The sharp reaction wasn’t a surprise: Since it including nothing about privatization, and outlined a deficit that widens to dangerous levels, the budget was nothing but bad news for investors.

Russia, by virtue of its myriad economic travails and poor overall performance, faces an equally dour near-term outlook. Given those two laggards, is it possible that the Goldman Sachs Group Inc. (NYSE: GS) “BRIC” group of exciting emerging-market players will narrow the to the “BC” – meaning investors should focus their attentions on Brazil and China alone?

Insights on India’s Economic Travails

Investors had hoped that the thumping electoral victory for the Congress Party in May would have opened the way for further financial reform and privatization, but new Finance Minister Pranab Mukherjee is an old Congress Party warhorse left over from the days of state control. Mukherjee was previously finance minister under Indira Gandhi in 1982-84, a period of state-controlled economy and sluggish economic growth that took place well before the Indian economic liberalization began in 1991.
The new budget confirmed that investors’ hopes of the new Congress-led government are likely to be dashed. It increased the deficit further – to 6.8% of gross domestic product (GDP) – raised state spending by a startling 36%, and boosted subsidies for food and petrol by an astonishing 55%. Since the budget also increased the target for state and local government budget deficits – to 4% of GDP – an overall Indian state sector deficit in excess of 10% of GDP seems assured.

India isn’t the United States, in which such large deficits can easily be financed – or at least can be for a time. Moody’s Investors Service (NYSE: MCO) rates India’s domestic debt as a Ba2 – a “junk” rating – and the country is already running a significant balance-of-payments deficit.

India has foreign-exchange reserves of $223 billion, so one year of a $95 billion budget deficit (plus about another $60 billion at the state level) can probably be financed, but if there was an overrun – not impossible, particularly if organic economic growth does not resume – the strain on India’s foreign exchange reserves would probably become unbearable.

Most important, such large budget deficits might well lead to a substantial “crowding out” effect in the Indian domestic market, in which Indian businesses find it difficult to raise money. Unlike in the United States, the Reserve Bank of India cannot just buy government bonds to prop up the market; Indian inflation is already running at 8.7%, and any “monetization” of the government deficit by the central bank would push it well into double digits.

India-watchers have seen this move before – periodically, until reform began in 1991, and speeded up after 1998. From 1947 to 1991, whenever economic growth picked up, the government would attempt to spend all the extra money that was being generated by the tax system and the deficit would become impossible to finance.

India’s economic sluggishness in the period to 1990 – when economic growth peaked at around 3%, or 1% per capita, while other Asian countries were racing ahead – actually spawned a controversial and derogatory term, known as the “Hindu rate of growth,” which spawned even more angst when it was attributed to cultural difficulties.

With the growth of the last two decades, we now know this to be nonsense: India can perfectly well grow as rapidly as China if it wants to. The obstacle is India’s government, and that’s an impediment that’s not going to disappear anytime soon.

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The Outlook for Stocks

The implications of all this for Indian stocks are dire. If India’s government runs budget deficits that burden the capital markets, and economic growth slows sharply, domestic stock prices are likely to be affected accordingly.

India’s stock market, currently trading at a Price/Earnings (P/E) ratio in excess of 20, will be devalued until it has a P/E like Turkey (8.2) or Sri Lanka (7.7). In such a situation, the rupee would also be weak (it has already dropped by 10% against the dollar in the last year) giving U.S. investors doubly painful losses, perhaps even in the range of 50% to 60% from current levels – which already are 30% below the January 2008 peak. Only major exporting companies with liquidity sufficient to fund their operations without raising new domestic capital would flourish.

The world is thus in a position in which two of its great growth engines – India and Russia – are likely to run into increasing difficulties. Fortunately a third, Brazil, has been growing much better in the last few years, with policies of high domestic interest rates and contained budget deficits that have allowed its resources sector to flourish.

And while Western economies remain mired in recession, global growth is currently excessively dependent on China, the largest emerging market of them all.

Source: India’s Budgetary Woes Are a Warning to Global Investors