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Over the last 13 years, India has had a huge boom in capital inflows. An increase in the quantity of money has led to high inflation in consumer and asset prices. Over the last few months, these inflows have started to reverse and India now finds itself short of foreign capital. Consequently, the Indian rupee has fallen more than 20% in 2013.

In addition, property prices have seen unreasonable increases over the last decade. Prices are up more than 5 times across the nation. These prices are much above the inflation adjusted levels, and must correct. Such a correction would make the consumer increase his propensity to save and leave the economy in ruins. As foreign investors exit India, they will leave the Rupee even weaker.

The best way for a trader to short the Indian Rupee is to short the Rupee ETF, WisdomTree Indian Rupee (NYSEARCA:ICN).

Why Short The Rupee?

Due to market expectations of higher interest rates in the US, many Asian economies saw a drop in their currency exchange rates with the US. This occurred due to an outflow of capital from those countries, back to the US. However, a few of those countries, in particular India and Indonesia, have higher current account deficits, higher fiscal deficits and high inflation.

As the foreign investors assessed these measures, their fears about access to their own capital were exacerbated. For instance, since India has a high current account deficit, it is always in need of forex reserves from abroad to fund its net imports (imports - exports). An exit by other foreign investors from India has caused a situation similar to a bank run, where depositors form queues to withdraw their money before it runs out. This has and will continue to cause a spiraling effect that strengthens the outflow of foreign exchange reserves from India. Such transactions weaken the Rupee.

History:

Until now, this demand for dollars was catered to by optimistic investors. India witnessed high capital inflows over the decade and could thus fund its current account deficit. But as they lose hope, India would find itself with a serious shortage of capital.

The current account balance and the capital account balance are joined at the hip. One affects the other. If a country were to attract a large amount of foreign capital, it would generally import more (which might lead to a current account deficit), since the investment/spending in the country has turned out to be higher than the savings of the residents.

In simpler terms, imagine being given a billion dollars in foreign capital to invest within your city. On starting your asset purchases, you would soon cause a shortage of products for the other investors, and the vendors would then resort to imports to satiate the demand caused by an increase in funds available. The only way an increase in capital would not cause increase in net imports is if the total income savings in the city were equal to or greater than the total new investment. Thus, current account deficit = domestic saving - domestic investment.

Now, as investors shift their capital allocation, India becomes devoid of capital, and frequent selling of Rupee in exchange for the US Dollar makes the Rupee cheaper.

If this were all there were to the story, India's capital inflows would decline, and the current account would soon balance. And that would stop the decline in the value of the rupee. However, capital inflows usually bring with them another serious demon - the bubble like rise in property prices. These prices rise until the music is playing, but the subsequent decline is never soft, and usually takes the economy into deep deflation (fall in consumer prices). This is exactly the risk India faces.

India has a property bubble that would make the American housing bubble of the last decade look feeble. Prices in major cities and small towns have risen upwards of 5 times in the last decade. As the prices start to fall, so would the consumer's propensity to consume. With that, all consumer prices along with asset prices would decline. The economy would be in a very bad position. As a result of this, the currency would decline much further.

True Level for House Prices:

How does one estimate the correct value for real estate? Historically, over longer periods of time, real estate prices have matched the inflation levels. So, if inflation was 200% over 30 years, then the nominal house prices should match the appreciation. Sometimes, due to property bubbles or economics slumps, the house price increases exceed or stay behind the inflation levels. However, over a longer period, they do match, as can be seen from the graph below. This is the inflation adjusted house price index for the US.

These housing bubbles usually start because of speculative frenzies in the markets. Some other good modes of detecting a housing bubble are the Rent to Price ratio and the Rent to Income ratio. Not surprisingly, all of these ratios have gotten skewed in India.

From the above graph, inflation can be said to have grown at an average rate of almost 6% between 2001 and 2013. Let us put a liar's premium on it and assume inflation grew by 10% each year during that period. Using a 10% inflation rate for 13 years produces a cumulative CPI increase of 250%.

Now, let's compare it to the house price increase in New Delhi, the capital of India. From the 2 charts provided below, we determine that house prices grew by 500%.

When compared with inflation during the same period, house prices in Delhi seem overpriced by 250%. Although, the housing figures for the rest of India are not provided here, they pose a similar picture.

Scenarios:

As seen from the charts above, housing prices must correct to their inflation adjusted levels over a longer period. Thus, anything short of that means that the bubble has not burst completely. In addition, there is a chance that a housing market could overcorrect and become undervalued. For that to happen, prices in India would need to fall more than 50-60%. However, a mere correction that brings home prices in line with inflation does demand a drop of 50% in real estate prices.

The house price decline in India has just begun. Prices in the second quarter of 2013 fell 1.5% in New Delhi.

It is difficult to predict with certainty the time period over which such a decline would occur. But house price declines generally take longer than 3 years to completely materialize. For instance, in the US, home prices started to fall in 2005-2006 and fell until 2009 at high rates, and continued to fall marginally till 2012.(S&P/Case-Shiller 20- City Composite Home Price Index Factsheet).

Would a Monetary Policy Response Work?

To counter the deflationary spiral, the Reserve bank of India would start to print money. But, as has been noticed in the US, once the consumer decides not to spend, there is very little the central bank can do through quantitative easing. The same has been evidenced in Japan for the last few decades. Japan had a major stock market and property bubble collapse in the early 90s, and has not recovered completely, as yet.

Instead, the printing of money may scare potential investors and reduce the capital inflows further. The only way India can start to recover is through a sustained focus on higher exports and lower imports. This, however, would only be possible after immense pain in the system.

The Reserve Bank of India is unlikely to raise interest rates much to make the rupee strong. Higher interest rates can induce investors to send capital back to India. However, such a policy measure would have terrible consequences. Interest rates rise when liquidity in the market is reduced. If the quantity of money were to fall in India, the economy, which is already weak, would weaken further. This would make equities a terrible investment, and the only destination for foreign capital would be blue chip bonds. However, that may not be an attractive option either. Indian companies are said to have a large amount of dollar denominated debt, and there may be an increase in defaults due to the recent decline in Rupee value. This should dissuade investors from lending them money.

In addition, higher interest rates and reduced liquidity would make property prices fall faster and lower consumption even further. In light of these, very little capital would enter the country and thus, the Rupee would remain weak.

It is a lot likelier that the Reserve Bank of India would lower rates as the economic situation worsens. With lower rates, the currency would fall dramatically.

The Indian economic conditions provide a unique risk/reward ratio to the currency trader. The Rupee is likely to depreciate a lot, and the magnitude of appreciation (although highly unlikely) would be low.

Historical Analogies:

What has happened in India is not in any way an anomaly. This appears to be part of a very common economic cycle in the globalized world. In such a sphere, countries with the highest rates of return attract huge amounts of capital. This leads to trade deficits and asset bubbles. However, the pain arrives much later, as investors move their capital to the next hotspot of activity. This places deflationary pressures on the now deserted economy, and pulls the currency exchange rate down.

Some economies that have witnessed such a change in fortune are Indonesia, Thailand and Hong Kong. Real Estate prices in these countries fell more than 50% during and after the 1997 Asian financial crisis. These drops reversed almost all the gains these countries had seen for several years prior to 1997. Also, currencies lost a large percent of their previous values. The Indonesian Rupiah fell from 2,000 Rupiah/1 USD to 18,000 Rupiah/1 USD.

This graph shows the house price decline in Hong Kong:

How To Profit From The Falling Rupee?

The easiest way to short the Rupee is to short the Rupee ETF ICN. This ETF tries to closely match the performance of the Rupee against the US Dollar, and provide money market returns to the holders of the ETF. The ETF has a low expense ratio of 0.45%, and is one of the cheapest Rupee ETFs available.

Another exchange traded product that follows the Indian Rupee against the USD is INR. However, this ETN has a higher expense ratio. In addition, it hasn't done as good a job of tracing the Rupee's decline as has ICN. Thus, ICN is a much better short.

Conclusion:

In light of the events of the past few months, and keeping history in perspective, it would be prudent to build a short position on the Indian Rupee against the US Dollar. The Rupee may see slight corrections every now and then, but the long-term trend for the currency seems down. In addition, the bearish sentiment on the Rupee shall subside only after a complete correction in housing prices.

The best way to enter into such a transaction would be to short the ETN ICN. This is not an inexperienced investor's trade, and care must be taken to avoid unreasonable amounts of leverage.

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.

Source: Why Short ICN And Bet Against The Indian Economy?