Indian rupee rattled by Brexit, Rexit one-two punch; depreciation to 68.50 seen

By: |
Updated: June 26, 2016 10:17:43 PM

There are decades where nothing happens; and there are weeks where decades happen: Vladimir Ilyich Lenin.

indian rupee vs us dollarIndeed two unexpected and impactful things happened over the past two weeks. First, it was the surprise announcement of Dr Raghuram Rajan not to seek re-appointment when his first term ends in August and second the political earthquake of ‘Brexit’ (Reuters)

Indeed two unexpected and impactful things happened over the past two weeks. First, it was the surprise announcement of Dr Raghuram Rajan not to seek re-appointment when his first term ends in August and second the political earthquake of ‘Brexit’, UK’s exit from the European Union. The referendum is going to be have significant long term political impact on the region. Though the near term pain may seem unbearable in some financial pockets, especially European asset markets, but we believe coordinated central bank intervention can help stabilise things in a couple of weeks’ time. However, make no mistake, the event is enough to become a major headache for the world financial markets and politicians in the coming months and years.

Let us delve a little into the history of the European Union. The need for a politically unified Europe was felt after the end of WWII. The horror of previous 100 years, where worst form of nationalism caused epic devastation and deaths across the continent, the policymakers felt the need to tie the European countries economically. The idea was to start with economic co-operation and then move onto a political union. The European Economic Community (EEC) was a regional organisation which aimed to bring about economic integration between its member states. It was created by the Treaty of Rome of 1957. Upon the formation of the European Union (EU) in 1993, the EEC was incorporated and renamed as the European Community. European Community went onto become a full-fledged economic Union called European Union. Within the European Union, some of the countries came together and decided to take the co-operation to even further with monetary policy union or currency Union and the Euro was launched. European Union like any country has legislative, judicial and executive arms knows as European Parliament, European Court of Justice, European Commission and the European Council. The laws they frame is applicable on member’s states.

One can always be tempted to compare the European Union to India because of its diversity of cultures and languages. However, the similarity ends there. India, unlike EU, has been a nation of common shared values and identity. Europe lacked that common identity. Europeans have always felt their feeling of nationalism supersede any pan-European nationalism. As a result, over the years, anti-European sentiments have gained momentum. The movement has caught speed post the global financial crises, which drove a wedge between well-off countries and not so well-off countries in the continent. Within EU, anti EU feelings have manifested in a serious way in France, Greece, Italy, Netherlands, Poland, Sweden and Spain. Now with the second largest economy of EU stepping out of EU, we fear that the far right, anti EU parties across the continent may now swell in popularity. UK may become a catalyst to the process of European dis-integration.

There is also a risk that the core members of the EU may be tempted to use the Greek medicine on UK to set an example for other countries not to think of doing the same. However, we hope it is not the case and better sense prevails. Incase such a path is chosen it can lead to a path of mutual harm for UK as well as EU. European economic recovery is anemic and their banking system is still saddled with toxic assets, especially the banks in the Eurozone. At a time like this, a political brinkmanship can prove quite costly as a fresh downturn in Europe may become too much to bear for political parties across the continent. UK’s importance to EU can be gauged from the strong linkages its financial sector has with EU. It is to be noted that UK’s financial sector assets are 8 times of its GDP. One-third of the UK’s financial and insurance services exports are to the EU. More than half of the UK banking sector’s cross-border lending is directed to the EU and almost half of the foreign direct investment received by the UK comes from the EU. Therefore it was not a surprise that the prices of credit of weaker countries in Europe and also of their financial institutions were worst hit on Friday. Several of the stock indices in mainland Europe suffered deeper cuts, much more than what UK stocks did. Many of the financial institutions in the Euro zone have loaded up their balance sheets with bonds of their governments and now if Brexit causes these bond yields to rise, inspite of ECB’s asset purchase program, then it can lead to renewed Euro zone contagion. In that case ECB may have to increase its size of the asset purchase program.

At this early stage, great uncertainty exists over just what the Brexit will ultimately mean for the UK economy. UK has two years to draw curtain on its relationship with EU and within that time frame it has to negotiate with the EU the terms of its withdrawal, and renegotiate trade relationships with 60 non-EU economies where trade is currently governed by EU relationships. At the same time. Countries like Scotland and Northern Ireland may push a referendum on exiting from UK and integrating with EU. Heighted uncertainty and risk aversion is likely to discourage new investment in the UK and weigh on consumer sentiment. The negative list of factors to consider are rising inflation, falling asset prices, high uncertainty and weakening private domestic demand countered by positive impetus from a more competitive exchange rate or monetary and fiscal policy easing. In our last write up on Brexit we talked about the possibility of a loose integrated model in light of the Norwegian European Economic Area model. We see a strong possibility of UK adopting some version of the EEA as it will offer it time to get its house in order. The only risk is political brinkmanship from EU, which we hope does not happen, but if it occurs, it may scuttle the chances of an amicable split.

A global event like Brexit is bound to have global ramification, in emerging markets as well. We see a few channels of impact, over the short to medium term and long term as well. Over the short term, unless central banks can quickly move to douse the dollar shortage into the world financial markets it can push the price of dollar against EM currencies, including the Rupee. The global market turmoil is also another channel of impact on EMs. Add to that the fact that, a chunk of foreign capital inflows come from UK is also a source of concern. Last but not the least, we need to keep an eye on China and how its currency behaves in the face of this kind of global turmoil. With Europe being its biggest trading partner, an already stressed Chinese economy may finally pull the plug on its currency and let it depreciate. A weak Yuan may then cause sharp depreciation in currencies like Rupee. We have to be careful about such eventualities, as out of control currency decline can quickly morph into self-fulfilling cycle of depreciating asset and currency values.

Over the near term, we see the Rupee to come under pressure as Rexit and Brexit both act as a headwind on the currency. We see the risk of depreciation towards 68.50 on spot.

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.