Brexit leads to unchartered territories
The outcome of the much awaited referendum has put the markets in doldrums as Britain voted to leave the EU on concerns over sovereignty and surge in immigrants at its borders. Withdrawal from EU would have to follow the rules of Article 50 of EU Treaty. This would set off a complicated two-year countdown for the withdrawal from EU. If UK fails to negotiate in two years, it could lose access to the single EU market. UK would also have to renegotiate trade agreements outside of EU which could extend the transition period beyond the two-year window. With PM Cameron deciding to resign by October, the decision to invoke Article 50 will be left to the new leadership. This would likely postpone the economic impact of the exit. Brexit will affect UK’s trade, investment, productivity, incomes and public finances
Global policy makers likely to reassess their stance
We think increased global uncertainty and financial disruptions could prompt global policymakers to take a re-look at their stance. With adverse macro implications in sight, BoE is likely to resort to monetary easing, and ECB will also follow suit. Fed is expected to postpone the next rate hike, while BoJ may have to aggressively ease, partly to curb sharp gains in JPY. Besides, renewed weakness in global demand will reinforce disinflationary pressure, partly through lower commodity prices and further complicate the policy stance.
India’s direct macroeconomic impact limited, but financial ripple effect could amplify impact
India’s export exposure to UK is limited with only 3.3% of total export basket directed at UK (~0.5% of GDP). Textiles and apparels, pharmaceutical products, and gems and jewelry form the bulk of exports (see Exhibit 4). Service exports to UK account for ~0.3% of GDP. However, a fall in global demand will further weaken the exports trajectory. India received 2.2% of the total FDI inflows from UK in FY2016. While these numbers may not warrant much concern, global volatility will weigh on capital flows.
Safe havens to gain; risky assets to lose
We expect Brexit and consequent events to weaken risk appetite, leading to flight to safe havens such as JPY, USTs, Gold and CHF. US dollar’s strength may come back as a theme even as Fed postpones rate hikes while commodities may weaken further. Commodity linked currencies and other EM asset classes will likely be hit as well. INR should remain under pressure, in line with the EM peers. Further, FCNR redemptions in September-November could magnify volatility in INR. However, (1) limited direct economic implications of the UK move, (2) net gains from commodities’ weakness, and (3) stable macro fundamentals, will support INR to outperform its EM peers. We revise our FY2017 average USD-INR to 68.5 from our earlier estimate of 67.9
This is an excerpt from Kotak Economic Research's latest note. Copyright 2016 Kotak Institutional Equities (Kotak Securities Limited). All rights reserved