India: Lots of Gains Later… But First Comes the Pain

India has great long-term prospects. No doubt about it.

Indeed, India has enjoyed very decent growth rates for the last decade, pulling many of its people out of poverty in the process.

But investing in India can be tricky, as I will show.

The bottom line: The Indian stock market is trading at an exalted valuation – based entirely on the country’s short-term potential.

If you are interested in investing in India, my advice is to hold off – at least until the inevitable crash has brought share prices down to take account of India’s short-term problems.

Number Games

For instance, the budget plan that Indian finance minister Pranab Mukherjee presented on Feb. 28 demonstrated yet again that India’s government, which cannot break free of its appalling 1950s-era state socialism, is holding it back.

At first blush, Mukherjee’s budget looks plausible. For the fiscal year that ended in March it claims to have reduced the fiscal deficit from 5.5% of GDP to 5.1%. And for the current fiscal year Mukherjee’s spending plan purports to further reduce it – all the way down to 4.6% of GDP.

But two factors are warping those seemingly bullish figures.

First, last September’s telecom-spectrum auctions generated a $23-billion revenue windfall. Without this, last year’s deficit would actually have been 6.4% of GDP.

That’s a substantial overshoot from the February 2010 budget in a year in which record economic growth has poured revenue into the Indian treasury.

Second, the GDP figure itself increased by more than 20% in India’s just-concluded fiscal year, largely because of a relentless inflation rate that’s in excess of 10%.

Since India’s interest rates are in the 6% to 8% range, the Indian government has made money by borrowing aggressively in the markets at rates that, in real terms, are below 0.00%.

The Looming End to a Boom?

Economic growth in India for the last decade has unleashed a torrent of tax revenue, which flowed into India’s treasury. Unfortunately, instead of using this “found money” to reduce the fiscal deficit, India spent it.

Now, facing a major inflation problem as well as capacity constraints, India is close to the top of an unsustainable boom. In this situation the budget should be running a substantial surplus – not a deficit of 4% to 5% of GDP.

In March 2010 India’s public debt on a consolidated basis was a record 74% of GDP. That debt-to-GDP ratio has been reduced since then, but only because of the low interest rates and the gigantic increase in nominal GDP.

This year’s budget contains still more spending – 18% more than last year. Some of the increase is quite sensible. For instance, a new food-subsidy program to feed the poorest makes some sense, especially when food prices have rocketed up.

But rather than adding the new program onto all the other subsidies, it should have been funded by reducing India’s fuel-subsidy programs, which are gigantically expensive with oil at $100 a barrel.

These are politically popular. But they are transfers to the middle class, not the poor.

At some point, India’s economic growth is going to slow – maybe as a result of the interest-rate increases necessary to stop inflation spiraling into hyperinflation. At that point, the revenue bonanza for the Indian government will dry up, and the budget deficit will spiral out of control.

A Look Ahead

In the long run, India has fantastic potential. The 8% growth rates of the last decade have been real and India’s rapid integration into the world economy will ensure that the growth rates continue.

But before that happens India’s government must be reformed: stripped of its corruption and of its 1950s-style socialism. That process will be politically painful and will meet with huge resistance from the Congress Party and other defenders of the status quo.

Fortunately, as a democracy, India has in the past shown that its electorate can demand reform.

If you are an investor with an interest in investing in India, you can do no right now besides standing back to wait.

But be prepared: At some point, India’s stock market will be down – perhaps as much as 50% to 70% from its recent highs.

When that happens, ignore the cries of warning from those who have lost money, and plunge in. You will be well rewarded.