Talking Point: Brexit and Indian markets

 The stage is set for an epochal event in the history of the UK – its likely exit from the European Union. The Brexit, as it is commonly called, will follow if the citizens of UK vote that the country should cease to be a part of the EU in the referendum that is to be held this Thursday.

 Financial markets are already shivering in their boots at the prospect. The pound is down over 10 per cent against the dollar since September 2015, bond yields in developed markets have been plunging and equity markets have turned quite volatile.

 Most regulators, however, think that it will be better for the UK and the global economy if the country continues to remain in the EU. The Bank of England (BoE) warned on Thursday that “The outcome of the referendum continues to be the largest immediate risk facing UK financial markets, and possibly also global financial markets.” Other central bankers, including the Federal Reserve and the Bank of Japan, concur with the BoE.

 So, what could be the implications of a Brexit on the Indian currency, equity and bond markets?

 There is consensus that if Brexit happens, it will take a toll on the British pound.

The UK Treasury, in a dire warning against Britain’s exit from the EU, has outlined the scenarios that can unfold, if the event takes place. The report says that in a shock scenario after the Brexit, inflation will spike, unemployment will rise, GDP growth will be 3.6 per cent lower after two years and the pound can fall around 12 per cent. In the event of a ‘severe shock,’ GDP is expected to be 6 per cent lower and the pound is expected to lose 15 per cent.

 A crash in pound value will directly result in a sharp appreciation of the rupee against the pound. The rupee has been strengthening against the pound since late-August 2015, appreciating from 105 to 96; gaining over 8 per cent. A vote in favour of an exit can take the GBP-INR exchange rate to 90.9; the low recorded in April 2015.

 While the rupee can appreciate against the pound, the dollar-rupee exchange rate will, however, be under pressure. This is because the dollar-pound exchange rate has 11.9 per cent weight in the dollar index. If the pound depreciates more than 10 per cent in the turbulence following Brexit, dollar index will gain. Dollar will also move higher due to its safe haven status.

 This will result in weakening of the rupee against the dollar. A re-test of the 68.89 level against the dollar cannot be ruled out if there is global risk-off trade.

The UK is one of the major financial centres of the globe where many fund managers are located. According the TheCityUK, an organisation that promotes the financial services industry in the UK, the country had £6.2 trillion of assets under management towards the end of 2013, making it the top jurisdiction for asset management in Europe. Of the global pool of conventional asset management (comprising mutual funds, insurance, and pension funds), 8.4 per cent originated from the UK in 2013. The US was the leading jurisdiction accounting for more than half of the assets.

 Given this key position as a source of foreign portfolio investor (FPI) funds, it is obvious that there could be some hiccups in fund flows following the event. The uncertainty regarding the status of various funds located in the UK, their taxability and other regulatory aspects can make these funds maintain status quo with regard to fresh investments in the transition period lasting at least six months.

 But that said, flows into India are not likely to be too greatly impacted as investors from the US and Mauritius hold the chunk of FPI assets in India. Towards the end of May 2016, FPIs from the UK held assets worth ₹106,280 crore in Indian equity, accounting for just 5 per cent of the entire FPI assets.

 But if risk aversion rises globally, FPIs tend to pull money out of emerging market equity first. This can affect Indian stocks in the short term.

 Indian bonds would be quite vulnerable if there is heightened volatility in global financial markets. It has been seen in the past that FPIs tend to pull money out of emerging market debt first once risk aversion rises. In the past week, US, German, UK and Japanese bond yields have moved sharply lower as investors are moving into the safer haven of developed market debt.

 Investors from the UK hold less than 1 per cent of the debt holdings of FPIs in India. But a move out of Indian debt by FPIs from other jurisdictions, fearing currency volatility, is also likely.