Apart from capital flows, exports key to higher GDP
With the Sensex closing 122 points up on Tuesday and the rupee stable at 67.95 to the dollar—compared to the pre-Brexit close, the Sensex is now down 477 points and the rupee 67 paise—there is a danger of complacency over Brexit setting in especially as calm markets take it off the front pages of even the pink papers. More so, since most economists are downplaying the dangers and arguing India has special factors, like a solid GDP growth, that will give it a quasi-safe-haven status of sorts once the dust settles. The problem is that unlike, say, Lehman, Brexit involves no real trigger event—if and when it finally happens, the process will take two years—so its impact depends on the way Brexit is negotiated and which other countries choose to leave Europe and how markets react to that; to that extent, we don’t know when the dust will settle. It is, of course, comforting that, since FY15, India’s current account balance has been more than covered by just FDI flows. That is why even a $46 billion swing in FII flows—from $42 billion of inflows in FY15, there was an outflow of $4 billion in FY16—saw the rupee just depreciate 6%. Contrast this with the obvious positives of Brexit. The dollar will continue to strengthen, ensuring the Fed does not raise rates. To the extent there is uncertainty, the ECB and the Bank of Japan will loosen the spigots a bit more, making it possible there may eventually be more FII flows into India. Add in the good monsoon, and you are talking a pretty cheery picture.
The picture, however, looks messier when you look at the drivers of growth. JP Morgan chief India economist Sajjid Z Chinoy had done an analysis at the end of the second year of the Modi government and pointed to a 100-bps gain in FY15 and FY16 GDP growth relative to FY14 due to oil prices falling, a 50-bps fall due to the poor monsoon and a 150-bps fall due to exports contracting. Assuming these numbers are broadly correct, there will be a 50-bps gain due to a good monsoon in FY17 while the 100-bps gain due to oil will go away if prices don’t change—that’s why JP Morgan projects FY17 GDP falling 50 bps to 7.2%. But, what if exports contract again? After all, with the dollar strengthening, US growth will slow again, putting a ceiling on global import demand which, in any case, has been slowing. And we are not even talking yet of the sudden shocks to the system and the financial instability this can cause—banking capital flows, which were $11 billion in FY16, could then fall substantially, certainly from banks in Europe. Keep in mind that, since the shocks will be sudden, and their impact uncertain as we are essentially talking of political events for which there are no known solutions like cutting interest rates or even helicopter money, there will be a tendency of markets to over-react. Continuous reform is the only way India can beat this; so, let’s not get complacent just because the markets are not fully pricing in the dangers.