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IN THE END

by Shashwat Panda

The author is a Partner at Pureheart Capital. Opinions expressed are personal.
The language used is intentionally colorful because the world already has more than enough bloodless annual

reports to wallow in. Those objecting need to get out in the sun more often.

I believe that the Indian Rupee (INR) and the Indian asset markets are headed into a
large drawdown. In terms of timing we are fairly close, as some of the technical and
fundamental developments which were anticipated are beginning to materialize.

I'VE PUT MY TRUST IN YOU;
When I was a young strapping lad, all of 8 years old, I was in a horrific fender-bender and ended up
dislocating both my shoulders. Between bouncing off my surprisingly elastic head and somewhat before
planting face-first in the shrubbery, was probably one of the pivotal moments of my life. Even though I
would not know it for years, but it was in that gloriously concussed and befuddled state that I had decided to
go into the hedge fund business.
I mean who doesn’t want to go through most of their life thinking that they are an utter and complete moron.
Trapped inside an amorphous, existential limbo-land where certainties of space and time have been replaced
by self-referential price fractals which are impervious to scale? What Fun! Sign me up please!
Causality runs simply in real life i.e. I taunt Kim, Kim shoots me, I am dead: Elementary stuff really! In the
markets, the causality is less precise: I taunt Kim, Kim tests H-Bomb, H-Bomb along with the solar eclipse
cause a tectonic shift, the shift causes six earthquakes, one quake unseals a cave releasing an unknown strain
of anthrax virus, in the ensuing apocalypse I am slain by an uprising of angry badgers over a bag of nuts.

PUSHED AS FAR AS I CAN GO;
I have always maintained that those who survive in this business are closeted masochists. It is quiet unlikely
that normal folks would ever stomach this kind of existential dread for a few instances of temporary
comeuppance. Every day I ask myself if I am getting too old for this gig. But it is not only the love of the
game that keeps me going, it is also the desire to one day wag my finger to the world and say “I told you so!”

My family contends I am a Nihilist. I contend that I am a realist who does not drink the kool-aid. As a fatalist
realist hedge fund guy, I have an unhealthy fascination for the upcoming Armageddon. In my defense, the
logic of math is on my side. Successful compounding of wealth necessitates avoidance of big draw-downs.
So a laser like focus on the downside really helps out, along with weekly bouts of paranoia.
I believe that the Indian Rupee (INR) and the Indian asset markets are headed into one of these manic decline
phases. I believe that the timing is fairly close, as some of the technical and fundamental developments have
accelerated. I am aware, that usually this kind of bravado and bluster ends in miserable failure. But I can’t
help myself, I landed on my head. What’s your excuse?

FOR ALL THIS, THERE'S ONLY ONE THING YOU SHOULD KNOW;
It is very easy to be bullish on India for the long term, for all the reasons that are well known. You have to be
an imbecile not to appreciate the economic prospects of a young English speaking democracy of a billion
people, with tolerable rule of law, still struggling to get the basic infrastructure in place. Enormous growth
prospects in India are easily spotted.
And yet, in keeping with my self-destructive tendencies, I will admit that I have been bearish on Indian
equities for a few years. It has been neither good nor bad, just plain boring! There have been better places to
put capital to work in that timeframe.
I agree with the long term story on India. But as a wise man once said: The long run is always a series of
ensuing short runs. This particular moment might not be where you would want to begin the bean-counting.
It is my opinion that the Indian Rupee is way too overvalued, and the tailwinds have become headwinds. If
you understand the inverted nature of the Indian asset markets, stuff is about to go boom in the night.

Source: Bloomberg: SENSEX priced in USD

I TRIED SO HARD;

The INR suffered a massive devaluation from the fall of 2011 to 2013 when it fell from 44 INR/USD to 68
INR/USD. The backdrop itself was some modest strength in the dollar prices. As a matter of fact, for the
most vicious part of the move in 2013, the dollar index was also weakening.

Source: Bloomberg: USDINR and Dollar Index

This drastic INR weakness was caused by a rapid buildup of the twin deficits on the current and the fiscal
account which deteriorated from 3.5% in 2008 to 11% by 2013. This was partly due to fiscal stimulus
delivered by the NPA government in 2009/10 and worsening current account deficits. Later on, the
perception that the government in power was...umm... impotent clearly did not help. The dual deficits have,
since then, fallen to 4% in 2017.

Source: Bloomberg: India Fiscal Deficit as % of GDP + Current Account Deficit as % of GDP

AND GOT SO FAR;

The story after 2014 has had a redemptive arc. Indian voters kicked out the incumbents and gave an
unprecedented mandate for change to the new Prime Minister Mr.Modi. Promising that good days were
round the corner, the new PM went on a global blitzkrieg to raise funding for India Inc. Fiscal deficit and
inflation were controlled. The Rupee got stronger, the SENSEX soared and everybody lived happily ever
after.
Well, not quite. The record is somewhat mixed. Even though there have been notable improvements, there
were two fortuitous events that really helped along the way.
India imports a lot of commodities, especially Crude and Gold. Global gold price crashed in the mid 2013
reducing import bills and investor demand. Crude crashed in 2014, reducing the current account deficits to
less than 1% of GDP, lowest in 10 years.
Since 2014, the INR has been a strong currency. As per the data from Bank of International Settlements
(BIS), in relative terms, INR is the most expensive with respect to 60 other currencies since 1994.

Source: BIS: INR Real Effective Exchange Rate against 60 countries (Broad Index)

BUT IN THE END;

Since July 2016, in these pages I have argued that the deflationary epoch is changing, and secular inflation is
taking hold (email me for copy of previous reports). I have made the case for a secular bottom in
commodities, sovereign rates and a secular peak in the dollar. The last note specifically dealt with Crude oil,
which I believe, will get a lot stronger from its year to date low of 42$/barrel.
While the price action leaves much to be desired, the call still stands. As expected, the US crude production
is beginning to flat line and there are signs of decline in the all important Permian Basin. If the Crude price
shoots up to 75$ as I expect, one of the wheels would come off the strong INR bandwagon. Estimates of
current account deficits are on the rise as the terms of trade deteriorate.

Source: Bloomberg: Citi Terms of Trade Index for INR (UP is Net export terms getting better and vice versa)

IT DOESN'T EVEN MATTER;
All this is run-of-the-mill bearish stuff, where is my free differentiated quality content you ask? Here it
comes, so brace yourself.
Ever since demonetization in the late 2016, the Indian bond markets have taken off like a scalded cat. Last
year while the global sovereign yields were going up, Indian yields were crashing as all the surplus cash
collected by the banks was recycled into sovereign bond market by the government banks.
The bond mutual funds did so well in 2016 that as a group, they outperformed the mid-and-small cap equity
mutual funds. All this is over and above the ongoing emerging market bond feeding frenzy / reach for yield.

Source: Bloomberg, Sovereign Yields in 2016

The central bank (Reserve bank of India) in all its infinite wisdom imposed a limit on total foreign ownership
of government bond market. So the feeding frenzy shifted to the corporate bond market and exhausted the
foreign limits there. As I write this, infrastructure bond limits have been exhausted and foreign capital is
flowing into bond proxies like Infrastructure REITs.

Source: Bloomberg, Foreign Limits reached in the Indian Corporate bond market

Demand always creates its own supply. So enterprising Indian Bankers put together endless number of debt
mutual funds with Indian bonds (both sovereign and corporate) as the underlying assets. These mutual funds
were then marketed exclusively to the foreign investors who lapped it up. The clear purpose of these vehicles
is to sidestep the RBI imposed foreign limits. But hay, as long as music is playing, you have to dance right?
The inflows have been so strong and persistent that INR hedging costs, which usually were in 5-7% range,
have fallen to 2-3%. All in all, I expect approximately 70 to 75 $billion of restless capital is currently nesting
in the Indian bond markets. Breathing is slow, tension palpable and silence is pin-drop. And the great exodus
is about to begin as the first frog drops from the sky.

I HAD TO FALL;
Indian macro is incomplete without a discussion of its colorful political environment. As I mentioned before,
current account deficits are on the rise. The second wheel on the strong INR bandwagon has been the fiscal
restraint. The political imperatives are about to break the same in the very near future.
India goes to polls again in 2019, which usually implies that the government is going to be spending like a
drunken sailor at the Moulin Rouge. But this year is somewhat special.
Clearly, de-monetization did not achieve its goals, whatever they were. The best argument that was put
forward was that it was a back-door bailout of the PSU banks. It is at best a temporary reprieve. As cash
begins to circulate in the economy, the volumes electronic and digital payments are reducing. With time,
credit-to-deposit ratios will revert to the old normal.
GST is an even bigger disruption. GST is first and foremost, a tax hike on everything which will increase
inflation. And the whole system will move from one crisis to another for 4-6 quarters till it stabilizes
operationally.
If a cancer patient who just recovered from chemotherapy (de-monetization) had every bone in his body
broken (supply-chains disrupted by GST) in how much time will he recover? It is hard to expect GDP growth
under these circumstances: the latest print was lowest in 10 years.
And the credit growth in India is at a 60 year low! The last two remaining Austrian economists in the room
will gasp in horror at this statistic. The credit growth is approximately 3% lower than effective interest rates,
implying that the real economy is brutally deleveraging. No wonder then that Gross Fixed Capital Formation
(Gross Investments in the economy) has completely stalled.

Source: Times of India

TO LOSE IT ALL;
Weak GDP growth going into an election cycle is not a great polling strategy, as Mrs. Clinton can testify. I
am sure PM Modi is well aware of the fact that the odds of a regime implementing GST and then getting
back to power in the next election cycle are slim in emerging markets, as borne out by several historical
instances in Latin America.
Also, the core supporters of his party, the small businessmen, have been deeply affected by both
Demonetization & GST and are expecting fiscal concessions. I expect the political imperatives will dominate
over any feeble impulse to be fiscally prudent, as they always do. “Print baby print” will be the name of the
game for the next 2 years.
Fun fact: the central government has already blown through 94% of its fiscal budget 6 months into the
financial year. And as of yesterday (21st September 2017) the government was contemplating a temporary
reprieve from its short term fiscal targets.
So if the fiscal and current account deficits turn higher along with inflation, the MoMo chasers and carry
traders who have piled into the Indian bond markets are about learn a painful lesson on of how small the exit
doors can be in emerging economies.

A section of the restive population has already figured it out and piling into physical gold (there might be
some elements of tax arbitrage in these numbers due to recent GST implementation). But, it is interesting
that the previous spike in unseasonal gold buying came just in before the spike in USDINR.

Source: Vivek Kaul, Volume of gold imported from April to July (https://teekhapan.wordpress.com/)

On a side note, India’s love for Gold confuses a lot of Ivy League types. I guess it takes a PhD in Economics
get confused about a 50 year bull market, which is a direct result of actively inflating away the government
debt stock held domestically, resulting in chronic devaluation of currency.

BUT IN THE END;
If we get the kind of bum-rush out of INR that we got in 2013, a devaluation of up to 50% over 18 months is
not unthinkable. I would look-out for a minimum 20 – 30% move which will stick after the volatility is over.
The implication for the bond markets are left to your imaginations as they are contingent on RBI policy
moves. A QE is not out of the question. And printing of money to bail out the PSU banks is a near certainty
in a crisis; as their paper trading profits from last year dissipate.
The equity markets have seen torrential inflows from the domestic retail investors this year. With the broad
market valuation already stretched, the market is chock-a-block full of weak hands itching for a tryst with
destiny. Low quality, small-cap names have seen a massive acceleration in prices. Seven of the top eight
private life insurance companies have scheduled their IPOs in the next one month.

Source: CLSA, Money Control

All the while, the foreign investors, who used to drive the market, are hastily exiting stage left. I believe the
meltdown of INR will provide that spark, which will initiate the endgame for this messy situation.

Source: Bloomberg, Foreign Limits reached in the Indian Corporate bond market

IT DOESN'T EVEN MATTER.

This note makes me sound like a Perma-Bear on India. I can assure you that I am not. I think for the next 20
years, the return from the Indian equities will be world beating. But it needs stronger foundation than we
have currently.
The banking system desperately needs to be fixed, the NPAs are too large to take care of themselves,
infrastructure needs to be built and systemic friction (like these high NIMs all analysts salivate over) needs to
be reduced.
There is a lot of work to be done to get to the sustainable growth phase. But the first step is always to
recognize the problem. Right now, the truth is hidden behind a deluge of liquidity. If it is not recognized, it
will not be fixed.
As Friedrich Nietzsche wrote: Whatever doesn’t kill you makes you stronger. So embrace the crash. If you
survive, you will be wiser and will see much better days ahead.

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