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Rediff.com  » Business » How Brexit and Rexit will impact India's economy

How Brexit and Rexit will impact India's economy

July 04, 2016 11:30 IST

While the UK will possibly go into recession, the bigger fear is copycat referendums from other EU nations. Back home, Raghuram Rajan’s successor at Mint Road will have his or her work cut out, says Devangshu Datta.

IMAGE: The fundamental impact of Brexit is bad. Photograph: Reuters
 
 

In a normal fortnight, the news flow would have included the US Federal Reserve standing pat, Indian inflation creeping up again, poor industrial data, the slow advent of the monsoon, the opening up of new sectors to foreign direct investment (FDI) and other mundane matters. 

Instead, India had its “Rexit” and that was topped when the UK voted for Brexit.

The last event is likely to dominate mindspace and financial markets for quite a while.

By definition, financial markets are structured such that prices respond instantaneously to perceptions of future growth or contraction.

The UK will certainly end up worse off due to Brexit. But there is no way to really quantify this yet.

The UK will take a long while to exit Europe and will have to renegotiate relationships with the European Union (EU) and the rest of the world. 

In a wider sense, if Britain goes into recession (and it’s likely), that will lead to global growth prospects being downgraded through this year and the next.

So the fundamental impact of Brexit is bad. But the markets could be overreacting and falling more than the fundamentals will ultimately justify.

On the downside, however, if Brexit triggers copycat exit referendums from other EU nations, the damage could be far worse.

Prior to the vote, markets were optimistic. In the classic manic-depressive manner of markets, they now seem to be discounting the worst-case scenarios.

The sterling has got hit harder than it did when George Soros took on the Bank of England. Stock markets around the world have reacted with shock.

Soros’ guru, Karl Popper, called the phenomenon of overreaction, “reflexivity”. He hypothesised that, when markets trended, they rarely stopped at fair value.

One of Britain’s KRAs is London’s ability to deliver all sorts of financial services.

That will get hit for sure. So will the UK’s positioning as a platform for “Anglo-comfortable” businesses to enter Europe.

This will hit Indian businesses, which find it convenient to locate in the UK, with its familiar laws and language, and its easy access to hard currency funding.

The Fed proved prescient in holding off on any interest rate hikes before Brexit. The USD hardened anyhow. 

The Fed might have to hold off any rate hikes for quite a while now, for fear of pushing the USD up even further.

Moving away from Brexit, the market perception of Raghuram Rajan’s impending exit from the Reserve Bank of India (RBI) is also negative.

The next chief will have his (or her) work cut out. The RBI has to manage an incipient bank crisis.

It must also unwind a large quantity of swaps in an extremely volatile market and it has to tackle inflation that seems to be creeping up. 

Somewhere between $20 billion and $34 billion worth of swaps will have to be reversed between September and December 2016. That’s about nine per cent of India’s current reserves and given market volatility post Brexit, the rupee could bounce up and down a lot.

The bank crisis is already of epic dimensions. About Rs 5.80 lakh crore is marked down as gross non-performing assets and the ratings agency, Crisil, expects this to rise to Rs 7.10 lakh crore by March 2017.

About 90 per cent of those bad debts are held by public-sector banks. It’s not clear how the government intends to recapitalise and how it intends to prevent bad debts from ballooning in future.

Inflation is being pushed up by higher food prices. The Consumer Price Index moved up 5.76 per cent year-on-year in May and the Wholesale Price Index rose to 0.8 per cent.

The rise in both indices was driven by higher food prices.

A decent monsoon may help bring this under control. The one positive from Brexit is that it has triggered a downtrend in energy prices, so there’s less chance of fuel inflation. 

The opening up of defence, civil aviation and pharmaceuticals to FDI would be positive moves.

In practice, however, Brexit might mean that capital is reluctant to come in at the moment. Support via policy changes to the textile industry is also a positive move in theory.

However, it remains to be seen if the Indian textile industry can recover its competitive edge versus Bangladesh and Vietnam.

Foreign institutional investors have cut their India exposure in the past few sessions, selling both equity and rupee debt.

However, the “one-eyed king” syndrome might operate in India’s favour as it is one of the few growth spots on the world map.

Technically, this could end up being a deep correction. Risk-averse investors are headed into gold and into US Treasuries at the moment.

If the big money does not return quickly, there may be a medium-term bear market. In the immediate future, look for support at Nifty 7,700-7,800 or higher, because that is where the 200-Day Moving Average is placed. 

However, if that breaks, prices could end up reverting all the way to the 52-week lows (Nifty 6,800-7,000 and Sensex 22,500-23,000), which were recorded on Budget Day.

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