In India, the fertilizer sector has long depended on gas as a key input. Over the last decade, several power plants that run on gas have been set up as well. Demand has grown 10% each year since 2002 while supplies, largely managed by state-owned enterprises (SOEs), have failed to keep pace. Inefficient capital allocation, lack of incentives and populist policies aimed at maintaining low prices have led the country to import 25% of its gas needs. This has further exacerbated India’s current account deficit, which now stands at 6.7% of GDP.

Sustained exploration and production requires substantial investment by SOEs. However, not only has the government fixed gas prices at half the international levels, SOEs also share in the fuel subsidy burden. Consequently, some SOEs have reported significant losses and investment has failed to match demand growth. Now, media reports suggest India’s Finance Ministry is considering directing SOEs with substantial cash to engage in share buy-backs or distribute special dividends. As the largest shareholder, the government has ready access to cash to address the current deficit, SOE investment priorities notwithstanding.

To reduce the subsidy burden and move away from artificially low prices, a special committee was formed in January this year. It developed a formula based on international prices and recommended a 90% price hike. However, the committee lacked representation from the power and fertilizer sectors. Combined, the two sectors utilize three-quarters of gas production and are expected to resist the committee’s recommendations. Political considerations also reduce the likelihood of price hikes. If implemented, both sectors will look to pass on increased costs to consumers. With more than half the country’s labor force engaged in agriculture, price hikes might turn voters against the current government.

An additional concern is that this price mechanism references U.S. gas prices. Should U.S. policy allow gas exports and U.S. prices rally, Indian prices could rise well above current proposed levels, stoking inflation fears.

In recent years, liquefied natural gas (LNG) imports have mitigated India’s gas shortfall. However, imported LNG costs twice as much as domestic natural gas. India's weak rupee has further driven up import costs. Moreover, LNG terminals are running at full capacity, constraining the volumes of gas that can be imported.

To address the gas shortage, the government could review prices annually and raise them as needed. The subsequent reduction in subsidies would free up resources for SOEs to acquire reserves. To increase transparency, the government could directly transfer subsidies to end users of fertilizers, rather than subsidize gas inputs. Further, the proposed pricing mechanism could be modified to include maximum and minimum price levels to moderate inflation. Parity with higher international prices could then induce private companies to increase their productivity. Rather than being reactive, the government needs to be proactive and invest in capacity well in advance of rising demand. Unfortunately, with general elections scheduled for next year, India’s politicians seem more likely to focus on short-term deals than on long-term strategic initiatives.

You should consider the investment objectives, risks, charges and expenses of the Matthews Asia Funds carefully before making an investment decision. This and other information about the Funds is contained in the prospectus, which may also be obtained by calling 800.789.ASIA (2742). Please read the prospectus carefully before you invest or send money as it explains the risks associated with investing in international and emerging markets. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. In addition, single-country and sector funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific industry, sector or geographic location. Investing in small- and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than large companies .

The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews does not accept any liability for losses either direct or consequential caused by the use of this information.

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