Short India Is a Perfect Emerging Market Trade

American fund managers investing in the emerging markets today are fundamentally assuming that, over a given time horizon, profits from equity investments will far exceed losses from currency devaluations. That assumption needs to be contextualized in the reality that, if investments in emerging markets like India were made on a fully hedged (forex risk) basis today, mutual funds would be forced to realize significant losses in their financial statements at the very outset.

The Indian rupee far forward rate, to offset currency risk on 3-year equity investments, will result in a net loss of about 24% today for dollar investors. Thinly traded 5-year contracts to purchase dollars are being offered at a premium of 35%. Few fund managers are known to actually offset foreign exchange risk unless, of course, they are confronted with panic conditions, like those witnessed this month.

Forward premiums apart, the rupee has lost 20% of its value against the dollar during the course of this year. There are several reasons to anticipate another 15% move downwards by early 2009 and to predict a further widening of forward differentials. Interestingly, the single most powerful indicator of the fate of the rupee is the behaviour of "hot" money being generated every day by India's huge and powerful underground economy.

Dubai's "hawala" traders claim that over $300 million has left India's shore this month alone; hawala currency exchanges are executed outside mainstream banking channels with an exceptionally high degree of anonymity. India's central bank, which periodically intervenes in the inter-bank foreign exchange markets for limited durations, has no ability whatsoever to control the flow of cash in the hawala system. Further bad news from the global economy, like Monday's downgrade in Pakistan's credit rating, will only increase hot money outflows.

Besides, the only inference one can draw form statistical data is that the Indian economy is now in reversal, as opposed to being in the midst of a cyclical downturn as many asset managers would like to believe, with several sectors contracting at an alarming rate. The default rate amongst 30 million credit card holders is likely to breach 22% before the end of this year, by conservative estimates. The crisis in housing will force most of India's leading real estate companies to renege on their debt service obligations in forthcoming weeks. Speaking of consumer confidence, a recent survey showed that more than 50% of working Indians fear losing their jobs in 2009. Darkening the scenario are rising food prices, which have been steadily chipping away at the value of middle- and lower-income family incomes since the commodity boom began in mid-2007.

Before fund managers invest in India or, for that matter, in other emerging markets, they should ask themselves the same three questions which the holders of underground capital, the ones with most at stake on a daily basis, ask themselves each morning: How much of the phenomenal growth in consumer spending power in this decade can be attributed to easy credit? Is the debt-induced fairy tale coming to an end? And, perhaps most importantly, are poverty levels in the urban and rural centres creating the potential for deep-rooted social unrest?

The short India trade is justified by both currency risk arbitrage considerations and the status of the Indian economy. Such a short trade may not be possible to execute in the equity exchanges. But the short India canvas is wide enough: buy synthetic shorts on exchange-trade India funds and shares on each rally, buy stock index puts in similar fashion, and buy 3-year sovereign default risk and far forward dollars now.

Stock position: None.

Comments

[Toxic:]

A very badly presented argument...Which emerging market is not struggling in the current environment..be it the Brazilian market or the russian...ur argument that the Indian economy is in reversal is laughable..

2008 Oct 29 10:17 AM

[User 288085:]

I agree with the author. All of the current events tend to supplement the theory put forth. What the US saw in terms of real estate bubble is yet to happen in India. It is not the question of, if but when it is going to burst. Giving free luxury cars, cutting the interest rates are home loans are all the things that were done here in US. It is strange how the India is following US step by step and still the sentiment is that Indian economy is totally different from US. Currency, real estate, credit cards, downturn is outsourcing are few of the challenges facing India. From what I hear, there is huge defaults in payments by US companies to their outsourcing partners.I predict an exodus of CEOs leaving the companies, before the layoffs have to happen. I would do the same if I were a CEO there. Why would I want to risk my life for any layoffs that I may need to so in my company.
Each of the BRIC countries are facing major challenges without any exception.

2008 Oct 29 11:44 AM

[stocks:]

I think Indian Market is a potential market. Some of our visitor are from Indian.

2008 Oct 29 11:47 AM

[Atim Kabra:]

Fundamentally flawed argument:

Information technology companies and basic commodity producers / integrated commodity based plays which make a significant percentage of the Indian market (be it the BSE 30 Index or Nifty Fifty: main indices for synthetic products) are not impacted if the rupee falls against the dollar. IT companies realise better profits while commodity producers price themselves in dollar parity terms.

A falling currency argument may have some merit (though argument may turn itself on its head when markets stabilize). However, the currency will fall, so short the market is not the best of the strategies.

2008 Oct 29 12:08 PM

[Teak:]

Yes, bloggerman, dump your Indian shares; short, short, short; run for the exits!!!!

But promise me this: never come back.

Teak

2008 Oct 29 11:25 PM

[ABCD:]

My modelling is clear-Get out of your investments both share market and real estate-Liquidate and keep your funds safe in ready cash,gold and silver coins and expunge all debt- In terms of work get into real service based industries-
Wait for 2 or 3 years and see what happens- I am modelling the effects of the cash bailouts of Banks and others and what the effect of this will be in 3 to 4 years and its looking real bad- reason-the savings of nations is being used to create more debt that will never be repaid-
Its time to stop propping up failures and cut them loose and back to basics-

2008 Oct 30 01:19 AM

[andyn:]

This argument would be ok maybe a year back, BEFORE the markets started melting.
Now, this is looking back... what money had to be taken out of the indian market, has already been.

Looking forward, India is actually poised better than other BRICs.
Commodities coming down in price is huge as inflation will recede, thereby allowing the central bank to start easing over the next few months.
I would be buying shares which have been murdered with the selloff, like IBN at under $15 is VERY cheap. You can actually catch a double within a year.

2008 Oct 30 09:38 AM

[hownow:]

2 points for the optimists:

1. ALL the retail investors are still holding their stocks since index 21,000 and will hold until 6,000.

2. Anyone tried selling property in India lately ?

Read indiaplay.blogspot.com for reality check haha :)

2008 Oct 30 11:32 AM

[dkp:]

Watch for the Indian boom in 2010, with currency advantage of nearly 30% over China, and industrialists of
of high calibre( compared to China's civil sevants run enterprises), the only handicap that India has to overcome is political corruption.

2008 Oct 30 09:10 PM

[gksmar:]

I agree with the last comment from dkp. There is a huge organic growth within India. This down turn in the commodity prices may be a boon to India to reduce its costs for infrastructure building and prop up the employment and economy. Also oil is is down which was a huge burden to the indian economy.

2008 Oct 30 10:38 PM