1. BREXIT may not be an armageddon situation for UK

BREXIT may not be an armageddon situation for UK

Past few weeks have been quite conducive for risk assets. Indian Equity markets have surged towards 8400 and Rupee too has come back strongly, appreciating from 67.80 levels to 66.50 on spot.

By: | Updated: June 12, 2016 10:08 AM
rupee UK, along with US, has been the best performing economy in the industrial world, with unemployment rate down below pre-crises levels and services sector humming. (AP)

Past few weeks have been quite conducive for risk assets. Indian Equity markets have surged towards 8400 and Rupee too has come back strongly, appreciating from 67.80 levels to 66.50 on spot. RBI policy has been an expected non-event, though a lot of speculation continues to happen surrounding the re-appointment of the existing RBI governor. Global risk sentiments have held up more or less, though some cracks are now visible. Traders are nervous about the UK referendum to be held on 23rd June. However, the nervousness is largely confined to options being traded on UK assets and UK currency GBP and no broad based fear on global markets as of now. We believe market believes that the remain-camp will score more votes and as a result there will be no risk to global asset markets. This weeks we would focus on one major risk – Brexit and also do a roundup of the economic data from India and world.

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UK, along with US, has been the best performing economy in the industrial world, with unemployment rate down below pre-crises levels and services sector humming. However, there are now fears that if UK votes to exit out of the European Union on June 23rd then it can have adverse impact on European economies, politics and markets. We believe a not so expected Brexit verdict can lead to sharp losses for the British Pound, something in the magnitude of 10/15% over the ensuing few quarters and also lead to major upheaval in global financial markets. UK economy is services lead and is dependent on the financial sector. The city of London is one of the major financial center in the world. UK has been running a very high twin deficit, Budget Deficit (Government’s fiscal balance) as well as current account. Thanks to higher consumption & investment over savings and high fiscal deficit (4%-5% of GDP), current account deficit has remained around above 5% of GDP. A country which runs current account deficit is short of adequate savings and hence have to import the savings or capital from abroad, and hence run a capital account surplus. Therefore, incase Brexit occurs, it may cause traders to fear two pronged risk, one, capital flows may dry up as the country enters unchartered waters and second risk of ratings downgrade. The result could be a reflexive process of selling Pound assets and hence weaker Pound against all currencies.

We should be careful not to imagine an Armageddon scenario for UK if it decides to exit EU. It is a developed nations well connected in the global commerce, finance and politics. Therefore, we would not be surprised if UK accepts the Norwegian Model of soft exit. Norway, though not part of the economic union called EU but is very much a part of the common market known European Economic Area. It means accepting the four freedoms of goods, services, capital, and labour that go with the EU single market. It means accepting some of EU rules and paying into the EU budget. According to a report by Adam smith Institute, Norway enjoys freedom of veto over EU laws under Article 102 of the EEA agreement. At the same time, they are exempt from the EU agricultural, fisheries, foreign, defence, and justice policies. They do not have to implement all EU law as often claimed. Norway’s latest report shows it has adopted just 1,349 of the 7,720 EU regulations in force, and 1,369 out of 1,965 EU directives. UK can work out a similar model if they chose to exit.

According to Open Europe, “UK GDP could be 2.2% lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU or reverts into protectionism. In a best case scenario, under which the UK manages to enter into liberal trade arrangements with the EU and the rest of the world, whilst pursuing large-scale deregulation at home, Britain could be better off by 1.6% of GDP in 2030. However, a far more realistic range is between a 0.8% permanent loss to GDP in 2030 and a 0.6% permanent gain in GDP in 2030, in scenarios where Britain mixes policy approaches.” Both of the reports indicate that there is no room for Armageddon for the UK economy even if they choose to exit EU. However, we can significant increase in volatility in financial markets. An EU without Britain may fan the anti-EU and anti-Euro sentiments across Europe. A fear that Euro project can be undermined politically may trigger a run on the Euro zone bonds, stocks and the Euro currency. The adverse impact will be felt across the emerging market as well, as the underlying economic situation for EMs remains fragile. In such a scenario, US Dollar would become the king of the Jungle with every other currency facing its wrath.

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Let me now conclude with a roundup of the key economic data. Fed Chairwoman Janet Yellen spoke last week and she maintained a neutral tone. Central banks have had a rough time since 2007, failing to predict major risks and forecast economic performance correctly. Market is not pricing any further hike before end of 2016. However, expectations can change quickly if the US economic data shows improvement and Brexit does not materialize, which then become USD positive. In other economic news, Chinese trade data was mixed with exports contracting more than expected by imports falling less than expected. We would not like to draw much economic implications from the import data because in China trade channels can be exploited for hidden capital flows. Fictitious imports can be used as conduits to take money out of the country. We believe China is facing significant risk of large scale capital outflows and imploding economic growth. In order to avoid a financial crises and economic collapse China needs to take control of its monetary policy. By having its currency softly pegged to the US Dollar, China has more or less relinquished control over its monetary policy. It needs to renege on the peg and go for a large scale monetary policy stimulation, lower rates and greater base money. The effect of such a move would be a sharply weaker Yuan which in turn would trigger the next round of currency war.

We have long held the view that Dollar/Rupee remains well supported between 66.20/66.50 region on spot and over a period of few months, we can see a depreciation towards 68.00/68.50 levels on spot. The weaker IIP data on last Friday would be Rupee negative. Over the next week, we expect a range of 66.50 to 67.30 levels on spot.

  1. S
    Sourav Saha
    Jun 12, 2016 at 6:38 am
    Superb write up...
    Reply

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