India’s Economy: Can India Climb Out From The Downgrade? (EPI, INDY, INFY, WIT, TTM, IBN, HDB)

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April 27, 2012 12:29pm NASDAQ:INDY NYSE:EPI

Sean Geary: Ratings agency Standard and Poor’s has cut India’s credit outlook to negative over multiple structural concerns plaguing India’s economy. The negative outlook implies “at least a one-in-three likelihood” that India will receive a credit downgrade as conditions continue to degenerate.

S&P currently rates India at its lowest investment grade rating of BBB-.

The breadth of problems for the Indian economy (NYSEARCA:EPI) is certainly worrisome for investors. A growing current account deficit, a slowing economy, an intractable fiscal deficit, a perpetually weaker rupee, outflows of foreign direct investment, and rising inflation all contribute to concerns over the long-term performance of the Indian economy (NYSEARCA:INDY).

Unfortunately, due to the current macroeconomic and political climate, none of these problems have an easy fix.

India remains a net-importer of fuel because of the country’s lack of oil and gas resources. As the price of oil in dollar terms remains elevated and the rupee continues to depreciate, India’s current accounts deficit is unlikely to ameliorate without a precipitous drop in the price of oil.

Furthermore, India’s weakening economy is not helped by the antipathy towards foreign businesses propagated by the Indian government. Woefully inefficient sectors like retail and agriculture would see a massive productivity boost from foreign investment but protectionist forces within the Indian government prevent such solutions from materializing. Airlines and banking would also benefit from capital injections from abroad.

While the Indian government has not yet embarked upon nationalizations à la Argentina, its treatment of entrenched firms in the telecom space will not encourage further investment from foreign firms.

A proposed tax that would retroactively penalize Vodafone and a massive increase in spectrum licensing fees is evidence that the powers in New Delhi are much more interested in extracting from corporations than fostering an environment that would allow them to thrive.

Until this course is reversed, it’s unlikely that the outflow of foreign direct investment will change.

And here lies the most concerning problem for India going forward: the country is in the midst of a political sea change. The two traditional national parties, the Bharatiya Janata Party (BJP) and the Indian National Congress (Congress), are seeing their power wane, whereas regionally and caste-based parties like the Trinamool Congress are becoming more popular.

These political entities seem to be less concerned about the health of the national economy and more preoccupied with regional populism. For example, West Bengal’s leader has adopted a particular focus on protectionism, both internal and external, as well as an emphasis on public-sector jobs at the expense of private-sector investment.

This trend does not bode well for India. Parliamentary gridlock will augment, not subside, as disparate interests will be unable to find middle ground. While there is much to dislike about India’s two main parties — the BJP can be uncomfortably jingoistic in its Hindu nationalist rhetoric and Congress has had their fair share of corruption and nepotism — both parties’ commitment to economic liberalism and to Congress’ Manmohan Singh’s capitalist reforms from his stint as Finance Minister in the early 1990’s allowed India’s two major parties to work together for the past two decades, at least on economic matters.

By passing effective legislation, the Indian economy finally shed the notorious distinction of always achieving the underwhelming, so-called “Hindu growth rate” of 3%. If Congress and BJP continue to lose political clout and more populist regional parties start to dictate the agenda in New Delhi, India’s economy will unequivocally suffer as a result.

Various sectors will face different challenges as the result of a changing political dynamic in India. Consulting firms like Infosys (NASDAQ:INFY) and Wipro (NYSE:WIT) that generate much of their income from US and Europe are unlikely to be affected by a weakened rupee. A weak home currency can actually inflate their revenues in rupee terms. As well, governments in places like Karnataka (Bangalore) and Andhra Pradesh (Hyderabad) are unlikely to enact reforms that would kill their golden geese.

As for the automotive sector’s darling Tata Motors (NYSE:TTM), considering that two-thirds of the company’s revenue comes from Jaguar Land Rover’s mostly international operations, the company would not be too affected by a weakened rupee. As well, while the company has been forced to rethink a few of its plants in India because of local government interference, more business-friendly states like Gujarat and Maharashtra are unlikely to impede the company’s operations in those locales.

However, it would appear as if the Indian banking sector could struggle as a result of the current Indian political quagmire. The ADRs for banks like ICICI (NYSE:IBN) and HDFC (NYSE:HDB) whose assets are mostly rupee-denominated would be affected by inflation and a perpetually weakening currency when evaluated in dollar terms.

As well, policy discord and a concomitant ratings downgrade would certainly affect the profitability of this sector, considering they generate the majority of their revenue from India.

Disclosure: Author’s immediate family are long TTM and EPI

 Written By Sean Geary For Emerging Money

Emerging Money provides insightful and timely information about the increasingly important world of Emerging Market investments. CNBC Emerging Markets Contributor Tim Seymour leads the  team of Emerging Money to bring you cutting edge global news and analysis.

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