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The Indian stock market and the currency are currently going through a roller coaster ride, thanks to the internal and external crisis plaguing the economy. The Indian rupee had plunged 29% since the start of the year to a fresh record low of 68.85 against the U.S. dollar on August 28 on concerns of a possible U.S.-led military strike against Syria.
 
However, the currency has shown some strength after the new RBI governor, Raghuram Rajan, took over office on September 4. The stock index CNX Nifty recovered around 8% from the low of August 28 (India ETFs Rebound on Central Bank Steps).
 
Though the recent rally in the market points to optimism, there has been a series of events and data that are weighing on the Indian markets at least for the short term.
 
Key Challenges
 
Weak GDP & Other Factors
 
India, which competed with China with its near double-digit growth rates a few years back, has lost its shine in recent quarters due to falling investment growth. India’s economic growth dwindled to a decade low of 4.4% for the first quarter (April-June) of FY 2013-14, against 4.8% and 4.7% economic growth in the last two quarters, respectively. 
 
Slowdown in industrial and services sectors is believed to be the major dampeners to GDP growth. Moreover, the HSBC Manufacturing PMI, which determines the business activity in Indian factories, fell to 48.5 in August from 50.1 in July, reflecting the lowest figure since 2009.
 
Current Account Deficit
 
India’s current account deficit has ballooned to a massive $90 billion from just $8 billion in 2007. The rising dollar is further posing a risk as the import bill of oil and gold - the country's two biggest imports – might further widen the current account deficit.
 
External Challenges
 
Increased chances of Fed QE3 tapering on the back of improving U.S. economy led to huge capital outflows from emerging markets. India is no exception and investors have pulled out around $4 billion from Indian equity markets during the period - May to August (read: 3 Emerging Market ETFs Surviving the Slump).
 
Inflation & Interest Rates
 
India’s inflation rate is stubbornly high, above 10%, for more than one year now. As of July 2013, India’s consumer price index stood at 10.85%, down 21 bps sequentially, but still much above the RBI comfort zone. Moreover, supply constraints and heavy dependence on fuel imports have kept inflation sticky. Additionally, a continued fall in rupee will further aggravate inflation forcing RBI to hike interest rates and thereby further hampering domestic growth.
 
General Election and Other Factors
 
With the general elections in India due next year, we are concerned that the recent populist measures taken by the government of India, like the food security bill, might further widen the fiscal deficit, leading to a further fall in rupee. Moreover, rampant corruption and crumbling infrastructure are also crippling the economy’s growth prospects.
 
The Repercussion Effect
 
These worsening economic and political situations have prompted some of the leading rating and research companies to lower their GDP forecast for India. On September 3, rating agency S&P hinted at downgrading India’s credit rating from the current “BBB-minus”. A downgrade will push the Indian economy to “Junk” status likely precipitating a further panic in the Indian markets (read: India ETFs--Behind the Mayhem).
 
Experts suggest that the massive inflows which the emerging markets witnessed during the period following quantitative easing might pause for a while. In fact, the Indian story has now been taken over by the global story.
 
The Optimists and Key Positive Takeaways
 
However, some market experts are still bullish on the long-term Indian growth story and believe that it can’t be written off due to short-term volatility and uncertainties. This is primarily thanks to a slew of measures taken by Indian government and the RBI governor lately to arrest the depreciating rupee and the widening deficit.
 
The country will likely boost its oil imports from Iran, which has agreed to accept payments in Indian rupees. This will likely avoid depletion of India’s foreign exchange reserves. Additionally, the government has cleared 17 FDI (foreign direct investment) proposals worth Rs 993 crores to boost inflows into the country.
 
Moreover, to curb India’s consumption of gold and help narrow the widening current account deficit, the government has hiked import tariff four times in a year’s span, while reducing the same only once (read: Two India ETFs Leading Emerging Markets Higher).
 
Furthermore, Rajan has proposed a number of measures to rescue the crippled economy including more trade settlement in rupees. The governor has also hinted at changing the current stance of inflation control to that of boosting growth and liberalizing the financial market by enhancing the limits for exporters.

Indian ETFs in Focus

Given wide trade deficits and a sharp fall in rupee, Indian ETFs have been struggling this year, plunging double digits over the timeframe (see more in the Zacks ETF Center).

For those seeking to tap this opportunity of beaten down prices could find the following ETFs as great choices if the Indian economy improves, the currency starts stabilizing, and inflation drops to a manageable level.

EGShares India Small Cap Fund (SCIN - ETF report)

This fund tracks the India Small Cap Index, and is relatively unpopular with a small asset base of $14.9 million, while it has an expense ratio of 0.85%. With a holding of 76 securities, the product is widely diversified across each sector and security.

The fund lost over 41% since the beginning of the year but jumped around 5% on the day Rajan joined as a governor (read: Rupee Slide Hits Small Cap India ETF). SCIN has a Zacks ETF Rank of #2 or ‘Buy’ rating, suggesting that it is expected to outperform its rivals over the one-year period

iShares India 50 ETF ((INDY - ETF report))

This ETF tracks the S&P CNX Nifty Index and has amassed $347.6 million in its asset base, which is spread across 51 Indian securities. The fund invests nearly 59% of its total assets in the top 10 holdings and is pretty expensive, charging investors 93 basis points a year in fees. INDY has lost around 23% year to date but was up 5.5% on Sep 4 and has a Zacks ETF Rank of 3 or ‘Hold’.

PowerShares India Portfolio ((PIN - ETF report))

This fund follows the Indus India Index, holding 50 stocks in the basket. The ETF has managed assets of $281.6 million so far, and has an expense ratio of 0.81%. PIN lost over 19% in the year-to-date timeframe but added nearly 7% on the day of Raghuram’s joining and currently has a Zacks ETF Rank of 3 or ‘Hold’.

The Bottom Line

Despite several constraints, growth in India is still among the highest in the world. The Indian economy seems poised for growth in the second half of the year as the government and the RBI governor engage in several reform measures to revitalize the economy (see: all the Emerging Asia Pacific ETFs here).

Further, positive factors like a rising middle class and a younger population with growing spending power would result in soaring domestic consumption and in turn fuel economic growth, suggesting that the India ETF outlook — at least over the long term —isn’t as poor as you might think.

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