By Martin Hutchinson
Contributing Editor

With sky-high growth potential, China and India are the two markets no investor can afford to miss out on. But that doesn’t mean they’re impervious to market turbulence, and in times of trouble, India is the more reliable investment.

No doubt, both countries’ markets are suffering this year, with China’s Shanghai A Index down 50%, and India’s Sensex Index down 25%.  It’s no secret that India is struggling with both a growing budget deficit and mounting inflationary pressure. But China has problems too – it’s just hiding them under the carpet until the Olympics are over.

That’s why, for me at least, the investment decision is clear – I’ll buy the country whose problems are out in the open and already reflected in stock prices.

China’s Pending Credit Crunch

China’s inflation has been quiescent recently. It declined from 8.7% year-over-year in February, to 7.1% in June, taking it below the People’s Bank of China’s (PBC) one-year lending rate of 7.47%. Since the principal driver of global inflation has been the sharp run-up in energy and commodity prices, China’s inflation moderation is anomalous.

Apart from any figure-fudging in the run-up to the Olympics, China’s moderating inflation can be explained by increased state controls and subsidies. Rice and wheat prices have been controlled only since January, while energy subsidies have increased in 2008, from $22 billion to $40 billion, as the country holds petrol prices down to two thirds the U.S. level – around $2.85 per gallon in Beijing.

Those effects alone would suppress reported inflation by 3%-4%.

China has also used every effort to produce a quiescent population and clean air for the Olympics –1 million cars have been banned from Beijing streets for three months, for example. But once the Olympics are over, those Herculean efforts will no longer be necessary. We can then expect an easing of food price controls (which themselves require subsidies to bail out farmers) and a sharp reduction in energy subsidies. At that point, it seems inevitable that reported inflation will soar into double digits.

The PBC’s lending rate of 7.47% and deposit rate of 3.33% will then be highly inflationary. It will also provide substantial disincentives to saving. Since the Chinese authorities appear to understand the role of interest rates in controlling inflation, rates will no doubt be raised sharply, so that at least the lending rate will be in double digits, along with inflation.

A post-Olympic credit crunch will be the result, but it won’t affect the largest government-controlled companies. They will be bailed out if they run into difficulty. However, the crunch will be particularly damaging to small businesses, as well as the true private sector.

The Devil You Know vs. the Devil You Don’t

In India, on the other hand, wholesale inflation rose from 7% in March to almost 12% in July.  The Reserve Bank of India is also running negative real interest rates; they are currently about 8% nominal.

As in China, the Indian government is subsidising food and forcing the state-owned oil companies to sell gasoline to domestic consumers below cost. The result has been an explosion in the Indian budget deficit, which is thought by many observers to exceed 10% of India’s gross domestic product (GDP) in the fiscal year to March 2009.

Both China and India are dealing with excessive inflation, interest rates that are too low, and budgets that are out of balance (though China’s figures are so opaque one cannot be sure of the true position). Falling oil prices could help the inflation position in both countries, but it is unlikely that oil prices will fall enough to restore stability in either.

The difference between the two countries is that China is still under the impression that its inflation is a moderate and controlled problem, whereas India has no such illusions.

For this reason, I would be more tempted by an Indian investment in the current market than by a Chinese one.

When investing in India, it is advisable to focus on companies that are internationally competitive and active exporters, rather than looking at the domestic market. That’s because any budget or inflationary difficulties will probably be reflected in a weakening of the rupee, which will help exporting companies. It is also preferable to look for companies with, at most, moderate leverage, which are less likely to suffer from a banking squeeze.

Infosys Technologies Ltd. (ADR: INFY) is India’s premier exporter of software, with almost no debt, that is currently trading at about 17 times earnings to March 2009, with a dividend yield of 1.9%. That high rating reflects the growth potential of Infosys’ business sector, in the context of which it is reasonable.

Dr. Reddy’s Laboratories Ltd. (ADR: RDY) is India’s premier manufacturer of generic pharmaceuticals, poised to benefit in the 2008 – 2012 period as many popular drugs lose their patent protection and are opened to international competition. It has moderate debt, about 50% of equity, and is also selling at a multiple of 17 times earnings to March 2009, with a dividend yield of only 0.8%. Again, the relatively high rating reflects the growth potential in Dr. Reddy’s global business.

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