By Invitation. Lethal impact of Brexit

Globally, markets seem to be celebrating the fact that with Brexit looming, developed country central banks will now be maintaining a more accommodative stance than previously expected.

However, this strange risk on rally is unlikely to last as economic growth remains elusive in most parts of the western world. When markets begin realising the fundamental weaknesses in the global economy and when this strange risk-on rally fades, the lethal impact of Brexit on emerging markets like India will be apparent.

Britain’s decision to leave the EU is likely to trigger in four sets of ‘direct’ adverse changes. One, slower export growth to the UK and the EU, which together account for over 17 per cent of India’s total exports; two, slower FDI and FII inflows into India; three, concomitant pressure on the rupee; and four, pressure on domestic money market liquidity.

The landmark vote by Britain to leave the EU is likely to affect growth prospects in both the regions. Since any region’s import demand is driven by its GDP growth, India’s exports to the UK as well as the EU will be impacted.

Apart from international trade, Britain’s exit from the EU may lower business and investor confidence around the world, affecting FDI as well as FII flows into India. It is critical to note that even as FII flows into India have abated over the past year, steady FDI flows have been a source of stability for India’s external accounts.

The increase in global uncertainty owing to Brexit, alongside Raghuram Rajan’s departure from the RBI, could trigger a flight of FII debt from India, which in turn is likely to push up short-term commercial paper and commercial deposit rates. To complicate matters, the RBI’s ability to intervene to improve domestic liquidity will be compromised by the fact that it will also have to work simultaneously to prevent the rupee from depreciating (as India’s capital account surplus disappears and perhaps becomes a capital account deficit).

There could be significant pressure on the rupee to depreciate as: (a) Brexit could lead to some of the FII debt heading for the door; and (b) India faces a potential $25 billion (1.2 per cent of GDP) in outflows when FCNR deposits raised in 2013 matures; at a time when India’s capital account surplus has been diminishing, quarter after quarter. While the rupee appears overvalued by 5 per cent from a Real Effective Exchange Rate (REER) perspective, an exchange rate ‘overshoot’ situation cannot be ruled out, whereby the currency of a country temporarily deviates meaningfully from its fundamental value.

Even as the direct effects of Brexit on India appear worrisome but manageable, it is the ‘second round’ impacts that could affect India more profoundly as: (1) China could seize this opportunity to decisively devalue its currency; and (2) Europe, which is already dealing with negative CPI inflation and negative interest rates, will now have to contend with the prospect of a drop in business confidence, which could tip Europe into recession and thus destroy its enfeebled banks.

The Chinese authorities continue to devalue their currency slowly but surely (yuan is down 6 per cent against the dollar in FY16). Now Brexit is likely to create sustained demand for dollar as investors seek a safe haven in an uncertain world.

This appreciation in the dollar gives China a golden opportunity to seize the opportunity thrown up by Brexit to decisively devalue its currency and thus boost its flagging GDP growth. India’s foreign currency debt now stands at $ 0.5 trillion (25 per cent of GDP). Hence, further devaluation of the yuan can be a catalyst for more pullbacks in the Indian markets going forward.

Secondly, deflation has always been disastrous for banks all over the world as it increases the real value of debt for the borrowers, and does so in an environment where there is little demand (since customers postpone their purchases today in anticipation of lower prices tomorrow).

As a result, corporates find it very difficult to repay their loans. Furthermore, if deflation becomes entrenched, demand for new borrowing drops off. As a result, banks get crushed both ways in a deflationary world — NPAs rise and the loan book shrinks.

The EU was already staring at deflation. Now this economic block has to deal with the prospects of a recession which will further damage the enfeebled balance sheets of European banks. The EU’s challenges will heighten if other EU countries now seek referendums on whether to stay in the EU or not.

The writer is Senior Economist, Ambit Capital