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Crouching tigers

Crouching tigers

Source: Chris Skinner, TowerGroup

In the first of a two-part report, Chris Skinner takes an in-depth look at the emerging Indian and Chinese banking markets.

For the past few years, everyone has been talking about the powerhouse economies of India and China and, more recently, Brazil and Russia. It is not surprising that such discussions became the norm when the next billion consumers will arise out of these economies, with affluence to match those of Americans and Europeans.

The real interest in the Bric economies – Brazil, Russia, India and China – arose from a Goldman Sachs research report published in October 2003 entitled “Dreaming with Brics: The Path to 2050” (see Global Economics Paper No. 99).

In this report, researchers at Goldman Sachs forecast that by 2040 the Bric economies would have a greater GDP than the G7, would be the main sector of growth for the next 45 years at an average 8% per annum and that, by 2050, only the USA and Japan would remain in the G6, with the Brics displacing Germany, the UK, France and Italy. The implications for the European Union appear to be grave.

The story of each economy is very different, with Brazil and Russia showing a contrasting form of growth to that seen in India and China. There is a strong relationship between the four economies however, with the ever increasing global expansion of China as a manufacturing economy and India as a services economy placing strong demand for supply of resources from Russia’s energy supplies and Brazil’s natural resources. As a result, increasing demand for Chinese products and India’s services fuels growth in Russia and Brazil.

For these reasons, the world’s eyes are on India and China, and one of the big things holding back these two economies is their banking and financial markets, or lack of them.

This is the first of two reports which reviews these two Asian tiger economies, and begins with a brief tour of the state of India’s banking. Next month, we will move on to look at China.

India services the world

India's economic success story dates back to the 1980s, when the government began investing in a critical program of education, focused upon technology and language skills. This educational program has enabled India’s educated population to become English-speaking programmers and support providers to overseas operators and the good news is that India can keep up this phenomenal growth thanks to a population that is young, educated and growing.

The over one billion people who live in India are replenishing at a rate of 2.73 children per woman – compared to only 1.28 in Russia – with over 130 million new workers joining the Indian economy during the 2000’s: a number equivalent to the workforces of Australia, Canada, Mexico, Poland, South Africa and the United Kingdom combined .

Not only are seven out of ten people under the age of 36, but they are also increasingly well educated. For the last twenty years, India’s educational program has achieved a population of 40 million graduate level citizens, 80 million achieving secondary education and nearly 150 million making it through primary education. On the other hand, two out of every five Indian citizens are still illiterate and a third live on less than a dollar a day. The challenge then is to achieve 100% literary, which is the firm target on the government’s agenda.

For example, successive Indian governments have increased investment in education consistently since the 1950s, with almost 4% of GDP placed into education since the late 1980s. This change of focus is evidenced by the fact that although two-thirds of India’s over 50 year olds are illiterate, only a quarter of under 18 year olds are. Therefore, India’s educational reforms and focus upon globalized services has been a significant success factor in their ability to achieve sustainable economic growth.

This is not to say that India relies purely upon services for its success, in that food production represents almost $70 billion of output every year and makes India one of the largest food producing nations in the world just behind China. But India is known for services due to the extraordinary success of its technology and call centre service industries, and it is these industries that can thank the educational and governmental reforms of the 1980s and 1990s.

In retrospect, these reforms were particularly visionary in terms of investments in technology and languages, as the 1990s saw the fuel of growth being delivered through globalised services via the Internet. The Internet boom allowed for the delivery of remote services which naturally relocated to India due to the cost savings. As a result, India has become the servicing operation to the world, with over three-quarters of global IT sourcing located in the country and most of the world’s most recognised brands locating operations there, including American Express, Microsoft, General Motors, Sony, Coca-cola, Philips, Wal-Mart, General Electric, Reebok, Boeing, IBM and so on.

The growth of India’s services has been particularly noticeable in the financial community. TowerGroup estimate that total spending on offshore outsourcing amongst the world’s financial institutions is rising from around $1.5 billion in 2004 to almost $4 billion in 2008, with India taking around 40% of that spend, or nearly $2 billion a year from the financial community alone. Nevertheless, financial services is not the only industry India serves, with services exports up by 71% in 2004-05 to $46 billion, of which software services represented $17.2 billion.
All of this is good news for banking, with consumer’s personal disposable income surging 42% between 1999 and 2003, over 15 million credit cards issued, and four out of every five cars sold through loans. But the news isn't all good.

India’s banking: run by civil servants

India’s banks have been fairly well protected from reform during this period, primarily due to governmental concerns over foreign ownership. Although government controls on foreign trade and investment, have been reduced in some areas, such as civil aviation, telecom, and construction, most other areas are still subject to high tariffs. These tariffs were running at around 20% on average for non-agricultural items in 2004, and severe limits on foreign direct investment (FDI) are still in place.

In banking terms, these restrictions are potentially constraining India’s competitiveness. 80% of India’s banking system is government owned following nationalization in 1969 to bring banking to the masses. The recent developments in private sector banks still only has a few names which stand out, such as HDFC Bank and ICICI Bank.

Of particular note is the fact that the central bank, the Reserve Bank of India (RBI), takes an active role in protecting India’s banking system from being open to full competitive forces. For example, RBI recently attempted to restrict the operations of a new PayPal style service set up by the India Times,, by enforcing Know Your Customer rules. These strict rulings severely hinder the convenience of the service, which is the whole point of providing an online wallet. Equally, RBI forced the new chief executive for HSBC India, Naina Lal Kidwai, to relinquish her non-executive directorship at Nestle because it broke strict guidelines for corporate governance, even though such guidelines would not apply to a bank executive in other regions.

For foreign banks, RBI’s activities create a major barrier to effective entry. First, there are domestic restrictions such as the requirement that any bank must prioritise that 40% of all loans and advances go into agriculture and small business, the so called ‘priority sectors’, and that 25% of bank branches be located in rural or semi-urban areas which are typically the least profitable. RBI also limits foreign ownership in private sector banks to a maximum five percent although, under government pressure, this may be changing. For example, in March 2006, RBI allowed the first foreign institution allowed to increase its investment in a private sector bank, to more than five percent, with Warburg Pincus taking a ten percent in Kotak Mahindra Bank.

Without such change India faces significant issues, as the government wants to open financial markets to more foreign ownership in order to increase capital flow. Government representatives have openly discussed financial reforms and want to achieve further liberalisation by 2009. As part of this liberalisation, they recently announced that foreign investment in domestic banks should be able to increase by up to ten percent per annum to a maximum 74 percent. The reason the government needs this to happen is that India has a shortage of capital and capital markets.

The total value of India’s financial assets including bank deposits, equities and debt securities in 2004 amounted to $900 billion. China has five times that capitalisation, with forecasters estimating that China’s stock will achieve $9 trillion by 2010, whilst India will reside at $2 trillion.

The major reason for this constraint is that India’s citizens do not trust banks. The culture of India’s citizens is to trust assets, and so most savings are ploughed into cattle, housing and gold, rather than into banking deposits and investment accounts. That is why India has the largest consumer economy for gold in the world. India’s people bought $10 billion worth of gold last year, twice the FDI in India, whilst owning over $200 billion of gold overall, equivalent to about half of the country’s total bank deposits.

It is this trust in physical assets that explains why only 40% of India’s citizens are borrowers or depositors and, as a nation, why India is one of the weakest in terms of borrowings. India’s mortgage debt totalled only two percent of GDP in 2002, compared with eight percent of GDP in China. Meanwhile, the collapse of Global Trust Bank (GTB) in 2004, one of the larger private sector banks created during the 1990’s, still reverberates in the minds of Indian consumers.

This causes India a major dilemma as, on the one hand, the central bank ‘owns’ the government debt and therefore can tell the politicians the way to go forward; on the other, the government needs to maintain economic growth of eight percent or more if India’s success story is to continue and this cannot be achieved if markets are artificially controlled and protected from free trade.

The arguments between the central bank and the government, along with the cultural mismatch between India’s citizens and their banks, will need to be resolved if India is to succeed in maintaining momentum.

India: the future is still bright

One of the biggest impacts India will have on world banking will not stem from today's domestic challenges, but from its ability to adapt and develop new services tomorrow.

As mentioned, India today controls three-quarters of the world’s IT sourcing. India’s National Association of Software and Service Companies (NASSCOM) states that 80 of the 117 software firms worldwide attaining the highest quality standards for software development are from India. This is substantiated by the fact that the major standard IT firms are measured by is the Capability Maturity Model (CMM).

CMM has five levels, with the highest level – level 5 – assigned to recognise those firms who optimize software development standards, rather than just using them. Three quarters of the CMM level 5 software centres are in India. This is why India has spawned so many development centres for banking; software solutions firms for bank systems, including i-flex, Infosys and Temenos; and outsourcing and consulting firms in bank services, such as Wipro, Tata and Cognizant.

The result is that India’s IT sector has been growing faster than most other sectors at a CAGR of over 30% since 2000, with India boasting over a quarter of the best IT systems sourcing talent on the planet.

This may sound fairly pedestrian insofar as yes, we all know that India has great success with IT and outsourcing. However, we may not all know the likely consequences of this expansion.

For example, many of India’s graduates over the last fifteen years have left their homes in Mumbai, Chennai and Delhi to live in Memphis, Charlotte and Detroit. As India’s expatriates have grown in stature and experience, they have been charged with more and more sourcing responsibilities and experience. The result is that many of these executives are more experienced in global sourcing than any others, and are now returning to Mumbai, Chennai and Delhi to return their knowledge to their home base. This is a natural move for many, as India’s wealth and quality of living increases to match the expectations for living standards which these executives hoped to achieve when moving overseas in the first instance.

The extrapolation of this movement is that, in around fifteen years, India will be teaching the world the management of operations. Some see this as an extreme but the logic is based firmly upon a similar revolution in management techniques seen during the 1950’s when the Total Quality Management (TQM) and Just-In-Time Processing (JIT) revolution came out of Japan. That revolution was created by Dr. William Edwards Deming.

Deming was invited to Japan at the end of Second World War to advise Japanese leaders as to how to change the perception that Japan produced cheap, shoddy goods to one of producing innovative quality products. A statistician, he introduced a range of techniques, including quality processes and JIT, which achieved that result over a period of years and was known as “Deming’s 14 Point Plan”.

Japan not only listened to Deming’s plan, but regimentally adopted it. By the 1970’s, Japan was not just producing good quality products from cameras to cars, but with minimal stock and inventory control. The improvements in efficiency soon fuelled an economic boom that lasted twenty years and led to Japan becoming the world’s second largest economy behind America.

This is the phenomena that many see occurring in India today. Just as Deming created a manufacturing revolution in Japan, global sourcing is creating a management revolution in India.

This revolution follows a number of phases, some of which were outlined earlier in this article, which lead to a natural conclusion.

The first phase is a cultural revolution inspired by government educational reform policies during the 1980’s to make India become a global competitor.

The second phase is a global revolution as corporations relocate operations globally through new technological changes. The result is that India becomes the leading centre for systems developments, services and operations.

The third phase involves learning how to integrate the competencies of sourcing across financial operations. There are three distinct competencies involved:

(a) how to source – insource, cosource or outsource – a combination referred to as rightsourcing;
(b) where to source – locally, nationally, internationally, nearshore, onshore or offshore; and
(c) when to source – front office, back office, commodity, strategy, product, service, channel.

The decisions involved in deconstructing bank processes and then reconstructing in a seamlessly integrated global structure is the demanding role of today’s sourcing leaders. And the leading proponents with these skills are Indian.

The fourth phase therefore is to use this experience and leadership to innovate the management and leadership of banking. This is India’s potential – to reinvent banking based upon leadership in global sourcing techniques – and, regardless of India’s domestic banking structure, is the likely major conclusion from India’s IT services operations over the next decade. Should India decide to leverage that leadership domestically however, as in to use the repatriated skills returning to the country over the next ten years, then that experience could be used to enable India’s banks to become the world’s most competitive banks.

The strategy for India – whether to export skills for bank structures or retain the leadership internally – will be one of the most fascinating aspects of India’s developments in financial services over the next decade.

Chris Skinner is a director of TowerGroup and founder of Balatro.
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Author's email: Chris Skinner

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