Political Case to Short India

On Thursday morning, 18 bomb explosions created havoc in towns across India’s north-eastern state of Assam; at least 70 people died, and more than 200 were injured. This latest act of terrorism, coming in the wake of similar serial-bomb explosions in a number of key Indian cities in recent months, raises two rather troubling questions for mutual funds managers investing in India, questions which perhaps need to be answered prior to granting credibility to any financial analysis of the India opportunity.

 

Is the Indian social fabric crumbling, one attack at a time? And will the terrorism, along with at least half-a-dozen robust domestic protest movements, force political changes which deserve to be recognized before dedicating investor money to Indian equities?

 

The unwinding of neighbouring Pakistan as a modern-day nation has already caused complete and undiluted chaos in the Karachi Stock Exchange. Credit default swaps for Pakistan have widened to unprecedented levels, with Asia reporting the absence of firm quotes even at 3,500 basis points for 5-year sovereign risk. Though the Indian economy can be distinguished from Pakistan in key fundamental respects, there are ample grounds to conclude that impending political changes in New Delhi spell trouble for India’s risk profile. Moreover, Indian intelligence officials routinely blame Pakistan for the terrorism inside India, and the common (and logical) assumption is that the worsening economic climate in Pakistan will lead to even more terrorism on both sides of the border.

 

Facts from the ground in India are increasingly suggesting that extremist right-wing Hindu parties and their equally partisan regional allies will capture a majority in next year’s general elections. And one does not have to dig deep to find out the reason why such radical entities are destined to make a strong comeback in traditionally secular India: growing middle- and lower-income discontent due to deteriorating living conditions in hundreds of big cities and small townships. Even committed leftist commentators have begun to draw parallels between the consequences of the Great Depression (1929) on the fate of Germany and the impact of today’s global recession on the future shape of India.

 

India’s rural landscape is another matter altogether, with extremist communist groups effectively controlling the majority of villages in at least 50 districts across 8 states. Despite 50 years of land reforms and poverty eradication programmes, more than 95% of the agrarian population lives in poverty, or extreme poverty, depending upon definitions. The success of their counterparts in Nepal has only emboldened those seeking social change through armed struggle.

 

It is important to understand how the political undercurrents will influence India’s credit ratings, India’s stock markets and, most importantly, future legislative changes which will alter perceptions governing the pricing of political risk insurance for those doing business in India. As of now, credit default swaps are being priced around 525 basis points, and political risk insurance beyond 2009 is unavailable. Thinly-traded far forwards contracts to buy dollars against the rupee continue to trend higher, from a low of 18% for 3 years earlier in the year to 25%-plus last week; this pricing shift is also being reflected in currency swap rates.

 

How then can India-friendly fund managers justify a medium-term position in India? Firstly, it is true that, regardless of the political transition, to a 21^st century version of Fascism, in this instance, select corporations can and will continue to record profits; so stock picking, as opposed to index-linked investments, should be critical. Secondly, taking post-1979 Iran as a classic example, religious extremism translates into massive government spending programmes, in economic terms; so infrastructure technologies should attract foreign joint ventures.

 

But specific situations apart, the case for an overall bullish tone on India defies logic.

 

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Short India is Perfect Emerging Market Trade

American fund managers investing in the emerging markets today are fundamentally assuming that, over a given time horizon, profits from equity investments will far exceed losses from currency devaluations. That assumption needs to be contextualized in the reality that, if investments in emerging markets like India were made on a fully hedged (forex risk) basis today, mutual funds would be forced to realize significant losses in their financial statements at the very outset.

 

The Indian rupee far forward rate, to offset currency risk on 3-year equity investments, will result in a net loss of about 24% today for dollar investors. Thinly traded 5-year contracts to purchase dollars are being offered at a premium of 35%. Few fund managers are known to actually offset foreign exchange risk unless, of course, they are confronted with panic conditions, like those witnessed this month.

 

Forward premiums apart, the rupee has lost 20% of its value against the dollar during the course of this year. There are several reasons to anticipate another 15% move downwards by early 2009 and to predict a further widening of forward differentials. Interestingly, the single most powerful indicator of the fate of the rupee is the behaviour of “hot” money being generated every day by India’s huge and powerful underground economy.

 

Dubai’s “hawala” traders claim that over $300 million has left India’s shore this month alone; hawala currency exchanges are executed outside mainstream banking channels with an exceptionally high degree of anonymity. India’s central bank, which periodically intervenes in the inter-bank foreign exchange markets for limited durations, has no ability whatsoever to control the flow of cash in the hawala system. Further bad news from the global economy, like yesterday’s downgrade in Pakistan’s credit rating, will only increase hot money outflows.

 

Besides, the only inference one can draw form statistical data is that the Indian economy is now in reversal, as opposed to being in the midst of a cyclical downturn as many asset managers would like to believe, with several sectors contracting at an alarming rate. The default rate amongst 30 million credit card holders is likely to breach 22% before the end of this year, by conservative estimates. The crisis in housing will force most of India’s leading real estate companies to renege on their debt service obligations in forthcoming weeks. Speaking of consumer confidence, a recent survey showed that more than 50% of working Indians fear losing their jobs in 2009. Darkening the scenario are rising food prices, which have been steadily chipping away at the value of middle- and lower-income family incomes since the commodity boom began in mid-2007.

 

Before fund managers invest in India or, for that matter, in other emerging markets, they should ask themselves the same three questions which the holders of underground capital, the ones with most at stake on a daily basis, ask themselves each morning: How much of the phenomenal growth in consumer spending power in this decade can be attributed to easy credit? Is the debt-induced fairy tale coming to an end? And, perhaps most importantly, are poverty levels in the urban and rural centres creating the potential for deep-rooted social unrest?

 

The short India trade is justified by both, currency risk arbitrage considerations and the status of the Indian economy. Such a short trade may not be possible to execute in the equity exchanges. But the short India canvas is wide enough: buy synthetic shorts on exchange-trade India funds and shares on each rally, buy stock index puts in similar fashion, and buy 3-year sovereign default risk and far forward dollars now.

                                                                                        

www.quoteplatform.com

crossborderreports@shaw.ca