It has now been more than a week and so far the fallout from the Brexit vote has been muted. Global financial markets were taken by surprise by the outcome, but the disruption has been less than feared. Fears of a sharp rise in global risk aversion haven’t materialised and it would appear that for now the adverse impact on near-term growth is likely to be limited to the UK and, to a lesser extent, the EU and Central European emerging markets.
There are two main reasons why this has likely happened. First, the direct trade and financial linkages between the UK and the non-EU world are small, despite London being a major financial centre, and second, the actual impact will not only take time to take effect but at present it is also unclear what these are. We only know the result of the Brexit vote. Brexit hasn’t happened yet. Between the vote and the actual exit, there is the Brexit process. This hasn’t even begun, as the UK is still to invoke what is termed as clause 50 of the Lisbon Treaty. Once this clause is invoked, the negotiations will start, which are likely to be long drawn and complicated, as these will have to cover a large number of issues that took the EU several decades to agree.
The Lisbon Treaty specifies a maximum of two years for these negotiations to end. Our sense is that even if the exit clause is invoked in late 2016, after the election of the new prime minister in September, it will probably take until 2018-19 before the details of the separation are nailed down. Once the negotiations with the EU are over, the UK will then need to negotiate new cross-border treaties with non-EU countries on trade, financial transactions, and many other areas. This includes the UK’s membership of the WTO, which has also been on the basis of its membership of the EU. The non-EU countries are unlikely to negotiate ahead of knowing the terms of the EU separation and will likely be in a stronger bargaining position given that the loss or scaling back of a large number of trading relationships upon EU exit is likely to be a blow to UK exporters making the need to get a successor deal more urgent for the UK than for its trading partners.
Only when these negotiations are over, can one, with any degree of certainty, start assessing the impact of Brexit on the UK economy and its implications for other countries. In the meantime, uncertainty will rule. First, there is the economic uncertainty of not knowing what the regulatory and trading landscape will look like in two years, which will delay individuals’ and firms’ spending and hiring decisions and if they start believing that things could be worse in the medium term, spending could be permanently cut or redirected away from the UK.
Second, there is the political uncertainty. While the UK as a whole voted to leave the EU, Scotland voted to remain. Reports already suggest that Scotland could hold its own referendum on independence and separate membership to the EU. The rest of the EU appears torn between fear and fantasy — fear that a UK exit will lead the region to unravel, and fantasy that without the UK the Euro area can take a leap forward in terms of integration. Neither of these extremes seems very likely. Non-mainstream political parties that are hostile to the EU will be energised by a UK vote to leave, but no other country in the EU looks likely to call a referendum on EU or Euro area membership. However, the UK’s referendum has demonstrated that the legitimacy and popularity of the EU project is not at all secure in the eyes of voters. And this will likely lead to institutional changes to better balance integration and centralisation, perhaps after the German and French elections next year.
Where does India stand in all this? The UK imports about 3.5 per cent of India’s total exports and the EU about 13.5 per cent. In terms of financial linkages, capital inflows from banks headquartered in the EU make up 20 per cent and that from the UK 13 per cent of total bank-related foreign inflows into India. As the rise in uncertainty shaves off growth in both the UK and the EU, cross-border traffic in trade and financial flows could well slow down. However, this is likely to affect only specific sectors and companies.
The larger question is whether these political changes and their possible contagion to other parts of the world restrain global trade further. Here are some numbers whose implications should be self evident. Over 2003-08 (before the global financial crisis), global trade in volume terms (adjusting for all price changes, including the large swing in commodity prices) grew around 7.5 per cent per year on average. Since 2012, it has grown at just about 2 per cent. Over these two periods, GDP growth in emerging market economies dropped from an average of 7 to 4 per cent.
India’s exports surged at an annual pace of nearly 18 per cent over 2003-08 as its share in GDP doubled from around 12 to 25 per cent. In the last four years, India’s export growth has languished at less than 1.5 per cent annually. I haven’t mentioned the comparable GDP growth rates in India over these periods. As it should be very familiar to all by now, they can’t be compared given the significant methodological changes. But just a “feel” test would suffice to establish that GDP growth in India is significantly slower today than during 2003-08. These and other more granular data suggest that the export-led growth model, which all emerging market economies adopted in varying degrees in the 2000s, now lies broken and new sustainable engines of growth need to be found.
But barring China, no other emerging market economy has started to rebalance its growth drivers. In India, we are still chasing the export dream. This time dressed up as a strategy to gain market share. But think about the arithmetic: With global export growth languishing at 2 per cent, India needs to keep gaining market share every year almost inexorably to sustain GDP growth anywhere close to its 2003-08 pace. If Brexit lowers global trade further, this task becomes all that more difficult. Rather than using up the limited policy and reform space pursuing this uncertain strategy, India needs to introspect and explore new engines of growth. Unfortunately, the conversation hasn’t even begun.