Thailand was the first domino to fall in the 1997 East Asia crisis. It was at the time the eighth largest economy in Asia. Trouble this time is brewing in the second largest economy in the region, and both the scale and the nature of the trouble are worrisome.
Let us first take a quick look at how the dominoes are connected. The chart below shows the exposure of some of the major banks in Europe and the U.S. to India.
Total debt exposure of foreign entities to India is $460 billion (includes government debt of $90 billion). Citigroup has an exposure of $25.6 billion, greater than JPMorgan Chase ($12.6 billion) and Bank of America ($10.6 billion) combined, enough to cause a dent in its $7.5 biilion annual profit. Bank of America with net income of $3.8 billion is also treading on thin ice. JPMorgan is in a relatively comfortable position with annual net income of $21.7 billion. Standard Chartered, after reducing its exposure to Indian corporate, institutional and commercial clients by 17% in a single year from $42 billion in 2013 to $35 billion in 2014, is still has the largest foreign lender. MUFG of Japan does not say in its annual filings how much of its $63 billion loans to foreign countries in Asia are exposed to India (a third party estimate is $8 billion). Shifting the center of gravity of the domino to near its top is the short term portion of the debt which is about 20% of the total foreign debt; when the domino loses balance, it will be quick to fall. In addition, India is home to more than $256 billion of foreign equity and about $121 billion of re-invested earnings, connecting the institutional investors and corporations invested in India to the chain of dominoes. That brings us to the second part: Why and how the domino is vulnerable?
The Enron model of the Indian government
The government is $1 trillion in debt. Fortunately, or unfortunately, about $936 billion of this debt is denominated in rupees. The government has been running fiscal deficits since 2004, and after the slowdown in the economy starting in 2011, monetizing this debt has been the only tool the government has relied upon. High inflation has not changed the government's opinion about the tool. Despite the rate of inflation well north of 5%, which was more than 10% not long ago before the slump in oil prices, the RBI has decreased interest rates multiple times in 2015, making it easy for the government to finance its previous debts and new social security schemes.
Moody's, however, overlooked these numbers and changed India's rating outlook to positive earlier this year; it took into consideration the drop in fiscal deficit from an enormous 7.8% of GDP in 2010 to a slightly less enormous 4.5% in 2014. The rating agency has missed a critical element in its analysis. Banks in India are owned and operated by the government and control more than 75% of the market. To bring the fiscal deficit down in books, repeat: in books, the government is selling the country's natural resources at sky high prices. Who is lending the money to corporations to purchase these resources? The same banks the government owns and operates. This model is not new. A similar model was tried more than a decade ago by Enron and we all know how that one ended.
Enron sold overpriced assets to Special Purpose Vehicles (SPVs) that used loans from banks to buy the assets. What the market failed to notice back in 2001 was that these SPVs had an equity claim on Enron, and that the debt in the books of the SPVs was not reported in the books of the company. The Indian government is essentially transferring debt on its books to the books of the banks that it owns, managing the receipts from the sale of the natural resources, and reporting a low fiscal deficit (and debt).
The scandal would have unraveled in 2014 had it not been the Supreme Court ruling that cancelled the previous government's auctions of mobile spectrum licenses and coal blocks. The government is now selling these resources again, this time at much higher prices. So far, the auctions of coals blocks and mobile spectrum licenses have fetched the government $61 billion and $18 billion respectively.
The trade deficit 'Made in India'
India's trade deficit has been south of $120 billion five years in a row since 2011.
The flow of foreign capital (debt, equity and remittances), that has been financing the continuing deficits, cannot all be attributed to the attractiveness of the emerging market or to the suppressed rates of interest in the U.S., Europe and Japan. Many of these foreign investments have an implicit government guarantee that owes its value to the more than $350 billion of foreign reserves with the RBI. In addition, the devaluation of the Rupee, that occurs when the RBI sells rupees to buy foreign currencies, spurred certain service sectors that foreign investors found lucrative. About 20% of the foreign equity investments has gone into the service sector. In short, and counter intuitively, the RBI, by collecting reserves, is fuelling India's trade deficit.
The new government wants to continue on the unsustainable path of its predecessor, financing the country's trade deficits with foreign capital. Prime Minister Narendra Modi has dedicated his first year in power to a campaign called 'Make in India'; he is going to foreign countries almost every other week asking investors to bring more dollars to India. At some point the creditors financing the deficits will realize that the country is never going to produce enough to pay them back. That point, it seems, is not so far off.
The domino's first wobble
India, unlike Thailand, does not have a fixed exchange rate regime. But it does not have a free float either, so it is only a different road to the same destination. Banks in India are in a deep mess. Assets under default have risen by 125% in just four years, from about 2% in 2011 to more than 4.5% in 2015. Excluded from these numbers are restructured loans that add another 6%. Also excluded is the government debt, which cannot be paid back with legitimate means, and does not show up in the books of banks as bad loans.
The crisis has begun and there are only two ways forward for the banks; they can either take money printing to yet another level or announce a bank holiday and force the depositors to take a haircut on their deposits. The former route, although more harmful for the economy in the long run, is more likely to be the choice of the government as it will prefer to maintain the pretense of payment (via money printing) and not have social unrest in the short run. In either case, the external debt and equity claims cannot be fulfilled.
The first wobble of the domino is visible to anyone paying attention. On August 11, 2015, the government chose money printing as the solution to its problems, and announced an $11 billion bailout package for the banks. The stage is set for a high inflation, and unstable, environment in India.
Short Citigroup (NYSE: C), Standard Chartered (LON: STAN) and all other banks and corporations that have significant exposure to India and buy corporations that have rupee liabilities. If you can, owe rupee denominated debt; it is a good way to short the local currency.
India is the second largest consumer of gold. Gold is embedded in the culture of India - family gold is never sold. When the crisis strikes, Indians will buy more of the precious metal to hedge against inflation. Support for gold also comes from India's giant neighbor; China is the biggest producer and consumer of gold. On June 14, 2015, the London Bullion Market Association announced that Bank of China will soon join the other five banks in the London Gold Fix. The Shanghai Gold Exchange recently announced its plan to launch a Yuan gold fix by the end of 2015. Fund managers seem to be aware of these developments and a recent survey by Bank of America Merrill Lynch revealed that the managers are viewing gold as undervalued for the first time since 2009.
Buy physical gold or title to gold held by Perth Mint. Euro Pacific Precious Metals is a reasonable company that provides both. If you believe that the paper market is not manipulated, buy ETFs SPDR Gold Shares (NYSE: GLD) and iShares Silver Trust Fund (NYS: SLV) or the levered ETFs ProshareUltra Gold (NYSE: UGL) and ProshareUltra Silver (NYSE: AGQ) if you want to assume more risk.
Disclosure: I/we 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.