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Financials, Consumers To Grow At The Expense Of Export-Led Sectors, Says Ridham Desai

India will grow faster than the global economy over the next 10 years, Morgan Stanley says



Customers walk past clothes on display at a Big Bazaar hypermarket, operated by Future Retail (Photographer: Dhiraj Singh/Bloomberg)
Customers walk past clothes on display at a Big Bazaar hypermarket, operated by Future Retail (Photographer: Dhiraj Singh/Bloomberg)

The Indian economy will likely be the third-largest in the world with a gross domestic product of $6 trillion by 2027. In that period, the benchmark BSE Sensex could reach the 1,30,000 mark. These are some of the projections made by the Morgan Stanley Research team for India.

Over the next decade, domestic-led sectors such as financials and consumers will grow at the expense of external-facing sectors such as software services and pharmaceuticals as India grows at a faster pace than the global economy, Ridham Desai, head of India equity research and managing director at the global investment bank told BloombergQuint in an interview.

This gain of market cap for consumer stocks and financials will come at the expense of exports.
Ridham Desai, Head-India Equity Research And Managing Director, Morgan Stanley

Here are edited excerpts from the conversation.

Audacious Forecast?

In this day and age when people find it so difficult to make even near or medium-term calls, what made you make the 10-year call?

It is easier to make a 10-year call than tomorrow’s call. It is not an audacious forecast. When you look at the $6 trillion forecast, we are already at $2.2 trillion, heading to $2.4 trillion. So, $6 trillion is 11 percent normal growth and that’s less that what we have delivered in the last 15-20 years. Yes, growth has to slow down now because our base is high.

When you look at the Sensex, 1,30,000 is actually the bull case. The base case is 1,00,000. That’s the tripling of the Sensex in 10 years. 

It about 11 percent compounded annual growth rate. The 20-year CAGR is 17 percent, I am actually calling for substantial slowdown in returns. Again, fairly consistent with inflation and macro conditions. None of these returns should be seen without context of the world. The world is also coming out of a very high-return period. The last 30 years have been very good for equities. The next 30 years may not be because the world is aging. So, India’s return will also reflect that slowdown in global equity returns. They look audacious because of these big headline numbers but the underlying logic is not that out of line with some rational expectations.

The report has more granular data on who is buying what in the economy and who is spending where in the economy and who is paying how much tax and it boils down to a bigger lending economy because banks and lenders have better data and consumers have ability to borrow more. All of these have a multiplier effects. Is that the central pillar of the report?

Yes. When you look at it in layman terms, borrowing is essentially bringing forward your future. You take your current income multiplied by a factor and you spend it. So, you spend your future income and you will spend rest of the 10 years repaying that debt. That’s how the American economy or the overall western economy or more importantly Chinese economy which registered those growth rates. For U.S., it was between 1980 and 2000, and for China it is the last 10-15 years. There is a substantial increase in debt.

But for India, there were two impediments. First was cultural which is that a lot of Indians don’t like to take debt at the individual level. And the second was the banking system and the way it did its lending. So, the first thing is now being overcome. That’s got nothing to do with Digital India but it is just a shift in culture. Maybe you and I have not borrowed money, but the 20-30 year olds in this studio may be borrowing money and looking to spend their future income and enjoy its fruits today. So, that culture shift is happening. You can see that in growth of personal loans is running into mid-teens. It’s not coming out of the availability of data but it is the cultural shift. The banks are capitalising on it.

The second bit is on how banks did the lending. Hitherto, banks did the lending by providing a loan against collateral. So you put a collateral on the table, they value the asset and give the loan. It was not cash flow based. The western world moved to cash flow-based lending a while back and in India we couldn’t. Primarily, because there was not enough data available and also because a lot of macro enterprises in India didn’t pay taxes, so you couldn’t rely on their claims and their finances. That will all change with GST. The thing that is forgotten with the GST, especially when there are a few issues around GST, is that it is a fully online platform. All the filings that you make can be forwarded.

If you can make any, that is...

We have got 9 million enterprises that are GST registered. There are bound to be teething problems. I have revisited what we had written in May and June , we were expecting things to be worse than what it is today. In fact, it is smoother than what the general expectations was. The Indian stock market has underperformed since April among emerging markets even though we are higher absolute terms. China is up 41 percent and India is up 20 percent. It has underperformed largely because the markets were expecting GST to produce near-term growth pangs. So, the actual rollout is smother than expected. We think that it will persist for few months before things smoothen out.

When the [GST] data gets available, and it will take a few quarters for the data to be available, that will provide for the first time in India’s history banks’ ability to lend on cash flows.

When you take collateral out of the equation, you can take that credit down the revenue and profit curve of enterprises. So, the top 20-25 thousand firms in India were the bulk of bank credit. Now you can take that down to the 9 millionth firm in the country. Imagine, what revolution that will create.

India’s Changing Economic Structure

How much of the expansion in the financial credit sector is supported by savings in any way? What does it say about the structure of the economy 10 years from now? We’ve seen the U.S. pay a pretty heavy price of consumerism or capitalism. Will the structure of our economy will be different?

That’s the best question I’ve been asked since the report was published. Very few people are looking at the other side of the balance sheet because a lot of it is at the liability side but the revolution is happening from the asset side in India. It is already underway, with or without digitisation because there is a big shift happening there. It is coming out of cumulative change in regulations.

Indian stock market was faced with back-to-back scandals. From 1992, we had a blow-up every couple of years. It took time for SEBI to get settled in. It was formed only in 1994. It took 5-7 years for them to understand the Indian market and to get rid of the archaic systems which were prevalent and to make the whole thing electronic. It went electronic only in 2002. So, that’s only 15 years ago. It is not long time ago that we had these regulations come in.

It takes time but the cumulative effect of this regulation change, as well as a lot of money and time spent on educating investors, is that finally people in India had got the joke, which is, if you want to invest or save for the long run then you have to save in financial assets. Even better - save it in equities. So, we are seeing the tumultuous shift from household balance sheet. The household balance sheet in India has got $1.7 trillion of gold and $350 billion of equities. I don’t think there is any place on the planet where household owns 4 times the gold than they own stocks. This country has got such ownership of gold, which yields nothing to you, it costs a lot of money to store and it just sits in your vault waiting for the price to appreciate.

Compare that to a financial asset, which is an yielding asset, including equities and which grows on underlying cash flows of enterprises. It is very different. So, that revolution is only happening now. People look at the month before last, that the domestic mutual fund is $4 billion and say, “Oh my God! This is the bubble”. But the point we are making is we are just about starting now because we are making that shift today and that is the big deal here. Digitisation will give further push to the shift of household balance sheets. On the liability side it is greater lending, but at the asset side it is more financial savings. It is good news for capital productivity in the country because we are used to saving in non-productive assets like gold, and now we are saving in financial assets which can be converted into something which can yield output, jobs which then fuel income and further savings, consumption. This is the virtual cycle. We are just starting that.

Will we still run a current account deficit?

I think we will run a current account deficit unlike China which ran a current account surplus and then it was such a rise in savings that they couldn’t keep investment rates at that level. India’ s investment rate will remain higher than savings rate which will translate into a mild current account deficit.

Winners and Losers

You mention that it could be $6 trillion market cap by 2027. Financials and consumers will be $2 trillion a piece which leave the remaining $2 trillion for a bunch of heavyweight sectors as of now. What, from now until then, underperforms to be part of the remaining $2 trillion club?

It’s the external facing sectors because the likelihood is that the world will grow slower than India. Therefore, anyone relying on the global market place to drive their earning will have a lower growth. Software service and pharmaceuticals fit the bill. Materials, energy will be more cyclical and therefore may not create the same wealth as domestic consumption financials.

This gain of market cap for consumer stocks and financials will come at the expense of exports.

You were one of the few people who expected software services to make a comeback. Selectively, they have. Overall they haven’t . Do you reckon that over the next one year to the next 10 years they will stay underperformers over others.

For the past few months, it has been a spectacularly poor call. Software has underperformed compared to my expectations. It did not bounce back. Of course, there will be a period where software and pharmaceuticals will do well. We could be entering such a period now because the sectors have now got so badly hurt. You always get those trades but they remain as trades rather than compounders. The compounders will be consumers and financials and you will keep getting trades in it. For example, materials. It is the best performing sector today. You can get this in the next 10 years. But will they be compounders? It’s unlikely.

You were clearly shying away from PSU lenders in a big way. If at all, some mid-size or small sized players among private sector financials are finding their space over a 10-year period.

Public sector banks today account for 70 percent of the system versus 100 percent 15 years ago. They have lost 30 percent market share. We think that they will lose market share at the rate of about 3-4 percent per year over next 10 years. So their market share will decline to half of what it is currently. All that is available for the private sector to gain. It’s a no-brainer for the private sector.

It is happening because fundamentally it looks like public sector banks will not get enough capital to grow. They will get capital to back stop any problem, so they will not be a failure. We will enter 2019, when Basel III requirements are to be met, with most of the public sector banks at 6.5 percent Tier 1, which is the minimum capital requirement for them to survive. Just a handful of them could have more than what is required to grow.

There is a philosophical shift that has happened. No longer are we pumping taxpayers’ money into public sector banks to grow them. They have not proven to be an efficient way of dispersing capital in this country and that’s probably the call that government has made. So, public sector banks, as a group, will end up losing the share. There can be 1 or 2 exceptions but as a group they will end up losing share.

It is very similar to what happened to telecom sector in the late 90s. We privatised the sector rather than privatising the public sector companies. We are seeing similar things which has been going on for a decade now but probably continues for the next decade, which is privatising the banking sector rather than the public sector banks. Ideally, we should have privatised the banks but there are constraints around it. So, that not happened.

NBFCs and some of the private banks are buying into the story of cash flow based lending, analytics in a big way but there is a fear that this is not been tested in a downcycle...

Let’s at least get an upcycle first. Of course, there will be problems in the downcycle. That’s how thing happen.

Do you think that regulatorily they are strongly looked at?

All my conversations with the RBI suggest that they are keeping a keen eye on what’s happening. We should not be worried about that. Will there be a downcycle. Of course, there will be one. But first the upcycle has to come which will happen in the first five of the next 10 years and then the downcycle will come. Which is why I have said in the market forecast that 1,00,000 is not coming in 10 years but in 5 years.

Of all the companies that you have listed among pure consumer plays, why have you picked ITC?

Let me explain the consumption theme for a moment. Today, 60 percent of the India’s consumption is food. Because we are a poor country, 400 million Indians don’t get a econd meal to eat, so we are very poor. So we spend bulk of our money on food.

As incomes grow, in the report we have cited that our per capita income grows from $1700 to $4100. That puts us in the high middle-income category. When you become high middle-income category, your food basket stocks grow because there is only that much food were every individual can eat. So the possibility is that the share of food drops. So think about it mathematically. If Rs 100 is what you spend on consumption today, Rs 60 is food and Rs 40 is non-food. If food stops growing, when Rs 100 goes to Rs 110, then Rs 40 is grown by 25 percent.

All stock calls have to have two things in it. One is the fundamental story and the second and most important thing is the price you are paying for that business. So, you got to have a valuation framework. If you buy stocks which are trading at very rich valuations, they may do well fundamentally but they will not make money on those stocks. Because at the end of the day, I cannot get tired of reminding the people that we don’t buy companies but we buy stocks.

Do you think the Indian auto companies will survive the electric vehicles onslaught?

A lot of Indian companies are preparing for EV. EV will be a separate debate but it is a very interesting situation and it goes beyond autos. Think about the entire ecosystem that is affected by EVs. Autos is very small part of it. You have auto parts, refiners, distribution companies, electricity companies, real estate companies, it is a very long list of the sectors which are affected by the simple move of taking India’s automobile industry to EV.

OMCs have been the heroes of last three years. Is that industry under a cloud because of electric vehicles over a five-year call?

Not yet, I think. Five years is too small a time frame for EV to evolve. The U.S. is talking 20 percent by 2030, incremental sales from EV. So, we are not talking about five years but a much longer time frame. It will be a few decades before we move completely to EV. The OMC story has been more about removing government intervention and releasing their real return on capital. So, they were depressed, they were subsidising the Indian public, and now they have ceased to do that, the returns have gone on their balance sheets. I think that’s the story, which is very well understood now.

None of your stock picks suggest that you expect the infrastructure story to come back?

Infrastructure is going to be crucial in the next five years. I will opine that it will lead India’s capex. Already infrastructure spending has exceeded the previous high. Quietly. We are at 9.5 percent of GDP, the previous high was 9.4 percent. We have exceeded the previous high. This year it may go to double-digit spending.

China did double-digit infrastructure spending for 10 years on the trot. We will do it for the first time in our history next year. We will get a five years of double digit infrastructure spending. That’s certainly a story.

It’s not part of the digitisation story. The other struggle is identifying stocks. So, it’s a motley group of companies that operate in the infrastructure sector. I need some brand new stuff out there to get listed.

Do you think it’s miles to go for the insurance sector?

Insurance will be more popular, penetration will rise meaningfully in next 10-15 years, so lot of this companies will do well.

Watch the full interview here.