India Faces A Currency Free-Fall

Aug.29.13 | About: WisdomTree India (EPI)

The Indian Rupee is in absolute free fall, hitting a level not seen in 20 years as market participants rush for the exits in what was once a favored emerging market. As you can see from the chart below, orderly selling has given way to a panicked dumping of the currency, leaving India's Central Bank scrambling to stabilize the rupee. For instance, the bank will now exchange dollars for rupees off the market with major Indian oil companies, which would alleviate $400 million-$500 million in daily selling pressure on the spot market.

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For investors, we have to ask if this selling is rational or whether it is a buying opportunity. Through various ETFs, namely the Wisdom Tree India Earnings Fund (NYSEARCA:EPI), investors already have several billion dollars in Indian equities while many U.S. multinationals do significant business on the subcontinent. Unfortunately, I don't see the Indian situation getting better and would sell holdings dependent on a strong India. I feel this way for several reasons.

1. While still considered a "fast growth" economy, the Indian economy has decelerated severely since the financial crisis:

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The Indian economy is now barely growing faster than the U.S. economy, which for an emerging market with 400 million living on a dollar a day is unacceptable and pathetic. The Indian government is plagued by corruption and bureaucratic red tape. For instance, thousands of tons of wheat and rice are rotting in warehouses while millions live in starvation. Unfortunately, the government is so mismanaged it has been unable to help the poor rise into a middle class, leaving the country with a society of a small privileged class and a large destitute one. That level of inequality does not breed economic growth. Worse, the government has been racking up massive deficits in the process, leaving it without the firepower to do a pro-growth stimulus plan that could kick start the economy as shown in the following chart. With a slowing economy and impotent government, investors will run from India, sending its currency and stock market lower.

In the mid-2000s, there was widespread enthusiasm India could grow dramatically despite a weak central government. GDP growth consistently was above 10%, and the hope was that level of growth was sustainable, which would create a middle class. Further at that level of growth, tax revenue would increase dramatically, putting the Indian government back on strong financial footing. Sadly, this thesis has not played out with growth slowing dramatically. Five years ago a prevailing thesis was India was analogous to 1995 China, a budding emerging market that took off in the following decade. Using the China template, investors poured into India, hoping to garner that level of returns. The Indian government has proven incapable of supporting the level of growth seen in China. As this thesis has proven misguided, investors have left India en masse.

The Chinese economy grew dramatically because the country leveraged its low input costs (namely wages) to become an exporting powerhouse. With India, like China, having a large number of poor citizens, many thought India too could become an exporting hub, growing the economy and improving standards of living for the poor. As you will see next, India has been unable to deliver on this promise with its current account deficit deteriorating to new record lows.

2. India's trade data are disastrous. A major reason for the decline in the rupee has been India's trade deficits. The country is a major importer of energy and agricultural commodities whose prices have soared. On the other hand, the country exports few manufactured goods. As such, since the financial crisis, the nation's current account deficit has blown out.

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Commodities are priced in dollars, so to buy these products, Indian companies must sell rupees in exchange for dollars. In the last 12 months, the current account deficit reached an unprecedented $87 billion. For comparison, India maintained a current account deficit near the flat-line from 2000-2007, never dropping below -$12 billion. In other words, India's trade problem has gotten eight times worse than it was before the financial crisis.

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As imports grow while exports stagnate, this selling pressure grows, sending the rupee lower while exacerbating the current account deficit. In a situation like this, you are left with a self-feeding, ever-worsening downward spiral. Without a strong central bank ready to step up and put a floor on its currency, the market could collapse, tanking the Indian economy while sending inflation higher. Unfortunately, the Indian Central Bank is limited as its foreign reserves have been declining steadily for 24 months, now down to $280 billion. Further, its window to the oil companies will erode that total by $500 million every day. The Reserve Bank of India is so concerned about its dwindling reserves that there have been reports it is considering selling dollar denominated debt to help it stem the fall in the rupee market. Unfortunately with such a large current deficit and weakened central bank, the rupee's decline is set to continue

3. A low rupee could translate into numerous Indian corporate defaults. Many Indian companies have already resorted to selling dollar denominated debt. As the rupee declines, this debt grows more expensive, and at some point, many of these borrowers will be unable to pay the loans back. Dollar-denominated corporate obligations currently surpass the central bank's $280 billion in foreign reserves by $100 billion:

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A rash of corporate defaults could lead to an Argentina-like crisis which would seriously weaken the Indian stock market. Further as foreign debts far exceed foreign reserves, there will be significant net selling pressure on the rupee in the spot market. This selling will weigh on the currency for months if not years. With the currency down 20% in six months, a company with $1 billion in debt essentially has a rupee-adjusted $1.2 billion in debt, leaving the Indian corporate sector with a significant amount of hidden leverage. In other words, India's corporate balance sheet is a lot worse than it appears. Defaults will send stocks lower and the rupee weaker than 70 to the dollar

4. The great Fed carry trade is coming to an end. Lastly, India has benefited greatly from the Federal Reserve's policy of quantitative easing. Essentially, investors who couldn't earn anything in the United States, thanks to record low interests, moved their money overseas where they could earn a higher rate of return. Basically, you could borrow in dollars at 0.25% and invest them in Indian rupee bonds earnings for 5%. Even after hedging currency exposure, you saw earnings with very low risk. As the Fed pulls back from easy money, borrowing dollars is getting more expensive. At the same time, India's growth prospects have faltered more quickly than those in other emerging markets. As such, we have seen a rapid unwind of the dollar-rupee carry trade. In the past month, a trade that has been accumulating for 3 years began to reverse quickly. I expect this unwind to pressure the rupee through at least the end of the year

Conclusion:

Based on my analysis, India may be the most endangered emerging market on the planet, and I would eliminate exposure to the struggling sub-continent. The country has a weak central government that lacks the capacity to restore growth to normalized levels of 5%+. Its current account deficits are emblematic of an economy that has little real growth and will exacerbate its currency crisis, especially because its Central Bank lacks the reserves to stem the decline. Indian companies have overexposed themselves to the rupee by selling nearly $400 billion in dollar denominated debt, and the drop in the rupee has added hidden leverage to the corporate sector. Last, the coming end of QE will lead to an unwind of the dollar carry trade, which will send the rupee tumbling further. From here, I see another 10% of downside to the rupee, and as a result, the Indian economy will be stuck in the mud and stare down a possible contraction. You should sell the EPI and any other Indian investments in your portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.