India’s stock market is down 23 percent this year. But it’s still one of the world’s great long-term growth plays, says Martin Hutchinson in part two of Money Morning’s special report on BRIC economies.

India is suffering high inflation, its growth is slowing and there are signs that a credit crunch is about to hit. But this can work to the advantage of investors. Without these problems, India’s stock market would be trading at 40 times earnings - and not 18 times earnings, as it is now.

Martin says that buy buying into India now, investors are likely getting in on the ground floor of a major long-term bull market. And he has selected three stocks most likely to benefit from the country’s growth potential…

India’s economic growth was 9% in 2007, and will be around 8% in 2008, so the overall market seems reasonably valued at the current multiple of 18. If India can get its political and economic houses in order, it has some very real prospects for a couple of generations of rapid growth before living standards start to approach the West and growth rates slow.

In the short-run, however, there are some potential pitfalls to be aware of. The current Indian government, in office since 2004, is a coalition between the Congress Party, which had ruled India for most of the period since independence without any great success, and the anti-market Communists. Although Prime Minister Manmohan Singh is a moderate, the government has seen India’s economic emergence as an opportunity to fund favorite projects and social programs.

The budget for the current fiscal year (ending next March) proposes an 18% spending increase, and that’s after spending rose 24% last year. The state budget deficit (federal plus local) is around 7% of gross domestic product; in any kind of recession, that could easily spike to the 10% of GDP level at which deficits become difficult to finance.

There is hope on the horizon: An election is due in May 2009, at latest, and the center-right opposition is currently leading in the opinion polls. But wise investors know better than to base their investment plan on something as uncertain as that.

India’s other big problem is inflation, currently running at 8% per annum, which is higher than short-term interest rates. Higher commodity and energy prices have affected India as they have other countries; India’s position is made more difficult by the poverty of much of the population.

The Indian government has restricted exports of rice and has subsidized other foods and gasoline (the latter makes no sense socially since automobiles are largely owned by the middle classes).

Needless to say, these subsidies and restrictions make the budget deficit worse, and will pose an additional problem when they are lifted and newly unfettered consumer prices soar in response.

Growth has now acquired huge momentum, and any conceivable Indian government will do no more than slow it temporarily. Furthermore, the economics of the contracted-out customer support and manufacturing services that India has built into a national mainstay – in the era of globalization and the Internet – is so compelling that it will inevitably continue to produce huge profits for decades to come. The question is not:
“Should I invest in India?”  It’s actually: “How can I afford to ignore India?”

And the answer is: You can’t.

Stocks to consider would include Infosys Technologies Ltd. (ADR:INFY), the Bangalore-based software giant, which seems pretty invulnerable to Indian or global recession and is selling at a fairly reasonable 19 times current earnings and 20 times next year’s earnings.

Another possibility is the pharmaceutical company Dr. Reddy’s Laboratories Ltd. (ADR:RDY), a major generic drugs manufacturer that can expect to benefit from the expiration of many U.S. pharmaceutical patents in the next five years, and carries a fairly reasonable forward P/E ratio of 23.

Finally, you might consider India carmaker Tata Motors Ltd. (ADR:TTM), whose shares currently trade at about 8.5 times earnings. In the luxury end of the market, Tata recently bought Jaguar and Land Rover from Ford Motor Co. (NYSE:F). And at the bottom end, Tata has grabbed global headlines with its $2,500 Nano, a car that’s 40% cheaper than anything else on the world market.