India’s inflation deters foreign investors

Few would have guessed a year ago that a rise in the price of onions would put a brake on the stellar growth of India’s stock market and force investors to rethink exposure to Asia’s third-largest economy.

That, though, is what has happened. A sharp jump in food prices has revived fears that high inflation in India could threaten its economy, which last year attracted billions of dollars from overseas.
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On Tuesday, the Reserve Bank of India raised interest rates for the seventh time in less than a year in an effort to curb food price inflation. This could also undermine growth prospects, and the likely returns for foreign investors.

Duvvuri Subbarao, the RBI’s governor, has warned that “should global recovery be faster than expected, it may enhance the attractiveness of investment opportunities in advanced economies, which may impact capital flows to India”.

Goldman Sachs, Credit Suisse, Morgan Stanley and Nomura are among a number of banks to have recently warned clients of the risk of slower growth.

After a deluge of foreign investment last year, when inflows into India’s equity market hit a record $29.4bn, many investors have been advised to cash in their gains and take a “detox” period from Indian stocks. Since the start of this year, foreign institutional investors, the main drivers of Indian equities, have sold more shares than they have bought, leading to a net capital outflow of $711.5m, according to data released by India’s market regulator.

The effect on India’s stock market has been sizeable. Bombay’s benchmark Sensex index, which hit an all-time high in November, has since tumbled nearly 8 per cent.

India’s wholesale price index, the country’s main inflation indicator, rose to 8.43 per cent year on year in December.

The more politically sensitive food inflation measure rose to about 16 per cent, as vegetable prices, in particular for onions and garlic, spiked 70.7 per cent year on year in January. At the same time, state-run fuel retailers have been increasing petrol prices – by as much as 22 per cent since the government deregulated the market in June. This has added to pressure on manufacturers struggling to keep costs down.

A recent rise of between 17 per cent and 30 per cent in minimum wages across different Indian states has benefited rural incomes, but is also likely to add to inflationary pressure, economists believe.

Optimism, therefore, is limited, at least in the short term. Ridham Desai, chief India strategist at Morgan Stanley, says: “Our recent investor interactions and investor survey underpin a rather bearish sentiment for India in 2011. Only one-fourth of the buyside investors believe that India will outperform emerging markets in 2011.”

Rohini Malkani, economist at Citigroup, says last year’s benign domestic macroeconomic environment has been jolted by the rise in inflation and a widening current account deficit, at a record 4.1 per cent of gross domestic product.

Food prices

FT In depth: News, comment and analysis on rising concerns about food security and prices

Abby Joseph Cohen, investment strategist at Goldman Sachs, said recently the group had an optimistic view of developed markets this year, as their economies recovered and valuations looked attractive. “From the valuation perspective, the developed markets look more attractive than the developing market at least from the six to 12 months perspective,” she told the ET, an Indian business daily. “This is not necessarily our long-term view.”

Indian stocks have been trading for more than a year on a price-to-earnings ratio well above their long-term average for forward earnings of 13.8 times.

Even after the latest correction, the ratio is between 19 and 22 times. This is substantially above the ratio for the MSCI Emerging Market index, which is 12, and for the developed world, which is about 12.5 times. On a price-to-book ratio, Indian shares do not look that expensive in historic terms, but look pricey compared with emerging market peers, at 2.7 times versus 1.8 times.

Last year, many investors were content to keep investing in Indian stocks on the grounds that they could look forward to double-digit growth. That was the case for most of 2010 as the MSCI India index outperformed the MSCI EM index in nine out of 12 months. However, as economists revise their overall growth outlooks downward, few investors see value in buying assets that look to be overpriced.

Assuming India’s inflation is dealt with, however, economists’ long-term view is far from pessimistic.

“India has, in the last decade, seen both near-term and long-term obstacles pop up. However, these have been consistently overshadowed by larger and broader opportunities. We believe this tussle will persist through 2011, but opportunities will continue to overwhelm these obstacles,” says Ms Malkani.