China And India's Tuesday Bust:
A Local's Perspective
Editor's Note: After the bust in Chinese stocks yesterday, which turned into a global bust, I called on DailyWealth's "Man in Asia" to give us his perspective. Rahul Saraogi manages Atyant Capital (www.atyantcapital.com), a hedge fund specializing in small-cap Indian stocks.

Steve Sjuggerud
"Shanghai Index Plunges 8.8%," read a Wall Street Journal headline yesterday. At the same time, the Japanese yen strengthened by 3%.I was surprised to see that the Journal's 1,000-word article didn't mention the word "yen." It should have. It is my opinion that the fall in Chinese stocks and the rise in
the yen are strongly related

Up until yesterday, Wall Street thought it had discovered a perpetual money-making machine, called the Yen Carry Trade. As much as $1 trillion is thought to be in this trade, which has been incredibly profitable so far.

The Yen Carry Trade is simple

Right now, big investors can borrow Japanese yen at an interest rate of 0.5%. As long as they can invest that in something that pays more, they can earn the spread, or "carry." It's usually done by investing in U.S. dollars that pay 5%.In other words, big investors simply borrow yen at 0.5%, invest in dollars paying 5%, and pocket the difference. They do it with leverage, so the returns are magnified to be phenomenally profitable.

As long as the dollar and the yen are relatively stable, the profits are huge. At first, investors just did it by selling yen and buying U.S. Treasuries. But steadily, investors have borrowed yen to take on more and more risk including buying stocks in China and my home country of India.

The leverage these guys take on magnifies the risks...

If the dollar strengthens versus the yen, the profits just get silly. But if the yen strengthens versus the dollar, these big investors can lose a substantial amount of money. The yen has been weakening for a long time, so this risk hadn't shown itself until yesterday

Yesterday, investors in China (and then the rest of the world) got scared. The market was falling. If you had borrowed a mountain of money in yen, you were now in the red, big time. You absolutely had to close out your carry trade to cut your losses before they became too great.

The initial trade was to buy Chinese stocks and sell the yen (the carry trade portion). So to close out that trade, investors had to sell Chinese stocks and buy the yen. Therefore, yesterday Chinese stocks crashed (triggering a domino effect throughout the world), and the yen soared.

The success of the Yen Carry Trade created a self-perpetuating cycle. The trade's success attracts more people, which weakens the yen and makes the trade more profitable. That, in turn, attracts even more people. The yen is now incredibly weak it's cheaper than it was before the Plaza Accord in 1985 (on a trade-weighted basis). It soared by 100% against the dollar after that.

In short, the Yen Carry Trade has created a flood of money around the world, looking for any investment that can make more than 0.5%. In other words, just about anything For example, high-yielding currencies, like the New Zealand dollar, have appreciated significantly. Yields on real estate in developed markets have fallen to all-time lows.

And debt-funded private-equity deals have risen to all-time highs.

Asian economies like Thailand, China, and India are now facing an unprecedented "problem" of excessive money inflows.

India, for its part, appears to have benefited significantly from the carry trade The huge influx of money has created a benign interest rate environment that has fueled consumption and investment. All the easy money entering India has fueled a boom that has used up all the "slack" in the economy. India has the raw human capital and the potential to produce all the goods and services that are in now in short supply. But there are numerous structural problems with the economy, mostly related to the government.

These problems are easy to gloss over when money is easy, as it is now. But to me, the structural problems and the easy money combined are a potent mix that will become a problem for the Indian economy. It's already starting. For example, wages are growing at 20% a year. Property prices and housing costs for urban India are exploding. Headline inflation is at 6.73% (which grossly understates real inflation), but short-term interest rates are excessively low at 7.5%.

I am not bearish on India; I believe it is one of the best economic growth stories for this century. It also has one of the best pools of human talent, entrepreneurs, and companies in the world. But the excess speculative money that's now here, caused significantly by the Yen Carry Trade, is getting carried away with the India story. It ultimately will do a disservice to India, causing our economy to overheat.

The financial community is driven by fads and trends just like any other social community. Shifts between fads can be sudden and unpredictable and can have serious implications for investors, particularly in emerging markets. Given the problems the carry trade is beginning to create everywhere in the world, and given the almost one-sidedness of the trade, it is time to start taking the opposite view and to hold tight for what is likely to be the mother of allreversals.

The unwinding of the Yen Carry Trade, when it finally arrives, could be scary. I don't know if the 8.8% one-day fall in China or the fall in the Dow yesterday was the beginning of the end of the carry trade. But its time will come.

Therefore, I think it is time to take money out of the top-down India play, the China play, and other risk plays. The risk isn't worth the reward now.