Neena Mishra: Yesterday, Standard & Poor’s Ratings Services lowered the outlook on India’s long-term credit rating to “negative” from “stable” while affirming the rating of “BBB-minus”, which is just one notch above junk.

S&P said there is a one-in-three chance of a downgrade in the next 24 months “if external position continues to deteriorate, growth prospects diminish, or progress on fiscal reforms remains slow in a weakened political setting.”

According to the rating agency, large fiscal deficit and a heavy debt burden remain the most significant constraints on India’s sovereign rating.

India’s fiscal deficit widened to 5.9% of GDP in the fiscal year ended March 31, substantially higher than the government’s target of 4.6%, mainly due to massive fuel and fertilizer subsidies and lower tax revenues.

The government targets to reduce the fiscal deficit to 5.1% of GDP in the current fiscal year which began April 1, but no tangible road map to reduce spending was presented in the budget.

Last week, the central bank cut the key lending rate for the first time in three years by 50 basis points to 8%versus expectations of a 25 bps cut. The more than expected reduction was welcomed by Indian markets.

Earlier, the central bank had raised the rates 13 times in its efforts to rein in high inflation in the country. Central bank’s task in containing inflation is complicated by the fact that the timing and extent of administered price increases are decided by the government and are determined by the political considerations.

The central bank expects growth to rise to 7.3% in the fiscal year ending March 2013 and inflation to be around 6.5%.

Indian stocks had a dismal performance in 2011, as the economy grew at its slowest pace since 2009 and foreign investors withdrew funds for safe haven investments as the global risk perception deteriorated. Inflation worsened and current account deficit widened.

The country’s investment image also took a beating from major corruption scandals. The Indian rupee was the worst performing Asian currency in 2011.

The situation appeared to be improving in 2012 as the foreign institutional investors poured about $9 billion in Indian equities since the beginning of the year. The ultra-low interest environment in most parts of the world and signs of US economic recovery encouraged investors to put money into risky assets.

As the problems cited by S&P were already known, the rating agency’s action had minimal impact on the India ETFs. However unless the Indian government treats the downgrade as a wake-up call and implements some  initiatives to reduce structural fiscal deficits and to improve its investment climate, the gains in the India ETFs may be rather limited for the current year.

Going by the past performance of the government and the timing of the national elections (2014), the chances of any meaningful reforms being introduced are rather slim.

At the same time, despite several constraints, the growth in India is still one of the highest in the world. Positive factors like a rising middle class with growing spending power which results in rising domestic consumption will continue to fuel growth.

For investors looking for exposure to broader Indian markets, following ETF choices are available.

Wisdom Tree India Earning Fund (NYSEARCA:EPI)

EPI tracks the Wisdom Tree India Earning Index, which weights the Indian companies based on their earnings, adjusted for a factor that takes into account the shares available to the foreign investors. In terms of sector weightings, the fund has highest exposure to financials (24.02%), followed by energy (18.80%), materials (12.64%) and information technology (12.19%). Indian banking sector looks stable as of now, as the non-performing assets have declined and the capital levels have improved. A reversal in the monetary cycle will also be good for the banks. Further, with a large percentage of population still unbanked, the banks have significant growth opportunities. Top 10 holdings account for about 40% of total holdings. The fund has returned 16.8% year-to-date.

PowerShares India Portfolio (NYSEARCA:PIN)

PIN which tracks the Indus India Index, has assigned highest weighting to the Energy sector (24.83%), followed by information technology (16.69%) and financials (12.60%). The Indian IT industry faces some near term challenges due to sovereign debt crisis in Europe (resulting in budget delays) and an appreciating currency. Top ten holdings constitute 53.7% of the holdings. The fund has returned 15.5% year-to-date.

S&P India Nifty 50 Index Fund (NYSEARCA:INDY)

INDY follows S&P CNX Nifty Index, free float market cap weighted index of 50 largest and most liquid Indian companies. Top 10 companies in the fund account for 56.47% of the fund. Sector weighting are Financials (24.57%), Information Technology (13.98%) and Power (13.75%). The fund has returned 14.1% year-to-date.

iShares MSCI India Index Fund (NYSEARCA:INDA)

This is the newest in the space, launched in February this year. The fund follows MSCI India Index, which is float adjusted market cap weighted index. Holdings and sector weighting are not very different from the older three discussed above but with the expense ratio at 0.65%, this is the cheapest option now. Financials enjoy highest weighting (24.87%), followed by information technology (18.85%) and energy (12.22%). Top ten companies account for more than half of the total holdings.

Written By Neena Mishra From Zacks Investment Research

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

NASDAQ:INDY, NYSE:EPI, NYSE:INDA, PIN