Indian Financial Services Sector - Strong Bet

There has been a considerable broadening and deepening of the Indian financial markets due to various financial market reforms undertaken by the regulators, the introduction of innovative financial instruments in the recent years and the entry of sophisticated domestic and international players. Sectors such as banking, asset management and brokerage have been liberalised to allow private sector involvement, which has contributed to the development and modernisation of the financial services sector. This is particularly evident in the nonbanking financial services sector, such as equities, derivatives and commodities brokerage, residential mortgage and insurance services, where new products and expanding delivery channels have helped these sectors achieve high growth rates.

Capital Markets
There were 4,821 companies listed on the Bombay Stock Exchange as on March 31, 2007. In recent years, the equity capital markets have undergone substantial reforms in regulation and supervision. Reforms, particularly the establishment of SEBI, market-determined prices and allocation of resources, screen-based nation-wide trading, T+2 settlement, scripless settlement and electronic transfer of securities, rolling settlement and derivatives trading have greatly improved both the regulatory framework and efficiency of trading and settlement. There are 23 recognised stock exchanges in India, including the Over-The-Counter Exchange of India (“OTCEI”) for small and new companies and the NSE, which was set up as a model exchange to provide nationwide services to investors. In 2003, NCDEX and MCX were set up for trading of futures in various commodities.

In addition, the growth of the economy and Indian corporations has coincided with a sharp increase in foreign direct investment, including significant participation from private equity firms, a marked increase in investment in the real estate sector, increasing M&A activity, and a growing demand for credit from both corporations and consumers. With it, there has been a proliferation in the presence of intermediaries such as investment banks and securities firms that closely monitor the performance of the markets and provide extensive fundamental and technical research on the economy, sectors, and companies. All of these have contributed significantly to the growth of the Indian capital markets.

Corporate borrowing requirements are primarily met through the domestic banking system, due to the limited development of the corporate bond market. Large corporations are able to tap into the international banking system for their funding requirements however the RBI has placed restrictions on these borrowings by establishing limits on the amount and the rate at which corporations can borrow abroad. It is widely believed that for the healthy development of the Indian capital markets and corporate sector, it is imperative that the debt markets develop in a systematic and scalable manner.

Primary Equity Market
The primary segment of the capital markets in India has been witnessing a surge in activities driven by the strong fundamentals of the Indian economy, a buoyant secondary market, revival of structural reforms by the government, and an investor friendly framework provided by SEBI. In addition, sustained growth of the corporate sector and its increasing capital requirements have resulted in a record level of capital raising from the primary equity market in the present year.

The Indian equity markets have witnessed a strong rally since 2003 with the benchmark BSE Sensex crossing the 15,000 mark in July 2007 from 5,200 in September 2004 and 6,600 in January 2005 setting a new historical high. As in the case of the primary markets, the primary drivers for the record level of activity and in the secondary market have been strong economic growth and growing corporate profitability, leading to increased international and domestic investor interest. The turnover on both exchanges has increased significantly over the years, with derivatives (the Futures & Options Segment) constituting over 70% of total turnover.

Debt Markets
The Indian debt market is the third largest in Asia ex-Japan after China and Korea, with approximately USD 420 bn of securities outstanding. A large variety of instruments are available to investors, ranging from government bonds and T-bills to certificates of deposit, commercial paper and private-sector bonds. Issuers include the central government, the states of the Indian Union, private and public sector companies, and financial institutions.

However, outstanding Government of India bond issues in the local debt market are estimated to approximately USD 310 bn making up approximately 76% of the longer dated market; adding in public-sector entities this would increase the public share to 92%. The corporate bond market continues to lag behind the government debt market owing to problems such as non-availability of a trading platform, central clearing and settlement, stringent documentation requirements and secondary market volumes which continues to deter issuers from raising money via the bond route.

Accordingly, Indian debt capital markets such as investment grade and high yield debt, mortgage and asset backed securities, both onshore and offshore, have remained underdeveloped relative to the equity capital markets. Debt financing requirements of Indian corporates is primarily met by Indian banks and select International banks that participate in foreign currency international syndications. Large corporations are increasingly able to tap into the international debt capital markets in order to meet their borrowing and acquisition financing requirements. Banks have recently been growing their assets by 20-30% per annum, but given the lack of depth in the asset and mortgage based securities markets, banks are unable to effectively manage their capital and balance sheets by offloading risk. There are several reasons for the underdeveloped debt markets in India such as regulatory limitations, underdevelopment of infrastructure, high transaction costs, and a limited investor base. RBI has placed restrictions on borrowings by establishing limits on the amount and the rate at which corporations can borrow abroad. It is widely believed and recognised by various constituencies that the development of the Indian debt markets is necessary in order to meet the large funding requirements of the growing corporate and financial sector.

Investment Banking
With the strong growth in the economy, Indian companies have grown profits rapidly and have increased the scale of their operations. At the same time, their requirements for capital have increased as has their demand for increasingly sophisticated methods of funding, need for strategic advisory services related to mergers, acquisitions and restructurings, and need for risk management solutions.

Indian companies have been increasingly raising funds from both domestic and international equity and equity linked and international debt capital markets. In addition, the pace of private equity activity has accelerated over the past few years. As private equity investing in India has gained momentum, the size and nature of investments has also evolved, increasingly moving from smaller start-up and early stage funding to later stage growth capital investments. There has also been a significant increase in merger and acquisition (“M&A”) activity by Indian companies in recent years. This continuing increase is evident in the inbound, outbound and domestic segments.

Equity Brokerage
As the Indian capital markets continue to evolve, they are undergoing rapid consolidation driven by increased trading volumes, increased regulation, customer sophistication, availability of better technology and increased back-office requirements. As a result, significant changes have been introduced to strengthen risk management systems. Changes in the regulatory framework and settlement mechanics have resulted in smaller operating players losing market share, leading to consolidation in the industry.

The market share of the top five brokers on the NSE has increased from 12% in Fiscal 2004 to about 15% in Fiscal 2007. Similarly the market share of the top ten brokers on the NSE has grown from approximately 17% in Fiscal 2004 to 24% in Fiscal 2007. These figures indicate a long-term consolidation process in a highly fragmented securities brokerage industry, with number of smaller players exiting the market and the larger brokers gaining market shares.
Technology has been one of the key enablers of the consolidation that has taken place in the Indian broking industry. New technologies such as screen-based trading, electronic matching, and paperless securities have made the process of trading more convenient and streamlined. Better telecom connectivity and lower costs have made it possible to have large interconnected operations across multiple locations for centralised operations and effective risk management and control.

Asset Management
Growth in the asset management industry in India has been signified by two main factors, the growth in the primarily retail mutual fund business and the emergence of alternative asset management. From 1963 to 1987, Unit Trust of India was the only mutual fund operating in the country. It was set up in 1963 at the initiative of the government and RBI. From 1987 onwards, several other public sector mutual funds entered this sector and participation was finally opened up to the private sector in 1993. The mutual fund industry has experienced considerable growth since the last few years with total assets under management increasing from Rs 1,396,160 million as of March 31, 2004 to Rs. 3,263,880 million as of March 31, 2007. In recent years, the industry has witnessed consolidation in favour of private sector mutual funds with their assets under management growing from Rs. 1,049,920 million as of March 31, 2004 to Rs. 2,621,750 million as of March 31, 2007, accounting for over 80% market share of total assets. The fixed income asset class, which comprises income, liquid, gilt and money market schemes, comprises a major share of total funds under management. The other two asset classes, equity and balanced schemes, have experienced significant growth during 2004 and 2005 on account of the buoyant stock market. In the recent past, steps have been taken to improve governance practices in the industry, which have helped the growth of the industry.

Interest in India as an investment destination for alternative investors such as fund of funds, family offices, pension funds, and high net-worth individuals has resulted in increased allocation of investors’ money into alternative asset classes such as private equity, real estate, hedge funds, and art funds. This has resulted in the increased focus of several Indian financial institutions that have raised dedicated funds to fulfil the requirements of international investors that are focused on these asset classes. Interest in this sector continues to be strong given the performance of the Indian economy and the underlying assets classes.

Wealth Management
According to the World Wealth Report 2007, Real GDP and market capitalization growth rates, two primary drivers of wealth generation, accelerated throughout the calendar year 2006 — which helped to increase the total number of High Net Worth Individuals (“HNWI”) around the world as well as the amount of wealth they control.

Globally, the HNWI population grew by 8.3% in 2006, to a total of 9.5 million individuals. Singapore, India, Indonesia and Russia witnessed the highest growth in HNWI populations. HNWI population gains were particularly strong last year in Africa, the Middle East and Latin America, advancing by 12.5%, 11.9% and 10.2%, respectively, and outpacing more developed nations. These gains came amid these emerging markets’ attempts to solidify their infrastructures and become more developed economies. The following chart illustrates the growth of HNWIs in India from calendar year 2005 to calendar year 2006.

The BRIC nations (Brazil, Russia, India and China) are playing increasingly important roles in the global economy. Two of these four countries made their way onto the list of the 10 fastest-growing HNWI populations in 2006. The Organisation for Economic Co-operation and Development predicts continued growth for China, but sees a slowdown for Brazil and India. In 2006, the HNWI populations in the BRIC nations grew in number and accumulated wealth. China’s HNWI population, for example, grew by 7.8% in 2006, while India’s expanded by 20.5%. Meanwhile, India continued its strong expansion, with real GDP growth of 8.8% in 2006, thanks to increased private consumption — 9.1% in 2006, up from 6.6% in 2005 — and strong manufacturing and service sectors. Manufacturing led the way with 11.9% growth in 2006.

The NRI community is a key market segment. Successful NRI business owners and professionals are of great interest to wealth management institutions, as they tend to be global in outlook, savvy about the markets in which they live and well-informed about international affairs. Theirs is a close-knit community; members openly discuss investments and provide an excellent base for referrals. Almost all international private banks (and many domestic ones) have identified this rapidly growing segment’s need for specific products and services and have created practice models and advisor teams that specialize in servicing NRIs. Firms closely monitor changes in this community to continuously refine and enhance their NRI practices as they learn more about their client base and as the NRI community matures.

Insurance
The insurance sector in India is regulated by the Insurance Regulatory and Development Authority. In December 1999, the parliament passed the Insurance Regulatory and Development Authority Act, 1999 which opened the Indian insurance sector to foreign and private investors. The Act allows foreign equity participation in new insurance companies of up to 26.0% with a minimum paid-up equity capital of Rs.1.0 billion to carry out the business of life insurance or general insurance or Rs. 2.0 billion to carry out exclusively the business of reinsurance. Since then, various foreign and Indian private sector participants have targeted the market potential by providing a range of customized products. Major foreign insurance companies such as New York Life, Aviva, Tokio Marine, Allianz, Standard Life, Lombard, AIG and Sun Life, among others, have announced joint ventures in both life and non-life insurance areas.

Currently, there are 32 insurance companies in India, of which 16 are life insurance companies, 15 are general insurance companies and one is a re-insurance company. Of the 16 life insurance companies, 15 are in the private sector and one is in the public sector (Life Insurance Corporation of India). Of the 15 general insurance companies, nine are in the private sector and six (four associates of the General Insurance Corporation of India and its two subsidiaries, Export Credit Guarantee Corporation of India and the Agriculture Insurance Company of India) are in the public sector. The sole re-insurance company, General Insurance Corporation of India, is in the public sector.

Life Insurance Corporation of India, General Insurance Corporation of India and public sector general insurance companies also provide long-term financial assistance to the industrial sector. Gross premiums underwritten by all general insurance companies increased by 22.4% in fiscal 2007 to Rs. 250.0 billion, compared to an increase of 16.5% in fiscal 2006. First year premium underwritten in the life insurance sector recorded a growth of 100.6% to Rs. 754.1 billion in fiscal 2007 compared to a 40.6% growth in fiscal 2006.(All the above numbers have been taken from IRDA website)

Private Equity
The emergence of the Indian private equity (“PE”) and venture capital (“VC”) market dates back to 1996-1997 after which it rapidly scaled up in 2000 primarily driven by the Information Technology (“IT”), IT Enabled Services (“ITES”), Telecom and the Internet sectors. During 2001-2003, an element of risk aversion and decline in activity followed after the NASDAQ lost 60% of its value during the second quarter of 2000 and other public markets (including those in India) were also adversely impacted. Consequently, the VCs and PEs started investing less money and in more mature companies in an effort to minimize the risks.

With India’s economy growing at 7%-8% a year, investor interest has again renewed and an important feature of this resurgence has been an expanded focus on sectors beyond IT and ITES. The size and nature of investments has also evolved, increasingly moving from smaller start-up and early stage funding to larger-scale, later stage growth capital investments. India’s capital markets have benefited in recent years from the growth of the Indian economy, active secondary markets, structural reforms by the Indian government and an investor-friendly regulatory framework.

The increasing market capitalisation of small and mid cap companies in recent times reiterates investment potential in emerging companies and new ventures, as also the vibrant value-creating entrepreneurial culture in India, which presents significant opportunities for PE, VC and alternate asset managers.

Industry Outlook
The has been considerable broadening and deepening of the Indian financial markets due to various financial market reforms undertaken by the regulators, the introduction of innovative financial instruments in recent years and the entry of sophisticated domestic and international players. Strong economic growth, favourable demographics, increased geographic penetration, growth of small and medium enterprises and the increasing needs for capital among Indian corporations are expected to continue to drive India’s financial services industry.

Source: RHP of Edelweiss Capital Limited