Short Note on Impact of Brexit on India

By: Vatsal Gaur 

Brexit or as one British financial analyst called it “Conjuring Brexit” had been an overriding concern in global markets with many fearing catastrophic effects on a slowly recovering global economy. Now with the final referendum vote being passed in favour of the UK leaving the EU, the resulting effects in financial markets world over are in speculation.

In the aftermath of the Brexit, the volatility in global markets had a snowball effect in India as well, with the SENSEX dropping 1000 points in early trade. While it did rebound 250 points post, concerns about the UK’s exit from the EU on investment avenues have been paramount.

The UK was famously touted as ‘The Gateway to Europe’, with India accounting as its third largest source of FDI. The attractiveness of the UK as an investment destination lay largely in its single market access to all countries of the European Union. UK’s open economy and majority English speaking population only served to bolster investment. Non-EU countries needed a European base from where they could distribute their products to EU countries while circumventing heavy import duties and tariff barriers, and the UK fit the bill perfectly.

The argument raised by proponents of Brexit relies heavily on Britain’s capacity to conduct trade with other countries, especially emerging economies without the regulatory barriers that came with the EU membership. Brexit supporters feel that the UK’s membership with the EU is diverting its trade from other emerging economies and without it, Britain would be freer to enter into bilateral trading agreements. However, sceptics argue that Britain’s trade with other countries was majorly linked with its membership of the EU and that without access to the single market, existing FDI funded companies operating in the UK will face a major dilemma while potential investors in the UK will become more risk averse.

Now, while accompanying risk aversion may seem like the death knell for proactive investments, a blanket sentiment of risk aversion in markets across the globe may actually prove to be beneficial for India. The direct effect of risk aversion will manifest in the form of lower global commodity prices which will help India as it is a net commodity importer. A reduction in the import bill will reduce the current account deficit and fiscal deficit of the country. Brexit will lead to short term capital outflows (as investors seek safe havens such as the USD or gold), leading to increased volatility in INR with negative bias. This can be further aggravated by the impending FCNR (B) redemption in Sep-16. However, in terms of countering Rupee volatility, the RBI has adequate FOREX reserves (USD 360 billion plus) to counter a weakened rupee due to increased net capital outflows and an overall slower global economy. The RBI already managed to rationalise Rupee depreciation by selling dollars on the market.  

The immediate concern after Brexit revolves around businesses that use UK as a manufacturing base and then export goods/ services from the UK to other countries of the EU. These business concerns stand the most exposed as they will lose the trade advantage that they had on account of Britain being a member of the EU. The greatest advantage, in fact, stemmed from the import duty and tariff relaxations that came along with the EU membership. Commodities produced in the UK were considered as locally produced goods and hence export to other member nations of the EU did not involve any tariff or non tariff barriers. Investment from non-EU countries in the UK resulted in increase in net household incomes which in turn directly impacted the country’s GDP. The Centre for Economic Performance at the London School of Economics, in its paper on Brexit’s impact on the UK’s investment avenues mentions how the impact on FDI due to Brexit is likely to lead to a loss of GDP of around ￡2,200 per household.

Taking a more specific example of UK’s production of cars, companies like Tata Motors, which own the British based Jaguar Land Rover, have been hit considerably. According to an estimate, cars amount to 5.1% of the UK’s exports and 40% of those exports were made to the EU. JLR derives a significant portion of its revenue from the EU. As it stands now, these companies may suffer short to medium term loss in sales revenues due to loss of the single market access, unless Britain can successfully negotiate a deal with the EU that gives it the same advantages as hitherto enjoyed. This, however, does not mean that it will be able to circumvent EU regulations while negotiating such deal. The accompanying costs of negotiation itself may end up hitting Britain hard.

Major conglomerates like Infosys, Wipro, Hindalco, Dr. Reddy’s Laboratories, Lupin, Tech Mahindra, Lodha Developers, Indiabulls Housing Finance, Bharat Forge and Motherson Sumi have invested in the UK to gain access to the single market. Brexit’s effects are likely to to have a spill over effect on these businesses but what remains to be seen is how the UK will conduct its trade agreements now. If the UK were to engage into separate trade agreements with the EU, it will have to allow mobility of capital and labour to a certain extent and it cannot be presumed that it can completely circumvent regulatory mechanisms. It’s quite like the snake eating its tail situation for the UK presently. The primary (economic) reason to leave the EU was to do away the excessive regulations that came along with the EU membership and also to control inter-border mobility of labour which came as a natural collateral of the single market access system of the EU. Given the same, the UK will also have to devise trade policies that create a conducive environment for investment. In order to continue to retain as well as attract investors from non-EU countries, it is highly likely that existing FDI funded UK companies will be provided with some form of tax and/ or tariff concessions. This may reduce the direct burden existing Indian businesses may face as a result of Brexit.

Further, on the positive side for India (over the longer run), the experience of the long standing impasse on the trade agreement with the EU that has been pending since 2007 may not be repeated this time round if and when India and the UK negotiate and sign a bilateral trade and investment agreement. 

Closing Thoughts:

• Indian macros may actually benefit from Brexit, although this counter-intuitive inference may well be drowned by market noise in the immediate term. The ~80% surge in crude prices over 2016 was creeping into the economy via both CPI and WPI. The ask was rising on revenue collection (especially excise duty), even as India’s trade deficit expanded moderately. Inflationary, fiscal and CAD risks will now recede simultaneously. 

• Brexit will thus provide the RBI an easy (and obvious) trigger to reduce interest rates, especially as the monsoon sets in. On its part, government must get aggressive in policy reform (some of which is already visible). India now has the opportunity to demonstrate that it is not only the fastest growing large economy on earth, but the most stable too.

• Compared to the US (US$ 16tn) or China (US$ 10tn), the UK economy (US$2.5tn) is not large enough to have a direct impact on India. However, Brexit tremors will be felt in the near term through a fall in merchandise exports to the UK (US$ 9bn, ~3% of India’s exports) and indirect loss of access to EU via the UK (exports of US$ ~56bn, ~18% of total exports) in the longer term. Moreover, services exports (IT) to UK (US$~10bn) will also take a hit.

• A confluence of these factors will admittedly hit India’s exports, but longer term damage will be limited; India’s policy focus must hence shift to structural mending (domestic macros and policy reform) rather than reactive corrections. A normal monsoon, coupled with robust legislative vigour (eg. passage of GST), will accelerate India’s growth and help tide over the fall in exports.

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