Published: July 1, 2010

If it's able to control inflation and cut its debt, India could well become the world's most appealing investment opportunity.

Europe is choking on debt and scrambling to salvage its beleaguered currency. The United States is saddled by high unemployment and struggling to preserve its wobbly recovery. Even China - which has had to reign in its stimulus to cool its red-hot property market and curb inflation - may have peaked.

Yet India's gross domestic product (GDP) is shooting sharply higher, and many economists think economic growth in the subcontinent is about surge into the double-digits for the first time ever.

"For the first time it appears entirely within the realm of possibility that India will break into double-digit growth within the next five years," said Indian Finance Minister Pranab Mukherjee. "Our growth is coming not just from government action but from a variety of sectors and stakeholders from all of the economy, including our dynamic private corporate sector."

Indeed, India's economy, which grew at an annual rate of +8.6% in the first three months of the year, has been fuelled by strong domestic demand and exports.

Manufacturing output grew +16.3% in the first quarter, as consumers ramped up purchases. Meanwhile, hotels and transport services expanded by +12.4% and the financial services sector grew by +7.9%.

The momentum carried forward in April, as industrial output registered a double-digit growth rate for the seventh straight month, clocking a spectacular +17.6% increase. Growth in capital goods soared to +72.8% year-over-year and growth in consumer durables reached 37%.

Foreign demand also has boosted India's economy. Exports rose +36% in April and +35% in May, as the country shipped out $33 billion of goods and services in the first two months of the current fiscal year.

"To me, this multiple source growth is a sign of robustness," said Mukherjee.

The Indian government expects the economy to expand by +8.5% in 2010, and the International Monetary Fund (IMF) predicts +8.8% growth for the subcontinent.

But as stellar as that expansion would be, Mukherjee insists the government won't be satisfied until overall growth reaches double-digits.

"The +10% growth is a bare requirement for the government to be able to provide food, jobs, education, nutrition, and security to 100-core plus citizens," he said.

Still, Mukherjee and the rest of India's policymakers don't expect to reach that level of growth until 2013. Before then, the government must rein in the government spending that helped the country through the global downturn and tame inflation.

India's Growth Challenges
Indeed, despite India's strong first-half showing, a high budget deficit and rising inflation pose a considerable threat the country's economic growth.

While the central-government-budget deficit appears tolerable at 8% of GDP, provincial governments also run budget deficits - in amounts equal to an additional 4%-5% of GDP. That gives India a consolidated budget deficit of 12%-13% of GDP, meaning its fiscal position is on par with that of Greece, Britain and Ireland.

However, India's saving grace may be the fact that its public debt level is relatively low at around 60% of GDP. A large portion of that is domestically held, as well, primarily in the banking system, which is largely state controlled.

Indian Prime Minister Manmohan Singh says a medium term plan to halve the fiscal deficit by 2013-14 is in the works and that growth isn't expected to suffer as a result.

"We are giving a strong push to investment in infrastructure, relying on private public partnership as much as possible to reduce the burden on scarce public resources," said Singh. "We expect to grow by 8.5% in 2010-11 and we hope to go back to 9% in 2011-12. This is an ambitious goal and we recognize that we have much to do to achieve it."

India's infrastructure sector has doubled over the last five years, from 4% of GDP to 8%, according to the country's Planning Commission. The government currently is offering investment opportunities in the infrastructure sector that are worth more than $850 billion, according to Mukherjee.

As a result, India's six core infrastructure industries - crude oil production, petroleum refinery production, coal production, cement production, finished steel production, and electricity generation - grew by +5% in May after growing by +5.4% in April.

Long-term, India is looking to invest $1 trillion in infrastructure over the next seven years.

However, the plan for controlling inflation is less clear.

India's wholesale price index, the primary inflation gauge for the country, rose +10.2% in May alone. Food prices in particular have seen a spike. They were up +0.7% in the week ended June 12 from the previous seven days, and +16.9% from a year earlier.

The government also has deregulated gasoline prices and raised the cost of diesel and cooking fuel, which could push June headline inflation above +11%.

The country's current-account deficit, which widened to a record $13 billion in the first quarter, could weaken the rupee further. The currency already is the worst performer in Asia this quarter after the Korean won.

The Reserve Bank of India (RBI) started raising interest rates in March to combat the decline, and some analysts had speculated that the central bank would announce another increase before its next scheduled meeting on July 27. However, a liquidity crunch in the country's banking sector has made that unlikely.

RBI Deputy Governor Subir Gokarn said Tuesday that a rise in interest rates would do little to stem surging food prices anyway.

"There is a very significant structural driver to food prices, and the policy approach to that is not going to be confined to the working or capacity of monetary policy," he told The Wall Street Journal.

Meanwhile, Finance Minister Mukherjee said the inflationary effect of the recent hike in fuel prices would not last long and be brought under control before the end of the month.

"There will be some impact (on inflation) in the short-term, but it will be absorbed in the course of time," he said.

The direct impact of a fuel price hike on inflation would be an increase of about +0.9%, Mukherjee said, citing his chief economic adviser, Kaushik Basu.

"Though the immediate impact of this policy will be to increase inflation, in six to nine months, we will have lower prices than what would have happened in the absence of this much-needed reform," said Basu.

Prime Minister Singh is optimistic that inflation will be cut in half to 5-6% by the end of the year.

Investing in India
Regardless of the ongoing battles against inflation and debt, India is one of the most dynamic economies in the world. If the global recovery stalls, it will suffer a less severe impact than most developed countries, and it will outperform if the recovery continues.

If you're looking to capitalize on India's infrastructure build-out, you might look at Sterlite Industries (NYSE: SLT), which is a non-ferrous metals and mining company. Its aluminum and copper operations have the company positioned to take advantage of any rise in metals prices, as well as rising energy demand in India.

Tata Motors Ltd. (NYSE: TTM), the country's largest truck-maker and creator of the $1,000 Nano, could also benefit from India's infrastructure expansion.

More adventurous traders seeking to profit from India's currency fluctuations might consider the Morgan Stanley Market Vectors Indian Rupee/USD ETN (NYSE: INR). This fund offers exposure to India's currency by tracking the exchange rate of the U.S. dollar against the Indian rupee. INR rose gradually throughout the spring before plunging in May. It could slide further in the short-term if policymakers continue to abstain from interest rate hikes and inflation soars. But in the long-term, the rupee and the index will likely realize gains as the RBI caves to inflationary pressures.

At the very least, consider the WisdomTree India Earnings Fund (NYSE: EPI) and the iShares S&P India Nifty Fifty Index Fund (Nasdaq: INDY). The former tracks the WisdomTree India Earnings Index, a fundamentally weighted index that measures the performance of companies incorporated in India that are eligible to be purchased by foreign investors. Unlike most equity ETFs, EPI doesn't track a market cap-weighted index, instead replicating the performance of a benchmark that weights holdings by earnings. Its main focus is on industrial materials (32%) and financials (23%).

INDY follows the S&P CNX Nifty Index, a benchmark that measures the performance of 50 large cap Indian stocks. It also is weighted towards industrial materials and financials, but unlike EPI, INDY does not venture away from large cap holdings.

-- Jason Simpkins
Managing Editor
Money Morning