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The Indian economy has just ended a long phase of high economic activity. The country is in trouble on all economic fronts. Some of the problems it faces are a high trade imbalance, flight of capital, a real estate bubble, and an inverted yield curve. India is ill-equipped to deal with these problems, and its economy and currency should decline over the foreseeable future. This article advises investors on how to profit from such events.

Why Short India?

Emerging economies often suffer the consequences of high capital inflows during boom years. Once the economic activity declines, foreign capital is withdrawn quickly. This happens because investors always chase the highest rates of return. Thus, a country that depends on foreign capital for growth or for funding imports is always at risk of a capital outflow induced recession. The currency of such a country is weakened as foreign investors dump it in favor of the U.S. dollar, or any other reserve currency.

Also, high capital inflows often bring with them financial bubbles. The most common bubbles are in real estate. During such times, real estate prices soar and that infuses a sense of prosperity in the residents. However, as property prices fall, that sense of prosperity turns into fear and loss. As a result, consumer spending drops and the economy finds itself in a hard to reverse slump. Fiscal and monetary policy have historically not been able to rescue economies in such states of doom.

India is on the cusp of such a decline. The country has seen lower rates of growth recently. In addition, the property bubble in India seems more vast than any other the world has witnessed in recent times. Prices in India have risen over 5 times in the last decade or so. These increases have been much above the inflation rate in India over the same period. Historically, real estate values have returned to their inflation adjusted levels. In other words, home prices, over longer periods of time, rise no more than inflation in that country.

Average house prices in India (1990-2007):

House price growth (Major Cities):

Now what?

As the economy in India suffers due to lower property prices and reduced spending, the Indian Rupee would become even more unattractive. This would be a result of the continuation of capital outflows from the country.

India has supposedly had an average inflation rate of 6% over the last decade or so. However, actual inflation may have been much higher. The U.S., on the other hand has had inflation a little above 2%. Based on the International Fisher Effect (IFE), countries with higher inflation tend to depreciate against those with lesser inflation.

Basing our thesis on the IFE, we can conclude that since India has had much higher average inflation for over 13 years, its currency should have depreciated by the differential (around 4%).

However, that has not happened for a majority of the time since 2001. At that time, the Indian rupee traded at $1 = INR 47. The Indian rupee currently trades at INR 64 = $1. This translates into currency depreciation of 26%. However, based on the inflation differential, the Indian rupee could depreciate by more than 50%. Such movement would bring the exchange rate down to INR 100 = $1.

Economic conditions in India

The economic conditions in India are likely to become worse as capital outflows continue, and the real estate prices fall. However, there is another very serious indicator that points towards a recession in India, the inverted yield curve. The yield curve is a line that plots the interest rates for all maturities. The yield curve becomes inverted when the short-term debt of the government offers higher interest rates than does longer-term debt.

Higher short-term interest rates spell doom because it unravels the banking system. Banks tend to borrow short term and lend long term. Consequently, a bank must continue to reissue short-term debt to support the long-term assets. However, when the short-term rates rise higher than the long-term rates, the banks can no longer maintain this business model. In addition, banks must now issue short-term debt at higher rates to support the long-term loans already made at relatively lower rates.

Consequently, the financial institutions begin to suffer losses. And the economy follows, as lending falls.

The yield curve has gained recognition as an excellent recession forecaster. An inverted yield curve signals a recession within 2 to 6 quarters .

How to profit from these events

The article points to three related events. The fall in the currency, fall in real estate prices, and a recession that would create losses at banks. We recommend a short for each of these three asset classes.

One of the best ways to short the Indian Rupee is to short the Rupee ETF, WisdomTree Dreyfus Indian Rupee Fund ETF (ICN). This ETF tracks the Indian rupee against the U.S. dollar. ICN has done a relatively good job of matching the decline in the rupee this year.

To profit from a decline in the Indian real estate market, one could short a consumer ETF of India. Consumer spending should be the largest casualty of a decline in real estate prices. A good ETF to short is EGShares India Consumer ETF (NYSEARCA:INCO). The "EGShares India Consumer exchange-traded fund seeks investment results that correspond (before fees and expenses) to the price and yield performance of the Indxx India Consumer Index, a 30 stock free-float adjusted market capitalization index..."

And lastly, a good way of shorting the economy and the financial system of India is to short its second-largest bank, ICICI (IBN). One could purchase out-of-the-money puts for the bank. This is the option chain for the Jan 17, 2015 LEAPS.

Conclusion

The decline in the economic health of India provides investors an unusually wide range of possible shorts. It would be prudent to diversify the investments and choose some combination of the above mentioned trades. In addition, it might be a good idea to hold some cash as a hedge against huge corrections.

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.