In India, it seems like everyone wants to participate in the stock market. Benefiting from the demographic dividend and growing consumption, the profitability of large Indian companies is unusually high. At the same time, India is open to foreign investment, the government's budget situation is better than a few years ago, and it continues to invest in infrastructure such as roads, railways, and even data centers.

On August 23, Herald van der Linde, head of Asia Pacific stock strategy at HSBC, and his team released a report saying that although the Indian stock market is currently hot, there are still ten risk factors. None of these risks pose an immediate threat, but if they come together, they may be dangerous.

For example, banks in India have trouble absorbing deposits, private sector capital expenditure is sluggish, and foreign investment is weak and concentrated...

However, Herald van der Linde added that they will continue to increase their holdings in Indian stocks because the Indian emerging market has the strongest growth rate even if there are risks.

1. Indian banks are facing increasing pressure

Over the past few years, banks in India have performed well in cleaning up their balance sheets, with non-performing assets (NPA) falling from around 11% in 2017 to just 2.8% now. This reduces credit costs and allows banks to free up funds for new loans. Many companies are in a hurry to borrow money, and Indian families are also applying for personal loans from banks to buy goods and services.

There is nothing wrong with this in itself; however, the situation has reached a point where central bank officials are uneasy. Over the past few months, banks in India have also said that the quality of their assets faces new risks, particularly those associated with unsecured personal loans and increased personal leverage.

But that doesn't mean India is facing an imminent banking crisis. Abhishek Murarka, a banking analyst at HSBC Global Research, mentioned in the report:

The stressed sector is much smaller than the previous cycle, and despite rising credit costs, it is still far below the long-term average. Furthermore, banks' balance sheets are much stronger. Banks' risk and profit margins are rising, but they are still at a low level.

Despite this, it still shows that the profits of the financial sector are at risk. According to FTSE India's 2024 data, the total profit of the financial sector accounts for one-third of India's total revenue.

2. Banks are having trouble absorbing deposits

Attracted by strong returns over the past few years, it seems like everyone is investing in the stock market in India. Strong demand for investment has made it difficult for banks to attract deposits.

To attract deposits, banks raised deposit interest rates, which put pressure on their spreads. Furthermore, since loans are growing faster than deposits are flowing in, banks' credit-to-deposit ratios are rising, limiting banks' ability to provide new loans, which poses a downside risk to credit growth and also has a negative impact on banks' profit growth. According to HSBC global research, Bank of India's profit growth has slowed from 45% in 2022 to 9% expected in 2024.

3. India's private sector capital expenditure is sluggish

India has increased domestic investment, and the government has launched a number of large-scale infrastructure projects, including ports, roads, bridges, electricity, etc., and local companies involved can benefit from them. Additionally, the Indian government has provided tax incentives to support these companies.

According to Pranjal Bhandari, an economist at HSBC Global Research, private capital expenditure investment in an important component — “machinery and equipment,” has declined, and India's overall private sector investment in the economy is weak, which may pose a risk to stock market earnings.

4. Foreign investment is weak and concentrated

As can be seen from the above, domestic investment in India is uneven and is driven more by the government than by the private sector. So has India's foreign direct investment increased? The answer is no, not recently.

In fact, India's net foreign investment almost halved in 2023, due to increased divestment while investment declined.

Furthermore, foreign investment is concentrated in specific industries and states where it is easier to do business: Maharashtra, Karnataka, and Gujarat. These three states account for nearly 70% of all foreign investment in India. This also shows that the benefits that foreign investment brings to India in the form of employment opportunities are geographically concentrated.

5. Unequal consumption

Consumption is concentrated in India, with urban consumers performing relatively well, while rural consumers are much worse off.

This can be seen in the automotive and real estate industries. Over the past two years, the rise in the stock market and the popularity of credit cards have had a significant impact on the sentiment of urban consumers. Despite the weak performance of white-collar workers over the past year, this has not dampened urban households' demand for car upgrades. Meanwhile, in rural India, households are not benefiting from the rise in the stock market, are unable to obtain bank credit or credit cards, and rural consumers are unable to buy cars.

Consumer spending in rural India is very much in line with the ebb and flow of the monsoon. These households are more vulnerable to food inflation, which is in double digits in India. Prices of onions, potatoes, and tomatoes have risen sharply across India over the past few months. These households need lower food prices, increased income support, structural improvements to agricultural productivity, and increased support to combat climate change.

One solution to India's growing consumption inequality is to hire more women.

6. Profit risk

The attractiveness of the Indian stock market depends largely on whether earnings growth remains strong. According to Herald van der Linde and his team, India remains the strongest growing country among emerging markets. However, India's results in the second quarter of 2024 are worrying, with earnings growing only at a double-digit rate, unlike the rapid increase in the past few years.

According to Herald van der Linde and his team, this result was partly driven by seasonal factors. The heatwave in northern India and the months-long election meant that consumption and investment were sluggish, while weak demand in the US also affected India's software services industry.

In our opinion, all of this may soon be reversed. Some sectors, such as capital goods and real estate, provide good earnings visibility and are likely to see good growth in the second half of this year; however, all of this means investors need to keep a close eye on the upcoming earnings quarter.

7. ESG-related risks

Recently, allegations about the governance and structure of certain Indian companies have been widely reported, and if proven true, they may raise widespread concerns in the market about the governance of the Indian stock market.

8. Government regulation

Sudden changes in rules and regulations may adversely affect investor returns and weaken investor confidence. For example, on July 24, 2024, India retroactively raised capital gains taxes; for example, India recently imposed restrictions on the purchase of some long-term government securities.

9. Market concentration

Some of the risks in the Indian stock market are also related to the structure of the market. For example, India weighs more than 23% in emerging markets and Asian indices and is likely to rise further, increasing the risk of market concentration, as some funds are only allowed limited exposure to the single market. Simply put, these funds are unable to buy more Indian stocks.

Another risk is that investors may have to raise capital by selling Indian shares if they are interested in other large markets.

10. Macro risks

India is a major importer of oil and gold, and a sudden rise in the prices of these commodities could pose a risk to consumer demand.