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Financial markets have been weak and volatile recently as a result of the US sub-prime crisis, the credit crunch, a global economic growth slowdown and elevated inflation. The long-term case for India, however, remains compelling. India’s exceptional long-term economic growth prospects are likely to be driven by increased infrastructure spending, rising domestic consumption and significant expansion in immature sectors such as financial services.

With the global background uncertain, investors can be cheered by a number of specific features of the Indian economy. Exports accounted for only 16.5 per cent of gross domestic product last year and, consequently, India may be better placed than many other countries to withstand the global slowdown, especially given the impetus from economic reform and urbanisation. India’s banking system appears in quite good shape; its consumers have limited debts, with credit accounting for only 10 per cent of GDP and mortgages accounting for just 6 per cent in 2007 compared with 80 per cent for the US and 83 per cent for the UK.

After some years of 9 per cent GDP growth in India – and 8.8 per cent growth in the year to the first quarter of 2008 – UBS believes growth will slow to 7.1 per cent during 2008-09. Even so, India is expected to remain one of the world’s fastest growing economies, showing an expansion rate considerable in excess of rates prevailing in the developed world. Goldman Sachs analysts say: “India can potentially sustain real GDP growth rates above 8 per cent over the next decade thanks to favourable demographics, increased saving and investment, higher productivity growth due to catch-up, and rapid urbanisation.”

Rising inflation has been a global phenomenon recently as a result of increased prices for oil and other commodities, with emerging economies particularly affected. India’s inflation rate has risen to a 13-year high of about 12 per cent. This is nearly three times the levels at the start of 2008. India imports more than 70 per cent of its oil and its import bill for crude could rise to $120bn in the current fiscal year - almost twice the level of last year. This in itself constitutes a drag on GDP of about four percentage points. In addition, HSBC calculates that food accounts for about 60 per cent of India’s consumer price basket. Rising food prices, therefore, have a higher impact on inflation expectations than for the G7 economies.

In response to the rise in inflation, the Reserve Bank of India has taken decisive action. With three successive increases in the benchmark repo rate in two months, taking it to a seven-year high of 9 per cent, the Reserve Bank has issued a clear message that it will not tolerate high levels of inflation.

The BSE Sensex index rose to a peak of 21,206.77 on 10 January 2008 but then retreated significantly, ending July down 27.8 per cnet on the year. As a result, the index’s price earnings multiple has fallen from 27.8 to 17.9. This rerating offers investors an opportunity to invest, at reasonable prices, in companies offering strong long-term growth potential, including those focused on infrastructure and domestic consumption. At a corporate level, trends are encouraging. In the second quarter, the aggregate sales of the BSE Sensex’s constituent companies were growing at an annual rate of 31 per cent; their earnings before interest, taxation, depreciation and amortisation were increasing by 30 per cent and their profits after tax were rising by 20 per cent. If commodity prices continue to moderate, this should allow investors to refocus on the long-term business merits of Indian companies.

Global economic growth is slowing as a result of weaker demand trends caused by tighter credit conditions, with the slowdown particularly evident in the largest and most developed countries. US and UK economic growth has virtually evaporated while the eurozone economies actually contracted in the second quarter, with the core countries of France, Germany and Italy being particularly affected. Such trends are likely to lead to lower commodity prices and thus reduced inflationary expectations later this year. This should increase investor interest in emerging markets that are significant net importers of commodities such as India.

The fall in the BSE Sensex since January illustrates the impact of high oil prices on Indian investor sentiment but if commodity prices to maintain their recent downward trend, international investors are likely to start focusing again on the long-term business merits of Indian companies, particularly factors such as the domestic market demand growth created by a favourable demographic profile, the country’s skills base and the growth potential of the country’s still immature financial services sector.

Within India, various factors are likely to affect investor sentiment. Liberal reforms, especially in the pensions and banking sectors, and the divestment of public enterprises would be well received by investors. A benign monsoon season after a slow start, would also be influential. Internationally, the main drivers on investor sentiment towards emerging market equities are likely to be commodity prices and the flow of US economic data.

With oil prices having weakened recently and inflation coming under control as a result of the central bank’s proactive stance, the cheaper corporate valuations in India resulting from profits growth and weaker share prices are becoming compelling. This means investors are now being offered an attractive entry point into the Indian equity market and exposure to the robust long-term potential for gain within India’s economy.

Ian Beattie is head of Asian ex Japan for New Star Asset Management