the indian economy 20 20 mc kinsey

Perspectives on the Indian Economy and the Financial Sector

This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion.

Renny Thomas, Partner McKinsey & CompanyOctober 2007

1

•Perspectives on Indian Economy

– Context of Indian economy

– Forces likely to propel India ahead

– Challenges for the growth

CONTENTS

Perspectives on Indian Financial Sector

2

* Base year = 2002Source: Global Insight; Economic Survey of India; Team Analysis

Real GDP growth*

US$ billion

60118

279

464

709

1950 1970 1990 2000 2006Population (Million) 365 548 850 1,016 1,112

Average growth rate of 8.6% over the last 4 years

INDIA’s GDP HAS RISEN STEADILY SINCE THE 1950’s. . .

3.4%

4.4%

5.2%

7.3%

3

Source: RBI; EIU

Per cent

0

1

2

3

4

5

6

7

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

AS GROWTH HAS INCREASED VOLATILITY HAS DECREASED

10-year volatility of GDP growth

10-year mean growth

4

37.0

18.0

24.0

27.0

39.055.0

Agriculture

Industry*

Value added to GDP (Per cent)

Services**

29.0

10.0

46.0

50.0

25.040.0

ChinaIndia

AND TRANSFORMED INDIA FROM AN AGRARIAN TO A SERVICES-LED ECONOMY

* Industry includes Mining, Manufacturing, Electricity ,Gas & Water and Construction **Services includes Whole & retail Trade, Restaurants & Hotels, Transportation & Communications, Finance, Insurance, Real Estate & Business Services and Community, Social & Personal Services

Source: Global Insight; Team Analysis

1980 2006 1980 2005

5

High LowSEVERAL MEGA INFRASTRUCTURE PROJECTS ARE SET TO CHANGE THE LANDSCAPE

* Government Flagship ProgrammesSource: Economist; Press-articles; Government Budget Speech 2006-07; Analyst Reports; Team Analysis

Planned spending (timeframe)US$ billion

ProjectLikelihood of completion

2 (2006-07)

4 (2010)

1 (2006-07)

2 (2006-07)

1.1 (2006-07)

1.1 (2006-07)

0.2 (2006-07)

3.2 (2006-07)

0.9 (2006-07)

National Rural Health Mission*

Details

• Providing basic healthcare services to the rural population

• Upgrading Delhi’s infrastructure in preparation for games

• Developing urban infrastructure and providing basic services to the urban poor in ~ 63 cities

• Extending primary education to all children, especially in rural India

• Providing free mid-day meals to all children in government, corporation, panchayat and municipal schools

• Supplying safe drinking water in the rural areas

• Extending sanitary facilities in rural India

• Providing income security to the poor and bridging the rural poverty gap

• Improving the nutritional and health status of children in the age group of 0-6 years and reducing the incidence of infant mortality

National Urban Renewal Mission*

Sarva Shiksha Abhiyan*

National Rural Employment Guarantee Scheme*

Mid-day Meal Scheme*

Rajiv Gandhi Drinking Water Mission*

Total Sanitation Campaign*

Integrated Child Development Services*

Commonwealth Games 2010

6





CONTENTS


7

Source: Global Insight; Team Analysis

58%

60%

62%

64%

66%

68%

70%

72%

2000 2005 2010 2015 2020 2025 2030 2035 2040

Brazil

Per cent of total population

China

RussiaG6

India

A GROWING WORKING AGE POPULATION WILL PROPEL GROWTH TILL 2035 LATER THAN CHINA

Working age population (age 15-60)

5.5

4.0

3.7

2.8

- Average no. of people per household in 2007

8

HOUSEHOLD INCOMES WILL ACCELERATE ACROSS INDIA

0

100

200

300

400

500

1985 1990 1995 2000 2005 2010 2015 2020 2025

Rural

Urban

5.8%

3.6%

All India

5.3%

4.6%

2.8%

3.6%

Actual Forecast

1985-20052005-2025

Compound annual growth rates

Average household disposable income

Thousand; Indian rupees; 2000

Source: McKinsey Global Institute

9

THE SHAPE OF INDIA’s INCOME PYRAMID WILL CHANGE DRAMATICALLY AS INCOMES GROW

• Middle class to swell from just under 50 million today to about 583 million by 2025

• By 2025, India will produce 2 million globals annually

• Share of incomes of the middle class and globalswill rise from less than 30% today to more than 80% by 2025

Strivers (500–1,000)Seekers (200–500)

Aspirers (90–200)

Deprived (<90)

Globals (>1,000) 1.2

10.9

91.3

101.1

2.4

Number of householdsMillion

Household income bracketsThousand, Indian rupees, 2000

Aggregate consumptionTrillion, Indian rupees, 2000

1.2

2.1

8.5

4.1

1.0


Aspirers (90–200)

Deprived (<90)

Globals (>1,000) 3.3

55.1

106.0

74.1

5.5 4.1

11.8

12.2

3.3

2.7


Aspirers (90–200)

Deprived (<90)

Globals (>1,000) 9.5

94.9

93.1

49.9

33.1 14.1

24.6

11.9

2.4

16.5

2005

2015

2025

Source: MGI India Consumer Demand Model, v1.0

10

CURRENT PLANS REVEAL ASPIRATIONS TO SPEND OVER ~US$585 BILLION DURING 2007-12 (1/2)

AreaExpected spend US$ billion

Key projects

• Six-laning of 6,500 kms and four-laning ~18,000 kms of corridors and highways

• Dedicated Freight Corridors between Mumbai-Delhi and Ludhiana-Kolkatta, ~10,300 kms of new railway lines; modernisation of 21 railway stations

• Additional generation capacity of ~70,000 MW (includes rural areas)

• Capacity addition of 485 million MT in major Ports; 345 million MT in minor Ports

• Modernisation and redevelopment of 4 metro and 35 non-metro airports

• Construction of 7 green-field airports in North East

96

73

177

21

10

Roads

Railways

Power (generation, transmission, and distribution)

Ports

Airports

Source: Planning commission;

11

585Total

CURRENT PLANS REVEAL ASPIRATIONS TO SPEND OVER ~US$585 BILLION DURING 2007-12 (2/2)

• Growing subscriber base to 600 million, including 200 million rural telephone connections

• Providing broadband access to 20 million and 40 million internet connections

• Water supply and sanitation projects

• Developing 16 million hectares through major, medium and minor irrigation works

• Gas distribution infrastructure– LNG terminals, gas transmission lines, city gas

distribution

77

57

62

6

Communi-cation

Water

Irrigation

Gas

Storage • Storage to support agricultural development

6

AreaExpected spend US$ billion

Key projects

Source: Planning commission;

12

* As on 14 Sep 2007 ** As on year end *** Not all deals mentioned disclose deal financials. Deal values are the sum of only those deals where financials were publicly announced (90 deals in 2006 and 87 deals in 2007)

Source: Press articles; CMIE; Dealogic; Prowess; Team Analysis

Number of billion dollar companies

Local corporates expanding overseas

Spurt in number of cross-border deals by Indian companies

2006 2007*Deals # 163 143Value $23 bn $18 bn

A ROBUST AND HIGH-GROWTH PRIVATE SECTOR CONTINUES TO BOOST CONFIDENCE LEVELS

21

446

30

95

US$2-5 bn

US$1-2 bn

1432

1998

88

2007

>US$10 bnUS$5-10 bn

175% increase

Some success stories

• India's largest automobile company, with revenues of US$6.9 billion 2006-07

• World's fifth largest medium and heavy commercial vehicle manufacturer

• Current market cap of US$6.6 billion

• Incorporated in 1995, world's 5th leading & Asia's leading manufacturer of wind turbines

• Current sales of US$1.7 billion and market cap of US$9.8 billion

• Became a bank in 2000; 2nd largest bank in India today

• 30-50% market share across classes• Current market cap* US$24 billion• (US$0.6 billion in 2000**)

The transformation

13

* Number of deals for calendar year 2000, and till Sep 2007** Average deal size is based on deals for which the values has been disclosed

*** As on 13 September, 2007Source: Dealogic; Team Analysis

INDIAN COMPANIES ARE AGGRESSIVELY ESTABLISHING GLOBAL FOOTPRINT

Average Deal Size**

Number of Deals*

The recent spurt in outward FDI is caused by:• Regulatory changes:

Indian companies can now make overseas investments equal to 300% of their net worth on an automatic approval basis

• Easy access to capital

– Decline in interest rates coupled with liberal lending policies adopted by banks

– Active participation by PE firms – Nearly 20% of the deals were backed by private funds in 2006

Cross-border M&A by Indian companies

50

143

0

50

100

150

200

250

2000 2007***0

50

100

150

200

250

300

350

14

^ 2007: As on Sep 2007*Includes all completed deals even where deal value is not available

** Includes Finance, Insurance, Leisure & Recreation, Professional Services, Healthcare, Transportation and Publishing*** Includes Chemicals, Machinery, Auto / Truck, Consumer Products, Textile and Food & Beverage Manufacturing

Source: Dealogic; Press articles; Company website; Team Analysis

No. of Deals*

Acquisitions of Indian companies by MNCs

4

10

13

35

22

16

Manufacturing***

Services**

Cons-truction

Hi-Tech

Telecom

110166 195 301131 250

SIMILARLY, MNCs ARE ACTIVELY SEEKING THE INDIA OPPORTUNITY…

3.030

2002

2.268

2003

2.502

2004

5.748

2005

10.969

2006

27.442

2007^

ValueUS$ billion

Others

Per cent of Total Deal Value, 2007^Break-up by sector

15

THERE ARE 7 MANTRAS FOR SUCCESS IN INDIA…

Source: McKinsey team analysis

Strong India Commitment and local team

Leverage India’s resources for global requirements

Create & Shape the Market Redesign supply chain to profitably deliver value

Acquire if necessary, but re-assess cost of capital

Actively shape and manage perception and regulation

1

2

3

5

6

7

Indianise product and get the price-value equation right4

16

• 11th largest economy today (GDP US$560 billion)• 4th largest by 2025 (GDP US$3,200 billion, six-fold increase)

0123456789

2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

* Major world economies considered are the BRIC and G6 countries Source: Goldman Sachs BRIC report 2003

2.15.0

20.1

2000 2020 2050

Per cent

Real GDP growth (Per cent)

IndiaChina

Brazil

Russia

IN SUMMARY, INDIA IS ON COURSE TO BE AN ECONOMIC SUPER POWER OF THE 21ST CENTURY

India – will contribute a giant share of the incremental GDP growth of major world economies*Fastest growing global

economy by 2012

India – most rapid growth potential of the BRICs

17

* Base year: 2002Source: Global Insight; Team Analysis

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1980 1985 1990 1995 2000 2005 2010

ChinaCAGR = 10.1%(1990-2005)

India 1990-2005 CAGR = 5.98%

“Lead indicators”of inflection

visible in India

“Lead indicators”of inflection

visible in India

1978: China liberalizes

1992: India liberalizes

Inflection in China GDP

Inflection scenario

Conservative growth estimates

• Taxes: Laws simplified resulting in better compliance and ease of tax payment

• Infrastructure: Increased investment in infrastructure e.g., Ultra Mega Power Projects

• Liberalisation: FDI in key sectors like airports, NBFCs, Insurance, electrical equipments, telecommunications, construction etc allowed

US$ billion

AND GROWTH IN INDIA IS AT AN INFLECTION POINT, SIMILAR TO CHINA 15 YEARS AGO

Triggers behind growth inflection in IndiaReal GDP growth PPP adjusted*

18





CONTENTS


19

THERE ARE CHALLENGES THAT COULD DETER GROWTH

Source: Team Analysis

Risks (in decreasing order of likelihood) Description Mitigating factors

• Large number of parties• Differing ideologies• Regional agendas influence

national policy

• Universal adult suffrage - a correction mechanism

• "Public stance" guarded – but parties realize liberalisation imperatives

1. Internal political complexities(high)

• Highly fragmented country geographically

• Risk of social unrest, resulting from increasing income divide – urban and rural India– rich states and poor states

• Higher inflation

• Few budgetary, fiscal and supply side measures announced by the Govt.

• Numbers below poverty line reducing• Realization (in last election) that only

broad-based economic reform is sustainable

2. Socio -economic factors (moderate)

• Border tensions with Pakistan and China

• Instability in Nepal

• Strong progress in Pakistan relations across two different governments

• China border issue (Sikkim) resolved recently

4. Military conflict(low)

• US economy slows down• Rising oil prices

• Low interest rates • Measures to increase FDI inflows and

competitiveness to capture a larger share of world trade

3. External factors (moderate)

20

INDIA IS A LARGE COUNTRY WITH HUGE GEOGRAPHIC FRAGMENTATION2006; Million Hectare; per cent

Source: Euro Monitor

US

Brazil

Canada

China

Australia

Russia

963171

84660

99846

960148

76846

1,710121

Total land

Arable land

17.8%

7.09%

4.6%

15.4%

6%

7%

Country Land acreage % arable

161

329

Total land

Arableland

Arable land in India is the highest and almost as much as that available in the US in absolute terms

Arable land as a proportion to total land across most countries range between 4 – 10%

However in India land used for agricultural purposes its as high as 48%

48.5%

2. Socio-economic factors

21

1.32.3

0.7 0.3 10.1

5.5

Product market barriers

India (complete reforms)

India (growth rate in 2000-01)

Land market barriers (affects real estate and retail sectors)

• Urban land ceiling act• Unclear land titles• Tenancy laws• Low property taxes

and low user charges• Urban transportation

infra-structure

Government ownership

Others barriers, e.g., labor market

• Lack of nationwide VAT coupled with lower indirect taxes

• Small scale reservations• Poor regulation in power sector• High import duties• FDI restrictions (e.g., retail)• Delicensing key sectors (e.g. coal,

fertiliser, retail, mining, railways)

• Central PSUs• State PSUs

including power• Municipal services

Last 2 years 7% GDP growth

Reforms completedReforms pending Reforms under consideration/ work under way

Overall downside in India is limited. Biggest risk is un-captured potential

THE BIGGEST RISK IS POLITICAL INDECISION WHICH COULD PREVENT INDIA FROM CAPTURING ITS POTENTIAL

* Public sector unit (i.e., government owned enterprises)Source: McKinsey Global Institute Study on Indian Economy (2001); Team Analysis

1. Internal political complexities

22

Australia

LOW CONCENTRATION OF POPULATION IN TOP 5 CITIES

Source: Web search; Census

Population living in the top 5 countries is very fragmented in Asian countries vis-à-vis its global counterparts, but in absolute terms it more than equates the top 5 cities population of the US

USBrazil China Russia

65

25 22 16

35

21

75

189

79

303

84

1427

94

1,1365

95

1,322

Population living in top 5 cities

Rest of population

100% =

India

2006; Million; per cent


23

INCREASING INCOME DIVIDE COULD LEAD TO RISK OF SOCIAL UNREST

. . .and income of rich states is 2.2X that of poor states

Rs. ‘000, 2006 prices Rs. ‘000, current prices

21.7

49.8

Urban average* per capita income

Rural average* per capita income

+2.3X

12.9

28.5

Per capita income average* of rich states#

Per capita income average* of poor states#

+2.2X

* Average over 2002-2005 # Rich states are ones having higher per capita income than the All-India average, poor states are all othersSource: Market Skyline 2006 – Indicus Analytics; Global Insight; CSO; Team Analysis


Urban income is 2.3X rural. . .

24


CONTENTS


25

KEY MESSAGES

• Indian financial sector has grown rapidly and recorded strong performance on back of continued reforms

•However, financial deepening has to be acclerated, else it could constrain the full potential of the Indian economy going forward

•Pursuing a continued integrated reform agenda for the financial system can help support and enable India’s high GDP growth trajectory

26

KEY MESSAGES


•However, financial deepening has to be accelerated, else it could constrain the full potential of the Indian economy going forward


27

3934 31 30 25

41 32 2326

4756 70

89

22

46

106

1994

18

40

1995

2

44

98

1996

217

44

20

9593

1997

220

48

94

1998

222

51

116

1999

124

53

110

2000

127

19

108

2001

130

64

122

2002

133

65

146

2003

2

57 68

160

2004

334

66

172

2005

5

36

64

195

2006

34

INDIA’s FINANCIAL DEPTH HAS GROWN RAPIDLYSINCE 2001

Note: Umbers may not add due to rounding1 Compound annual growth rate

Source: McKinsey Global Institute Global Financial Stock Database; team analysis

EquityCorporate debtGovernment debtBank deposits

CAGR1

1994-2001

2001-2006

-7.5

5.9

5.2

3.2

31.5

33.9

6.5

2.1

Financial stock as a percent of GDPPer cent

No deepening

CAGR14.1%

Financial depth

28

BANKING SECTOR HAS BEEN AT THE CORE OF FINANCIAL SECTOR GROWTH AND HAS CREATED SIGNIFICANT WEALTH FOR INVESTORS

Sources: RBI; national income statistics; Datastream; team analysis

1,700

19,496

1.6

~3.5

3,500

26,237

Contribution to economy of banking sector has improved over the years

1994 2007

1994 2007

16.7

1994 2007

Per cent

Rs billion

Rs billion

1Banking value add to GDP

2 Deposits

3 Advances

20.6

0

200

400

600

800

1000

1200

1400

Jan-

01

Jul-0

1

Jan-

02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Indian banks have outperformed share indices in last few yearsTRS CAGR Jan 01 – Oct 07

Indian Market: 29.63%Bank index: 40.54%

Old Private: 38.92%New Private: 44.17%

Public Sector Banks: 42.67%

New Private

Old Private

PSU Banks

Indian Banking

Indian Market

29

15.1Philippines

8.5Malaysia

8.2Thailand

7.1China

6.7Singapore

1.6Korea

1.4India

FINANCIAL PERFORMANCE OF INDIAN BANKING SECTOR IS AMONG THE BEST IN THE REGION

Asset quality Profitability

Per cent, FY 2006

Weak

Strong

* Data for all Scheduled commercial banks in India Source: Central banks of each country; Bankscope; CMIE, McKinsey analysis

NPL/GDP NPL/Net loans Pretax ROEPretax ROA

8.5Malaysia

6.7Singapore

5.9China

5.8Thailand

5.7Philippines

2.1Korea

0.5India

0.1Korea

0.8Thailand

0.8China

1.2Philippines

1.3Malaysia

1.3Singapore

1.3India

9.1Thailand

10.1Philippines

12.4Singapore

14.9Korea

15.1China

16.3Malaysia

17.9India

30

OTHER FINANCIAL MARKETS HAVE BEEN ON AN ACCELERATED GROWTH TRAJECTORY OVER PAST FEW YEARS

* Based on full credit for regular premium + 10% credit for single premiumSource: IRDA; AMFI; SEBI; McKinsey analysis

Life insurance

New business premium (APE)*; $ bn

Equity

Market capitalization; $ bn

Mutual Fund

AUM; $ bn

9.9

1.6

2000-01 2006-07

+519%

816

105

2000-01 2006-07

+677%

75

19

2000-01 2006-07

+295%

Over the past few years the Indian market has witnessed accelerated growth across financial services

31

HOWEVER, JUST 3-4 YEARS OF HIGH ECONOMIC GROWTH SEEMS TO HAVE LED TO A SITUATION OF TIGHT LIQUIDITY AND RISING INTEREST RATES

Source: RBI; Bloomberg; McKinsey analysis

Rapid credit expansion in past few years…

Outstanding advances; US$ billion

448

341

252

196157

Mar ’03

Mar’04

Mar’05

Mar’06

Mar’07

+30%

7572615559

Mar ’03

Mar’04

Mar’05

Mar’06

Mar’07

… resulting in tightening liquidity..

Credit/deposits ratio; Per cent

7.87.56.75.26.2

Mar ’03

Mar’04

Mar’05

Mar’06

Mar’07

… and rising interest rates

10 year G Sec rates; Per cent

32

KEY MESSAGES


•However, financial deepening has to be accelerated, else it could constrain the full potential of the Indian economy going forward


33

OVERALL FRAMEWORK FOR ANALYZING FINANCIAL SYSTEM IN INDIA

Source: McKinsey Global Institute analysis

Savers Borrowers

Informal finance

International financial system

Banking system

Equity market

Bond markets

1 23

4

Domestic financial system

Efficiency of each marketRegulatory environment

12

34

Supply of funds from saversAllocation of funds to borrowers

34

Note: Numbers may not add due to rounding*Japan number is for 2005Source: McKinsey Global Institute Global Financial Stock Database; McKinsey analysis

6078

45

51

7089

65 11992

155

104 281

43

Malaysia

145

134

195

Japan*

43

12962439

138

Indonesia

427

536

64

India

2237

85

209

Thailand

1314

150

220

China

1056

58

243

70

Philip-pines

32

254

South Korea

42

94

504

Singapore

369

EquityPrivate debt

Government debtBank deposits

Financial depth, 2006

BUT INDIA’s FINANCIAL DEPTH IS LOW COMPARED TO OTHER ASIAN NATIONS

Financial assets as a percent of GDP

35

THIS IS DESPITE INDIA’S HOUSEHOLDS BEING AMONGST THE HIGHEST SAVERS IN THE WORLD

* MGI estimate based on 2005 GDP and estimates of flow-of-funds information.Source: Country National Accounts; IMF; McKinsey Global Institute

Household savings as a share of gross national savings rates, 2005

162024

3744

55

69

India France China* Mexico Japan South Korea

United States

32.4 18.0 50.4 21.2 26.4 32.8 12.9

Gross national savings rates% of nominal GDP, 2005

Per cent

36

Note: Numbers may not add due to roundingSource: CSO; McKinsey Global Institute analysis

LARGE PROPORTION OF HOUSEHOLD SAVINGS NOT ACCESSIBLE TO FINANCIAL SYSTEM

2832 35

13 19 18

59

66

FY 1995

50

96

FY 2000

47

132

FY 2005

Machinery andequipment

Construction

Financial assets

100% =

Distribution of household savings by asset type$ billion, per cent

37

GOLD CONTINUES TO BE USED AS A SAVINGS VEHICLE DESPITE NEGATIVE RETURNS SINCE 1990

Source: Press Trust of India; Bombay Bullion Association; McKinsey Global Institute analysis

0

50

100

150

200

250

300

350

400

450

1970 1974 1978 1982 1986 1990

Gold

Bank deposits

0

20

40

60

80

100

120

140

160

1985 1988 1991 1994 1997 2000

Gold

Bank deposits

Index, adjusted for inflation

Gold was an attractive investment in the 1970s and 1980s . . .

. . . but has offered negative real returns in recent years

38

ACCESS TO QUALITY BANKING PRODUCTS AND SERVICES IN INDIA IS LIMITEDAccess to banking products is significantly lower in India . . .

ATM penetrationPer million people

Card penetration*Per cent of population

2006; per cent

* Includes both debit and credit cards; ** India Data as on March 2006 ; Mexico only credit cardsSource: Febraban; IBGE; Brazilian Central Bank; FSS; BOK; Bank of Thailand (BOT); NESDB; National Banking and Securities Commission;

Bank of Mexico; China Unionpay; Lit search; RBI; Venture Infotek

Number of bank branches

Deposits Credit

Metro centers

Top 100 centers excluding metro centers

Other centers

100% =

2006; per cent

. . . and is limited to large cities

65.1

25.318.3

17.9

20.6

16.2

17

54.165.4

70,776 20,911 15,138 Rs bn

19

51

81

1,240Australia

755Korea

477Singapore

330Thailand

261Poland

246Mexico

229Malaysia

193Brazil

Philippines

China

India 7

199

362

335

76

63

51

130

142

15

61

39

INDIA’s GOVERNMENT CONSUMES 70 PERCENT OF NETSAVINGS INJECTED INTO THE FINANCIAL SYSTEM

1 Computed as sector specific savings minus investment2 To balance with the current account, we subtract all errors and omissions (E&O) between savings, investments, and capital flows from

household savings (equivalently add it to household investment). Investment in valuables are added to E&O for the years 2000–2005. E&O average 1.4% of GDP over the period implying unadjusted household savings investment balance is 10.4% of GDP.

Source: CSO; McKinsey Global Institute analysis

ESTIMATED

Net contributions to the financial system1

1.2

3.2

9.0Household net contributionsto the financial system2

Foreign capitalinflows

Private sector borrowing

7.0Public sectorborrowing

Per cent of GDP, average FY 1995-2005

40

MORE THAN 80 PERCENT OF GOVERNMENT SECURITIES ARE HELD BY FINANCIAL INSTITUTIONS THAT ARE REQUIRED TO HOLD THEM

1 Latest available data. * Using Rs. 41 as Rupee to dollar rateSource: RBI; McKinsey Global Institute analysis

Ownership of central government securities100% = $ 306 billion, FY 20071

100.0

85.5

45.5Public sector banks

9.0Other banks

25.0Insurance companies

6.0Employee provident fund organization

Total regulatedholdings

8.0RBI own account

6.5Other

Total

Financial institutions required to hold government securities• Statutory liquidity ratio requires banks

to hold 25% of assets in government securities; actual holdings are higher

• Life insurance companies must hold 50% of their assets in government or other approved securities; additional 15% must be invested in infrastructure and social sectors

• Provident regulations cause 90% of assets to be held in government securities

41

INDIAN BANKS HAVE RELATIVELY A HIGH PORTION OF ASSETS IN GOVERNMENT SECURITIES

Fixed/other assetsOther securities and cash

Government securities

Loans 54 54 57

6857

81

2516 15 0.8

12

1618 18 25 18

165 12 10 8 13

2

0

India China Japan SouthKorea

United States(2004)

UnitedKingdom

Source: RBI; bank financial statements; Financial Supervisory Service (South Korea); PBOC; Bank of England; Federal Reserve Bank of the US; McKinsey Global Institute analysis

Asset breakdown of banksPer cent, 2006

42

7

30

13

11

39

211

Private corporatediscretionary

Private corporatepriorityAgricultureHouseholdenterprises and proprietorshipsPublic sectorenterprises

100% =

MORE THAN HALF OF COMMERCIAL CREDIT GOES TO SECTORS WITH LOW INVESTMENT EFFICIENCY

1 Gross bank credit to non-financial companies, corporate bonds and private placements, and loans and investments from the government to public sector enterprises.

2 The incremental capital output ratio is defined as the sum of gross investment divided by the total change in GDP over the period. Source: CSO; RBI; Public Enterprise Survey; McKinsey Global Institute analysis

Amount of investment needed to generate $1 of additional output2

FY 2000-2005

6.8

3.9

2.8Private corporate sector

Household enterprises andproprietorships

Public sector

15.0Agriculture

Distribution of commercial credit1

$ billion, per cent, FY 2005

Priority sectorPublic sectorPrivate corporate sector

43

Priority sector lending

1 Excludes public food procurement credit2 Small businesses determined by either amount of capital, sales, or employees. Now includes small loans to software industry and

investment in venture capital funds registered with SEBI.3 Includes wholesale trade, tourism, and non-bank financial companies.

Source: RBI; CSO; McKinsey Global Institute analysis

PRIORITY SECTOR ACCOUNTS FOR NEARLY A THIRD OF TOTAL LENDING, LIMITING ACCESS TO THE PRIVATE SECTOR

4832

12

8 136

Other priority sectors2

Agriculture

4

Medium and largeenterprises and other privatesector3

100% =

4

912

14

87

FY 2000

16

147

323

FY 2007

OtherMortgagesConsumer credit

Small scale industry

Distribution of gross bank credit outstanding1

$ billion, per cent

44

1 Small businesses determined by either amount of capital, sales or employees. Now includes small loans to software industry and investment in venture capital funds registered with SEBI.

2 Includes non-priority sector commercial credit, mortgages, consumer loans, and other.Source: RBI; CSO; McKinsey Global Institute analysis

PRIORITY SECTOR LOAN DEFAULT RATE IS ~40 PERCENT HIGHER THAN THE NON-PRIORITY SECTOR

2.7

4.9

4.6

8.3

3.5Agriculture

Small scaleindustry

Other prioritysectors1

Prioritysector total

Non-prioritysector total2

Nonperforming assets relative to gross bank credit outstandingPer cent, FY 2007

1.8x

45

SMALL CORPORATE BOND MARKET LIMITS ACCESS TO OTHER FUNDING SOURCES

Corporate bondsPer cent of GDP, 20051

143

10285

7464

48 45 3928 27

15 13 102 138

21

Uni

ted

Stat

es

Ger

man

y

Uni

ted

Kin

gdom

Mal

aysi

a

Kor

ea, R

ep.

Sing

apor

e

Japa

n

Can

ada

Thai

land

Chi

le

Bra

zil

Sout

h A

frica

Chi

na

Phili

ppin

es

Cze

ch R

epub

lic

Indi

a

Pola

nd

Turk

ey

1 India as of March, 2005; If bonds issued by development banks were included, China’s corporate bond market would be 11% of GDPSource: McKinsey Global Institute Global Financial Stock Database

46

INDIAN COMPANIES HAVE VERY LOW LEVELS OF DEBT

Note: Numbers may not add due to rounding1 as of March 2000 and 2005

Source: Central banks of respective countries; EIU; McKinsey Global Institute Global Financial Stock Database; McKinsey Global Institute analysis

Corporate bondsCorporate bank loans

89

119

22

109

83

22

48

0 50 100 150 200

68 157Malaysia

27 146Singapore

117 139United States

10 119China

34 118Hong Kong

56 78South Korea

23 71Chile

13

2

14India1

51

74

31

113

85

40

51

0 50 100 150 200

74 125

50 123

143 174

13 126

50 135

68 108

31 82

16

2

17

Corporate borrowingPer cent of GDP, 1999

Corporate borrowingPer cent of GDP, 2004

47

20 2634 39

35 4047 52

6610

India

2

72

1,916

Japan

3

63

40

Indonesia

3

59

562

South Korea

55

2

Singapore

4

55

91

Malaysia

47

100

United States

42

393

Hong Kong

EquityDebt

Internal funds

100% =

78

204 89

1 Based on sample of 160 companies per country outside of United States. Companies were ranked by gross sales, and 40 companies from each quartile were taken as the sample. US sample includes all listed companies with revenues exceeding $500 million, 1995 to 2004.

Source: Bloomberg; McKinsey Global Institute analysis

INDIAN FIRMS RELY HEAVILY ON RETAINED EARNINGSSources of funds raised

$ billion; percent, 2000–051

48

~ 55% OF EQUITY SHARES ARE HELD BY CORPORATE INSIDERS

1 Includes all those who, in bringing into existence a company or converting their private business into a company, secure control of the management of such company through shareholding and/or otherwise

Source: ISMR; SEBI

14

116

100

54

“Insiders”1 Indianpublic

6

Private corpora-tions

5

NRI’s, foreign corpora-tions

Foreign institu-tionalinvestors

FIs, banks, insurance compa-nies

3

Mutualfunds

Institutional Investors

Shareholding of NSE equity listingsPer cent, December 2006

49

KEY MESSAGES


•However, financial deepening has to be acclerated, else it could constrain the full potential of the Indian economy going forward


50

Source: McKinsey Global Institute analysis

Financial system problems

Key outcomes

INCREASING FINANCIAL DEPTH IS A KEY IMPERATIVE FOR THE FINANCIAL SECTOR

Underdeveloped domestic

institutional investors

Underdeveloped consumer

finance market

Suboptimal distribution of capital in the

economy

Very small corporate bond

market

Low lending rates and

conservative approach in

banking

Limited household

participation in capital markets

Root causes:• Lack of

competition in banking and high state ownership

• Statutory liquidity ratio and directed lending policies

Root causes:• Cumbersome

issuance procedures

• Lack of investor demand

• Poor bankruptcy procedures and lack of creditor rights

Root causes:• Restrictions on

asset holdings• Government

ownership of intermediaries

• Above-market deposit accounts

51

DOMESTIC INSTITUTIONAL INVESTORS ARE UNDERDEVELOPED IN INDIATotal assets as percent of GDP, 2005

60.3France

33.1US

22.8Korea

18.7Chile

6.2Thailand

6.3China1

3.8Mexico

4.6Poland

1.2Brazil

13.3India

0 10050

Life insurance

3.5

66.0

3.9

59.4

8.0

1.7

0.2

9.5

20.4

4.2*

0 10050

61.2

69.9

25.3

11.1

10.0

2.5

6.1

4.6

39.6

6.0**

0 10050* Includes only provident funds ** as on March 2006

Source: Financial institution regulators; industry groups; and central banks of respective countries

Registered pensions Mutual funds

52

A PHASED APPROACH HAS TO BE ADOPTED FOR A TRANSFORMATION OF THE INDIAN BANKING SECTOR

Source: McKinsey analysis

• Create 3-4 global sized institutions, 6-8 national champions

• Reduce government participation in the sector

• Allow greater access to foreign banks

• Separate central bank and regulator roles

• Remove directed lending and branch restrictions

• Encourage market driven consolidation

• Move to a coordinated regulator model

• Support creation of industry utilities for processing

• Enrich human capital and support re-skilling of employees

• Ease capital restrictions• Provide more operational

freedom to public sector banks • Develop blue print for sector

• Offer market based incentives for under-penetrated segments

• Remove regulatory arbitrage across different entities

• Effectively implement principles of good corporate governance

• Accelerate credit bureau and payment infrastructure

Industry structure

Social development

Unified regulator

Corporategovernance

Supporting infrastructure

Labour reforms

Build infrastructure and capabilities 1

Apply competitive pressure to local banks 2

Move towards freer structure3

53

Source: RBI; CSO; McKinsey Global Institute Analysis

6.3

5.1

2.321.8

7.8

Improved banking efficiency to best practice

Fully imple-mentelectronic payment system

Migrate informal lendingtoformalbanks

0.3

Reduce corporatebond default rates to bench-mark

Shift infinancing mix from bank loans tobonds

Direct impactof financialsystemreform

0.91.1Percent of GDP 0.7 0.1 3.20.3

18.9

6.6

25.5

Improvedallocationof capitalCapturingmoresavings

3.5

FINANCIAL SYSTEM REFORMS ARE WORTH US$48 BILLION ANNUALLY

US$ billion, FY 2005

Direct impact of financial system reform Indirect impact

54

MORE EFFICIENT INVESTMENT AND FINANCIAL MARKET REFORMS CAN BOOST INDIA’S GROWTH RATE TO 9.4 PERCENT

1 Compound annual growth rate.Source: CSO; RBI; Oxford Economics; McKinsey Global Institute analysis

0

200

400

600

800

1,000

1,200

1,400

1,600

1995 2000 2005 2010 2015

US$ billion 2000, fiscal year 2005–2015

9.4%

6.5%

CAGR1

1995–20055.9%

Baseline

Efficient investment and financial market reform

2015 per capita income: US$ 919

2015 per capita income: US$ 1,203

Real GDP CAGR1

the indian economy 20 20 mc kinsey

Business

growth perspectives

deprived us

indian financial sector

revenues of us

basic services

india todayus

transformed india

real gdp growth