Elections, Financial Services and Commodities: A Postcard From India

India’s financial sector can be as chaotic as a Mumbai street market. But when I recently visited India and looked beyond the noisy headlines, I felt excited about the attractive investment opportunities that were created by the liquidity crisis which started last September.

This is a fateful period for India, as the country goes to the polls through April and May in the world’s largest democratic election. Prime Minister Narendra Modi is campaigning for reelection, boasting a reduction in government corruption, a powerful annual GDP growth rate of about 7% and a record of economic reforms.

Reforms in the financial sector, however, have delivered mixed results. Every so often, India still faces a liquidity crisis. Most recently, last September, tightening liquidity hit non-bank finance companies (NBFCs) and housing finance companies (HFCs).

It’s easy to understand why investors get spooked. But in fact, the Indian financial sector is very diversified. Some companies simply aren’t affected by these liquidity crunches—and deserve a closer look when financial stocks are falling.

That’s exactly what we did. Over the last couple of months, we visited about 15 Indian financial firms, as well as newspaper editors, political commentators and government officials, to get the inside story.

After exploring the sector, gold lenders stood out for us. Why? Because, unlike other financials, they aren’t vulnerable to credit and interest-rate risks. When these firms lend money, they hold on to the gold jewelry as collateral, which can be auctioned off in a liquid market in case of default. What’s more, the loans are generally quite small and short-term—usually just three- to six-month terms—so borrowers are relatively insensitive to loan pricing.

We met with one gold lender in Mumbai who explained how it works: borrowers, he said, use these loans like revolving credit card finance, to support investments in farming and cottage-industry activities, and for consumption. India’s gold holdings are several times larger than banking system deposits. So gold lenders play an important role in channeling India’s gold wealth into the real economy.

Perhaps this explains why some Indian gold lenders such as Manappuram and Muthoot have much higher profitability than the broader financial sector. These companies have also been resilient to interest-rate and gold-price cycles in the past.

Generally speaking, tighter liquidity reduces competition, while well-capitalized and well-managed companies, like Manappuram and Muthoot, become stronger. And during tougher times, the dispersion of stock returns in the Indian financial sector—which is usually wide—can become even more extreme. That creates an opportunity for investors to generate alpha by identifying high-quality companies whose shares have been unfairly hit by panic in the sector.

Which brings us back to the elections. If Modi’s Bharatiya Janata Party-led National Democratic Alliance secures a parliamentary majority when results are announced on May 23, as recent opinion polls suggest, market sentiment is expected to improve.

This could help boost portfolio flows and direct investment flows, which would push market interest rates down. We believe the improved sentiment would be good for financial stocks—and especially for firms that had strong business models and growth potential in the first place.

**Emerging Market Views acknowledges the majority win in India’s election by Prime Minister Narendra Modi.**