What Would be Brexit's Impact on Indian Markets?

The formal exit of the UK (Brexit) from the European Union (EU) is likely to create more uncertainties rather than alleviating them in the coming months and will bring central banks back in focus, says India Ratings and Research (Ind-Ra). Indian markets are unlikely to be completely insulated from the impact of this global contagion, despite the relatively resilient domestic macroeconomic conditions.

Domestically, the ensuing global volatility could put the both currency and debt markets on tenterhooks, but the markets will await clarity from global central banks as they tackle this unprecedented event. The markets are likely to be gripped with two major concerns hereon: (1) the instability that euro area will face as other nations contemplate their membership in the EU (2) the response of global central banks especially the US Federal Reserve’s stance on policy rates.

The UK referendum decision is a harbinger for more volatility in the short to medium term while the modalities, process and timeline of the exit are being ironed out. Ind-Ra believes that Brexit will have a destabilising impact on the UK and euro region with increasing scope for other nations to rethink their position in the euro region.

The financial markets are likely to move back into the central banks’ zone as the latter steps in to stave off global deflationary pressure while boosting growth. The US Federal Reserve is likely to delay its ongoing rate normalisation. Concomitantly, the possibility of a weak domestic and global recovery, stronger dollar and slump in commodity prices may necessitate the US Fed to reassess its policy rate trajectory. The median federal open market committee expectation of federal funds rate for end-2016 suggested two rate hikes (with members seeing the rate between 0.75%-1%). An extended period of global volatility, however, is likely to keep the Fed on side of caution and constrain the imminent rate hikes before stability is restored.

Ind-Ra believes the Reserve Bank of India’s initial line of action will be to address temporary shocks in systemic liquidity through liquidity channels rather than policy rates. The possible tools can be (1) stepping up the size of open market operations (2) reducing the daily requirement of cash reserve ratio (3) broadening the collateral base in the repo market (4) increasing the size and duration of discretionary term repos. Presently, the liquidity conditions are broadly easy with core systemic deficit hovering in the range of 0.2%-0.4% of net demand and time liabilities.

The currency market is likely to witness high volatility, keeping the rupee trading with a weak bias in the near term. In terms of negative implications, an overall environment of ‘risk-off’ is unlikely to revive foreign flows to India in a hurry. In 2016, the equity segment noted a net portfolio inflow of USD2.8bn while debt outflows stood at USD1.1bn. Additionally, tail risks over FCNR B (foreign currency non-resident) deposits’ redemption may get pronounced on account of external volatility. On the positive side, Ind-Ra believes the US Fed will stay put with a protracted pace of hikes. This may check the deterioration in overall emerging market sentiments.

For the bond market, an interplay of three factors will be critical (1) the period of low global yields and benefit from near-term softening of commodity prices may augur well for the domestic market, keeping the head room open for the Reserve Bank of India to ease rates later in the year (2) in event of weak portfolio flows, scope for stepping up open market operation purchase will be supportive for G-sec market and (3) the high portfolio investors’ debt exposure at INR3.3trn presently (INR1.7trn in government securities and INR1.6trn on corporate debt front) suggest the risk of outflows cannot be undermined.

Ind-Ra continues to assert that the domestic corporate sector outlook will remain challenging over the coming two years, aggravated by this recent episode. Ind-Ra earlier has highlighted external risks could derail a fragile recovery. Bouts of global risk aversion corresponding with rupee depreciation are likely to limit the corporate sector appetite for investments, keeping the economy on an overall low equilibrium.

Principal Economist at Ind-Ra Mr. Sunil Kumar Sinha says, “As the outcome of referendum on Brexit is in favour, the impact is felt across the globe. However, from India’s perspective Brexit will have both positive and negative impact. As Brexit will vitiate the already uneven and fragile global recovery, it will exert downward pressure on global commodity prices and India will benefit being a net commodity importer. However, with risk rising in the global financial market foreign capital will flow out putting pressure on rupee to depreciate and making Indian financial market volatile. A number of Indian corporates having exposure to Europe/UK either through trade or in case their production units are located there would be adversely impacted.”

The World Gold Council (WGC) says, “With Britain voting to exit the European Union, we expect to see strong and sustained inflows into the gold market driven by the staggering level of protracted uncertainty that investors now face. The gold price surged to US$1,313.85/oz this morning, up 6% from yesterday, providing investors with a muchneeded safe haven. Sterling is trading at a 31-year low and world equity markets have plummeted. The Bank of England has said that it stands ready to take whatever action is necessary, a mantra that is likely to be repeated by other central banks. In practice, this could mean interest rates move further into negative territory in parts of the world, another positive for gold. Central bank action has already capped the gain in other safe haven assets, with the Swiss National Bank intervening early this morning.”

Vice President of the Indian Bullion & Jewellers’ Association (IBJA) Mr. Saurabh Gadgil says, “Britain’s exit from the European Union shocked global markets and unleashed uncertainty. The pound has jumped to its lowest level since last 31 years. Investors fled risky assets and turned to the dollar and the yen. While the magnitude of the market reaction is uncertain, the direction appears clear. Investors will now rush to safety and move steeply in global markets from risky assets to havens.”

“For India, the economic impact should be smaller relative to other open economies in Asia. Still, India is not immune, as it has strong trade linkages with the EU and is susceptible to a loss of business confidence and a potential tightening of financial conditions. Any adverse impact could be partly cushioned by upcoming domestic impulses to growth such as good monsoons, pay commission hikes and a likely easing of policies (both monetary and fiscal).”

“Gold and silver prices have soared and might reach as high as 36K. Investors will pull their money from the stock markets and banks, seeking safe-haven assets instead like Gold Investments. If the Euro currency plummets, they will also look to get out of cash and into real money such as gold and silver. Gold is seen as a haven for cash.”