“Brexit” what next for the World & its impact in India | srei
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“Brexit” what next for the World & its impact in India

Although polls suggested a tight referendum, financial markets underestimated the risk of a ‘leave’ vote. The direct impact of the ‘leave’ vote will apply mostly to the UK, as it begins long negotiations to exit the European Union.

These events will increase uncertainty, and with the UK running a current account deficit of 7% of GDP, the British pound should be expected to act as the main shock absorber.  UK’s GDP growth forecast has been reduced to 1.2% from 1.9% for 2016 and to 0.5% from 1.5% for 2017, by the markets. Markets will likely keep questioning who might be next, and with fringe parties in Europe on the rise, there will be no shortage of dissent. Though risk and pressures in the EU would increase, Brexit is not the beginning of the unraveling of the EU. The UK was always seen as the “awkward partner” of the EU, rather than a core European country. 

The UK’s historic vote to leave the European Union is now likely to be followed by a long process of negotiating the country’s exit and its new relationship with the bloc. The following important points are to be noted

  • The ‘Leave’ campaign has not presented a unified view of what the UK’s new relationship with EU should ultimately be, further complicating the issue.
  • The referendum has divided the ruling Conservative party. There is a risk that splits within the party and the lack of consensus over the details of UK’s future relationship with the EU could lead to an early elections.
  • Calls for a second Scottish independence referendum are likely to mount and will probably add to domestic political instability.
  • Bank of England may cut Bank rate to zero and go for a QE of GBP 100 billion in order to tide over the current fallout.
  • Rating downgrade of UK by Moody’s and S&P will add to the investment woes.

One should not confuse the symptoms (Brexit) with the causes of the centrifugal forces in Europe. Europe and especially the euro area are suffering from a dysfunctional common currency, and a disastrous austerity policy that has driven millions to unemployment. These problems and the immigrants issue would have kept social pressures high, with or without Brexit. Europe’s growth is likely to fall to to 1.2% from 1.4% for 2016 and to 1.2% from 1.5% for 2017. On the other hand markets will begin reassessing their expectations for interest rate hikes in the US. Fading rate hike expectations will be positive for sentiment.

The impact on the rest of the world is more likely to be indirect. Risk aversion to be high in the coming days if not weeks. This will likely keep risky asset classes under pressure. The same should apply to oil prices. USD to be supported, but may not break new highs. The USD tends to appreciate on rising interest rates in the US and/or amid risk aversion. This time risk aversion should be positive for the USD, but the readjustment of market expectations regarding Fed hikes should take away from the USD’s momentum.

As far as India is concerned, RBI seems to have already intervened in the FX market to smooth out intra-day volatility.

With USD363bn of FX reserves (about 9-10 months' of import cover), RBI has enough ammunition to smooth out currency volatility. If FX intervention continues though, then the RBI probably will announce further OMO purchases to ease domestic liquidity pressure. In the extreme scenario, if global financial and credit markets freeze, thereby impacting domestic liquidity, a CRR cut may also become necessary.

From a slightly medium-term perspective, India may not be materially impacted due to the UK referendum result.

India's macro position has improved significantly in the last three years and risk of a disorderly depreciation of the rupee (like in mid-2013) is therefore remote. India's Balance of Payments position is considerably strong today, with net FDI flows itself sufficient to fund the current account deficit.

Risks to Indian growth cannot be ruled out in light of the latest development, but markets have already factored in a conservative growth estimate for FY17 (7.5%yoy) compared to consensus (7.8%yoy). Indeed, from a trade linkage perspective, UK is not as important to India versus EU or USA. India's trade share with UK has been falling through the last several years, with a commensurate increase for other countries such as the United Arab Emirates.

Can FDI inflows from UK get impacted due to the referendum outturn?

Substantial FDI from the UK to India has come in the past, but the trend has been weakening of late. Between 2000 and 2016, India has attracted about 8% of total FDI from the UK, but the corresponding figure is just 2.2% for FY16. The fact that total FDI to India has increased appreciably lately suggests that even after factoring in lesser FDI inflows from UK, one can be fairly optimistic that the ongoing favorable FDI trend would continue.

Overall, the UK referendum can have a more indirect than direct impact on Indian macro.

If global financial markets remain volatile for a prolonged period, investment and business sentiments at home could be further impacted, thereby delaying the economic recovery. This as a non-trivial risk, as the UK referendum result raises risks for elections coming up in Spain, Italy, Germany and France over the next few quarters. Add to this the more near-term concern related to who will become the next RBI Governor and potential volatility surrounding the foreign currency deposits redemption from Sep'16 onward, the next few months will likely be characterized by uncertainty. Reforms thrust by the Indian authorities, such as FDI liberalization that was announced this week, will help to dampen the negative sentiment; increasing the pace of disinvestment, getting the GST legislation passed in the Parliament and announcing more administrative measures to counter food inflation.

The blog post is authored by Mr. K.R. Muthuraman, Sr. VP – Treasury, Srei Infrastructure Finance Limited.