compared to a 10.2% increase in nominal GDP. This is negative for banking-sector stocks and other cyclical stocks in India. Where were we wrong?

Looking into reports from the banks, there is clearly a three-tier structure to growth in the Indian banking system. We have focused on the year to the first quarter of 2017, but where second-quarter 2017 results are available, the pattern is the same.

The good news is in retail credit, particularly consumer and mortgage finance. Overall, we see loan growth of specialist mortgage lenders at 18.3% and that of consumer finance institutions at 16.9%. This pattern is mirrored within the loan books of more diversified private-sector banks. Private sector banks did well (loans +14.7%) but were generally held back by weaker growth in corporate lending departments. In the portfolio, we own a number of private banks. With strong consumer and mortgage growth and moderate growth in corporate loans from private-sector banks, the real disappointment is in state-owned (PSU) banks. PSU banks saw loans grow just 2.5%, with heavyweight State Bank of India at 7.3% and weaker growth elsewhere. It is particularly in the PSU banks where the much-reported non-performing asset (NPA) problem sits. The clean-up is positive for India in the long run, but the write-off of NPAs eats into both loan growth and capital of the banks and has been a drag in the short term. We remain believers in the Modi administration’s reform process, but view the PSU banks as a problem for some years yet. In this three-tier structure, private-sector banks (including those we hold) have been able to do well, particularly from the retail sector, and this has benefited the portfolio. However, we have not yet seen the broad increase in lending that would lift overall growth in the Indian economy. We still see opportunities in the banking system, but recognize that a broad credit recovery may still be some way off.

RISK CONSIDERATIONS: The Fund invests in international and emerging markets. International investments involve special risks, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs. These risks typically are greater in emerging markets. Such risks include new and rapidly changing political and economic structures, which may cause instability; underdeveloped securities markets; and higher likelihood of high levels of inflation, deflation or currency devaluations. Emerging markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

The small- and mid-cap companies in which the Fund may invest may be more vulnerable to adverse business or economic events than larger companies and may be more volatile; the price movements of the Fund's shares may reflect that volatility. 

The views expressed are those of the portfolio manager as of August 2017, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. 

As of June 30, 2017, the Fund had invested 0.92% in HDFC Bank, 3.18% in ICICI Bank, 1.75% in Axis Bank and 2.23% in Yes Bank; securities mentioned but not held in the Fund include State Bank of India.