Could India Go the Way of Greece and Italy?

Could India, which has the world's second-fastest-growing economy, follow the lead of Greece and Italy?

Long-term yields on India's debt are about 9%, much higher than Italy's when the European nation started to quake, an ordeal that ended with the resignation of Prime Minister Silvio Berlusconi two days ago. India's high yields are less concerning because the country's economy is growing quickly. Still, there are signs of slowing growth and a weakening banking system.

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India's economy, like China's, is struggling to maintain rapid growth against a backdrop of high inflation, rising interest rates and monetary tightening. The country's trade deficit is widening, inflation is very high, and the savings rate has been de-regulated even as rates are already rising. This year, India's central bank expects GDP to grow by 7.6%, less than an earlier estimate of 8%.The country's trade deficit widened to its highest level in 17 years in October. Some analysts think the deficit could get even bigger as higher oil costs drive up the value of imports. The deficit has weighed on the value of the rupee and, in turn, pushed up inflation. In fact, the inflation rate has stayed above 9% since the start of last December. In an effort to cap rising prices, the central bank of India raised interest rates for the 13th time in October, making borrowing more difficult. In a surprise move last week, Moody's downgraded the outlook on India's banking system to "negative" from "stable." The ratings agency, trying to anticipate deterioration in the banking system, cited asset quality as the cause for the downgrade. A majority of the banks are owned by the government, and it is assumed that state-owned lenders account for about three-quarters of the market in terms of assets. Government ownership means they won't let the system fail, but it could also mean large capital infusions by the government if things go awry.State Bank of India, one of the country's largest banks, reported that defaults on loans may increase and set aside funds to cover those potential defaults. Prior to the announcement, in October, Moody's downgraded the company's credit rating to D+.

Part of the problem in the banking system is the steep increase in borrowing costs. The central bank has raised interest rates by 375 basis points since March 2010, driving up deposit rates and hurting profits. Furthermore, savings rates have been deregulated, forcing banks to compete for customers. Coupled with higher borrowing costs, profits are shrinking.

Corporate earnings in India have begun to slow. U.S. technology bellwether Cisco(CSCO) for the first time mentioned India as a concern on its quarterly conference call last week. CEO John Chambers said "Europe and India obviously are two geographies we're watching, and India, it's partially currency and macro but it's a large part, the government gears are just grinding to a halt."

Tom Linebarger, president and COO of industrial-goods company Cummins(CMI), said in a recent earnings call that "government actions to reduce inflation in India and China have resulted in softer near-term demand."There are a number of signs that point to a slowing economy in India, making it a country to keep our eyes on. Reducing exposure to investments in India now would be wise. Remember what happened when Moody's placed Italy's rating on review?

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