Can India ETFs Beat Inflation Epidemic?

Emerging markets have hit some rough patches in 2011, as concerns over debt in the developed world as well as a possible slowdown in some key developing countries has caused many to pull out of risky markets entirely. As a result, broad based funds such as VWO or EEM are down on the year and are lagging behind their developed counterparts in both the U.S. and internationally. While this trend has hit all markets, some have been much more impacted than others. Markets such as Malaysia, Russia, and Poland are all up at least a few percentage points so far this year, outpacing many of their rivals across the globe. On the other end of the spectrum, are three countries that have turned in by far the worst performances this year; Egypt, Vietnam, and India.

While Egypt is down for obvious reasons -- the ousting of long time president Mubarak and the political turmoil that has followed -- Vietnam has seen its market plunge thanks to a devalued currency and continued long-term fears over the nation's ability to get its economic house in order. Given this weakness, many might be surprised to see India, a stalwart of many emerging market investments, among the worst performing regions of the world so far in 2011 [see all the India ETFs here].

India, as one of the four members of the BRIC group of nations, has been a favorite for emerging market investors for years. The country has tremendous promise thanks to its relatively well-educated English speaking workforce, rising incomes, and its strong demographic profile that is far superior to the fellow rising giant in the region, China. However, this growth has come at a cost, and now inflation is nearly spiraling out of control across the country. The rate of price increases for food in the country recently accelerated to 9.0%, a far quicker pace than the nation saw just a week before, when prices increased by 8.55% in comparison.

Although India has seen impressive rates of growth for several decades now, millions of the country's citizens are still extremely poor. In fact, it is estimated that India spends close to 20% of its income on food and close to 37% of the nation's people are considered extremely poor -- making less than $1.25 a day. With such a large number of citizens making so little, a 9% year-over-year increase in food prices can have drastic implications for the entire country [Inflation Fighting ETFs Back in Focus].

Banks Take Action
In response to this, the country's central bank has already hiked rates 10 times in the past 15 months, and many analysts are looking for the central bank to hike rates by another 75 basis points by the year end. Currently, rates stand at 7.5% after the bank's latest hike in June, but inflation still remains at close to the highest level among all the BRIC nations. "Notwithstanding both signs of moderation in commodity prices and some deceleration in growth, domestic inflation risks remain high," the central bank wrote in its mid-quarter policy review. "Against this backdrop, the monetary policy stance remains firmly anti-inflationary, recognizing that, in the current circumstances, some short-run deceleration in growth may be unavoidable in bringing inflation under control."

At this level, rates are the second highest out of any major economy -- only lower than Brazil -- suggesting that the RBI doesn't have very many options left when it comes to rate hikes in order to curtail inflation. Furthermore, since the country imports nearly 80% of its energy from abroad, an oil spike later in the year could boost broad inflation readings even if the central bank engages in further rate hikes, potentially crippling the economy from two sides [also read Emerging Market ETFs: Seven Factors Every Investor Must Consider].

Thanks to this reality, India ETFs are among the worst performing products in the emerging market category, only beaten out by the likes of Egypt and Vietnam. Take a look at how the region's ETFs have performed so far this year:

ETP YTD Performance
India Small Cap Index ETF (NYSE: SCIF  ) -20.6%
EGShares India Infrastructure Fund (NYSE: INXX  ) -19.7%
EGShares India Small Cap Fund (NYSE: SCIN  ) -12.7%
iPath MSCI India Index ETN (NYSE: INP  ) -11.2%
WisdomTree India Earnings Fund (NYSE: EPI  ) -10.4%
PowerShares India Portfolio (NYSE: PIN  ) -8.9%
iShares S&P India Nifty 50 Index Fund (Nasdaq: INDY  ) -8.1%

Perhaps unsurprisingly to many investors, the large caps in India -- as represented by EPI, PIN, and INDY -- have all lost the least so far in 2011, with an average decline of about 9%. That compares to the more severe losses for the small caps and infrastructure focused products that operate in the Indian market. This could be due to several reasons. First, investors should note that many of the large cap focused funds are heavy in energy, technology, and basic materials firms. Materials and energy firms generally have an easier time of pushing costs onto end users while tech firms can often benefit from inflation by appealing to companies looking to cut costs. Meanwhile, SCIN and SCIF have much higher levels of exposure to consumer companies; nearly 25% in both cases, suggesting that for reasons listed above, high inflation rates are hitting the small caps especially hard [ETN Investing: Facts And Fallacies].

How to Play
There are two ways to look at this situation; India's campaign to hike rates will eventually bring down the rate of inflation or that the level of price increases will disrupt the national economy. Further inflation is obviously likely to be devastating to the Indian economy and could push many investors further into the red, and especially those in small cap focused ETPs. On the other hand, for investors who believe that India can get its act together and keep inflation in check, this could be an excellent entry point to Indian ETFs, allowing investors to scoop up beaten down names across a variety of sectors. Additionally, sophisticated investors could play this trend by using a pairs trade, going long in a large-cap ETF and short in a small-cap fund in order to play higher inflation rates for the time being or vice versa if they believe the opposite to be true. Either way, investors are likely to see big changes in the Indian market in the second half of the year as high inflation coupled with large amounts of poverty cannot go last too much longer; something has to give [Corruption Scandal Sinks India ETFs].

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Disclosure: No positions at time of writing, photo is courtesy of Deepak Gupta.

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