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EM Currency: The Dangerous Trade

The one Asian market I have found the toughest to trade is India. In this I am not alone; Much more talented investors than me are often flummoxed by strange and unexplained movements in both equity and currency markets. Market depth shallow at the best of times disappears completely in a crisis, hedging instruments are limited and costly, stock market performance (talking of the indices- SENSEX and NIFTY) often diverges from economic realities to ridiculous levels (now for example) and buying hope trades (since Sept 2013 for example) is easier than buying earnings stories.
This, however, is not a rant about Indian markets. I want to discuss a very specific Fx trade that is being pushed across the street by sell side and i believe has been bought with alacrity by global funds.

The Trade: Relative value trade expressing negative view on the fragile five (Brazil, India, Indonesia, South Africa & Turkey) without exposure to USD achieved by going short Brazil, South Africa or Turkey (or combination thereof) while long INR (Sometimes IDR though i have not noticed any one push this aggressively)

Indeed INR has depreciated less than its peers in this round of Fx volatility. Nonetheless this is a brave trade given it assumes the Indian central banker has a lot more tools than his peers and economy will adjust rapidly to any fund flows.

Sentiment is broadly in favour of INR driven by improved current account deficit which is largely a result of clampdown on gold imports, and favorable views on Raghuram Rajan, the new Central bank governor, who is seen to be proactive in building Fx.

The problem is that India's Fx reserves remain low at 7.5 months of import cover (10 is a good number to aim for; Used to be 14.7 times in 2007) despite having raised US$34bn since Sept 2013 via combination of swap and non resident bond flows. 7.5x is better than Turkey's 4.8x but not much better than Indonesia (6.8) and materially below China,Russia and Brazil.

Most importantly, INR is different from other EM currency in that it is driven by equity inflows rather than bond inflows. Total foreign investment in Indian bonds stands at around US$15bn vs ~US$220bn in stock market investments. Thus, equity flows accounted for 80% of portfolio flows in contrast to 10% for Turkey.

Given equity bias in INR vs bond flow bias for other EM currencies the trade is using uncorrelated components.
Also, while Turkey can increase interest rates dramatically (as it did) to stem currency depreciation in case of a contagion, India will not be able to do the same since higher rates will further slow economic growth making equity investments unattractive. Indian central bank will largely have to depend on unorthodox means such as trying to mop us USD via swaps and repatriation flows.

Further, INR is exposed to event risk of general elections expected in April 2014. Which party wins the election will set the tone for equity market outlook (stock markets has re-rated in expectation of BJP, a right wing fundamentalist party, while a sharply left leaning party, AAM, has recently emerged as a challenger). In case of equity outflows, it will be impossible for the central bank to raise $50-60bn in a practical amount of time to stem INR depreciation.

I posit that investors are taking unknown and underappreciated risk in this trade. I will not be pretty when they will have to pay the price.