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This year has not been great for emerging markets in general but Indian markets have been among the worst sufferers. Indian stocks as well as the currency have been hit by a plethora of factors—some external and many internal—resulting in mass exodus of foreign investors.

Friday was one of the worst days ever for the Indian stock market as stocks plunged about 4%, their biggest loss since 2011. The stock market suffered a further decline of 1.6% on Monday.

The Rupee tumbled by 148 paise on Monday, its single largest drop in a decade to touch an all-time low of 63.23 to a dollar. Overall the currency is down more than 16% against the US dollar year-to-date. (Read: Is the Worst Ahead for the Egypt ETF)

As a result, many India ETFs have registered double digit decline in the past three months. Small-cap ETFs like Market Vectors India Small Cap ETF (SCIF - Free Report) and EGShares India Small Cap ETF (SCIN - Free Report) have been hurt the most—with more than 30% plunge, while other popular India ETFs like iShares India 50 ETF (INDY - Free Report) iPath MSCI India Index ETN (INP - Free Report) have dropped by more than 20%.

Did Reserve Bank Measures Backfire?

Last week, the central bank announced a series of measures to limit the capital flight and protect the currency. (See: Focus on these China ETFs for Outperformance)

The steps included limiting the investment Indian companies can make overseas without seeking regulatory approval to 100% of their net worth, from up to four times their net worth earlier.

The bank also reduced the amount that an Indian resident can send abroad to $75,000 per year from $200,000 earlier. Further, they said that the remittances cannot be used for buying property abroad. (Read: Indonesia ETFs in Crash Territory on Currency Woes)

Earlier in July, the central bank had increased the interest rate on its short-term liquidity window and capped its daily liquidity window, thereby raising short-term borrowing costs and restricting funds available to banks. Additionally they announced a sale of Rs 120 billion in bonds, effectively draining liquidity from the market. 

The measures announced by the central bank last week have obviously backfired as foreign investors feared that the country may impose more capital controls in future.

Macroeconomic Fundamentals Worsening

The Indian economy grew at just 5% during 2012-13 fiscal year, lowest in a decade and ~8% average growth rate achieved during 2006-11 now appears to be a thing of the past. The IMF expects the economy to grow at 5.7% in 2013. Many other agencies expect the growth rate to be much lower. Consumer inflation in the country is now near 10%. 

Is there Any Silver Lining?

Among the positive developments, exports have been rising recently as a result of weak rupee and gradual recovery in global economy. India’s IT sector in particular stands to benefit from these two factors.

Further, taxes on gold imports have been able to bring down gold imports, which are a significant factor in current account deficit, which widened to 4.8% of GDP in the fiscal year ended March. Still the government's plan to bring down the deficit to 3.7% of GDP by imposing curbs on imports of gold, silver and non-essential items, seems rather far-fetched.

Earlier this month, Indian markets had cheered the appointment of renowned economist Dr. Raghuram Rajan as the next governor of the central bank. His term starts at a very challenging time and it remains to be seen whether he will be able to provide a new direction to the monetary policy that can put the economy on the growth path.

The Bottom Line

Rising interest rates, strengthening US dollar and gradually recovering US economy is leading to a general reversal of capital from the emerging economies. As a result, many of these ETFs have been hit this year—particularly after ‘tapering’ concerns emerged in May. Countries like India that are dependent on external capital to finance their growing current account deficit seem to be the worst sufferers now.

India suffers from some structural problems like slowing growth, high inflation (consumer inflation touching 10%) and widening fiscal and current-account deficits. Massive corruption and crumbling infrastructure further impede growth.

Unless the government shows political resolve to address the structural problems affecting the economy, the outlook for India ETFs remains rather cloudy as of now. Any ‘band-aid’ measures may just bring some temporary reprieve. But with the general elections due next year, the chance for some major reforms is rather slim now.

While some market participants have argued that the economic malaise affecting India has been known for a long time and nothing has fundamentally changed in the last couple of weeks and thus there may be long-term value emerging in the Indian market; we think that in view of the negative sentiment prevailing currently, investors should avoid Indian ETFs for the time being.

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