What is driving India's services sector?

In our previous article, we discussed about the changing composition of GDP and the factors that have brought about this change. The service sector has been in the driver's seat registering CAGR of 8% in the last seventeen years, which has been mainly contributed by the growth in trade, hotels, transport, storage and communication sectors. The growth of these segments has been the result of opening of trade, liberalisation of policies, increased disposable income in the hands of the people and changing consumer attitude and lifestyle. The table below highlights the contribution of the different sectors that have been on high growth trajectory and have boosted economic growth directly or indirectly. While hotels and restaurants contribute least amongst the sectors discussed here, banking & insurance and real estate & business services contribute the most. The questions that are raised are whether an emerging economy like India will be able to sustain its growth momentum considering the current economic slowdown globally which has been the result of the subprime crisis. Unlike developed economies, India's economic growth is not led by the financial services industry alone. Besides this, India's exposure to the subprime crisis is almost negligible as compared to her US and European counterparts. Having said that, while rising inflation and interest rates are expected to slow down the economy a wee bit, in the long term the India growth story remains intact.

As mentioned earlier, the current economic growth not led by only one component of the services sector, let us understand the factors that have fuelled growth and whether this growth is sustainable going forward.

Hotel and restaurants:
The tourism industry that includes hotels and restaurants has witnessed good times on account of increased passenger traffic (business and leisure). The same has been the result of government initiatives such as 'Incredible India' campaign, signing liberal agreements with various nations in the recent past that increased international traffic, increased investments to develop and open new tourists destinations and increased focus on development of infrastructure such as modernisation of airports and ports; all of which helped the industry to flourish. However, considering the high crude prices and general economic slowdown, the tourism industry is likely to take a back seat in the near future. The fact that this industry contributes merely 2% to the overall GDP, slowdown in this sector may not have a significant impact directly.

Real estate:
The development of the real estate sector has enabled the economy to sustain its growth momentum on account of the significant backward and forward linkages with crucial and critical sectors of the economy such as infrastructure, construction activity etc. Real estate sector development has been backed by both demand factors such as unfulfilled demand of dwelling units and lack of infrastructure and supply side factors such as increased rationalisation of tax structure, reduced borrowings cost and tax benefits to loan seekers, legislative measures like repeal of the Urban Land Ceiling and Regulation Act etc. However, correction in property prices is expected to result in slowdown in the growth of the income of the real estate developers. At a time when the cost of development has been inflated on account of higher cost of raw materials, selling or renting properties at lower prices are likely to hurt margins of the real estate developers. The correction in prices can be attributed to the fact that the property prices were overheated, which impacted buyers forcing them to either defer purchases or exit in case of lease agreements.

Business services:
Growth in business services led by exports, which include IT/ITES services have also significantly contributed to the overall growth of the service sector. The increased investments, growing consumption and the outsourcing boom boosted the growth of the software sector, apart from India being a preferred destination to outsource services on account of large English speaking skilled manpower. We believe that the sector has enough steam left which can drive future growth. Although the US economy is slowing down and the capital market crisis has and is likely to impact business for these software companies, the fact that they (the companies) are trying to increase exposure to other markets like Europe, Middle East and Asia-Pacific is likely to stand them in good stead going forward. Some of the software companies are also trying to focus on new segment of clients (like mid-size local banks in US and Europe) who in turn are looking to reduce costs through offshoring. On a macro perspective, on the back of economic benefits that it provides, the Indian technology offshoring business is expected to grow whether the US economy grows or slows down. This is because growing pressure on technology budgets is forcing US companies to outsource to low cost destinations like India.

Overall, considering the 8% contribution of the real estate and business services sector to GDP and crucial backward and forward linkages to other sectors, slowdown in real estate and business services may impact the economic growth in the short run. However, the booming retail sector and the need to improve and develop infrastructure to support growth of various industries will continue to give a further fillip to the growth of the real estate and business services. Hence, the long term view point still remains positive.

Banks & insurance:
One must note that reforms have taken place in the banking sector since 1991 despite changes in the government. The Finance Ministry continuously formulated major policies in the financial sector such by giving licenses to private sector banks as part of the liberalisation process, opening of the insurance sector, designing measures to increase financial soundness like introducing capital adequacy requirements and other prudential norms for banks, limiting the entry of foreign banks etc.

While the policy changes have led to the development of the financial sector, growth has also been backed by the radical change in the Indian consumers' mindset regarding credit. The banking system has evolved from the traditional banking practices of lending and deposits to other avenues such as investment banking, insurance services etc. Going forward, banks that have ensured sufficient capital to sustain credit growth will increase focus on non funded income to sustain margins. A few domestic banks like ICICI Bank and SBI are likely to be impacted by the financial turmoil witnessed globally and will have to make provisions but the fact that they are dependant largely on the domestic business, the impact may not be that severe.