India may be one of the most vulnerable EMs, say Lambregts & Erken

EMs may struggle in the short term on the back of rising geopolitical developments, say Jan Lambregts and Hugo Erken

London-based Jan Lambregts , managing director and global head of financial markets research, Rabobank International, and Hugo Erken, head of international economics, RaboResearch Global Economics & Markets, tell Puneet Wadhwa that EMs may struggle in the short term on the back of rising geopolitical developments, which will likely cause a shift towards risk-off sentiment and capital outflows. Edited excerpts:

How do you see the global financial markets play out in the second half of 2020?

Lambregts: Consolidation is probably the best thing we can hope for, with significant downside risks returning in equity markets. While global liquidity remains ample and central banks keep reassuring us they will do more if need be, the virus reality remains grim. Promising news of vaccine trials going well can’t obfuscate that an actual vaccine and the mass distribution thereof is a story for the first half of calendar year 2021 (H1CY21) at the earliest. So we still got a substantial period of economic weakness to cover, which a source of gravity that will be hard to ignore.

How will the global financial markets react in case Joe Biden occupies the White House in a few weeks from now?

Lambregts: I think markets will mainly focus on whether the election offers a clear victory for either candidate. The odds of an initially contested election result are real, particularly when with a large share of mail-in votes expected. In the increasingly bitterly divided political landscape and with a potentially vacant or just filled US Supreme Court seat, this is the type of volatility the market could be quite worried about. Provided there is a clear winner, and if that were to be Joe Biden, I wouldn’t be surprised if the initial response is one of relief in financial markets: certainty is prized over uncertainty in that case. The long-term policies Biden will go for ultimately have their impact and create winners and losers in equity markets as well of course, but those implications won’t be so easy to digest from day one after the elections.

For how long will the global markets remain disconnected with the economic reality of a recession, slowing demand, job losses and pay cuts?

Lambregts: The market is perhaps rational and simply responding to the wave of central bank liquidity out there. Nevertheless, the next three – six months are going to be tough. We are zooming in on a vaccine, but it probably won’t be ready for mass distribution until H1CY21. Hence, we have got a substantial period of economic weakness still to cover, even under some of the most positive scenarios. While there are clear winners and loser, the latter do outstrip the former, and the losses are also mounting, with some industries being permanently scarred as this unprecedented economic crisis drags on. There’s the separate issue that the widening gap between Main Street and Wall Street eats at the fabric of our social contract as well, and threatens to introduce more political volatility.

What's the road ahead for global bond markets?

Lambregts: Central banks across the globe have made it abundantly clear that their ultra-accommodative monetary policies made up of extremely low or negative policy rates, asset purchases and ample liquidity provisioning in general will remain in place during crisis times and well beyond the support the economic recovery. Reflationary forces, as a result, are present across a variety of asset markets. Yet for developed economies bond markets it’s hard to see any scenario in which long-term interest rates will rise substantially in the upcoming years. For emerging markets (EM), bond markets the story is more complex, particularly if some EMs will try to print their way out of trouble as well and are likely to find out this is a lot harder for them than for developed economies. 

How are the foreign investors looking at India as an investment destination?

Erken: From a structural investment, India is still one of the EM’s with the largest upward investment potential. In the past, we have argued that India is one of the candidates that might benefit from economic activity exiting China, something we have not seen in the 2019 data by the way. But we expect that India will benefit to a larger degree in the future. 

Having said that, we expect that all EM’s might struggle in the short-term on the back of rising geopolitical developments and this will likely cause a shift towards risk-off sentiment and capital outflows from EM’s. Both China and the US are actively pursuing a decoupling strategy and we expect that geopolitical stress will continue to rise in the months after the elections. Against the backdrop of increasing risk and dollar strengthening, India might be one of the most vulnerable EM’s at the moment. 

Why do you believe so?

Erken: India has experienced one of the most severe contractions among G20 in fiscal Q1 (-23.9 per cent), the high-frequency data is looking bleak with consumer confidence being super low, there is stubbornly high inflation, rapidly sliding fiscal metrics, high stringency due to irregular lockdowns to contain a rapid further spread of the virus (which is not going well), and little or no policy options to revive the economy. Bottom-line, India is likely to bear the brunt from a global turn in sentiment, but in the longer term India could become the new global manufacturing hub. The latter of course depends on solid policymaking and reform efforts, something we unfortunately have seen too little lately. We expect the rupee to slide to 74.8 against the US dollar by 2020-end, basis the above reasons.

What are your economic projections for India?

Erken: Given the slow pace of the recovery, we expect the Indian economy to contract by 10.6 per cent in FY21. Needless to say, we are not optimistic. This is aggravated by the fact that there are not much policy options left to mitigate the direct pain of the corona crisis. We expect fiscal deficit of the central government to slide to -8.1 per cent of GDP in FY21 and remain elevated in subsequent years (-6.5 per cent in FY22 and -5.9 per cent in FY23). For now we have penciled in for GDP: FY 2020/21: -10.6 per cent, FY2021/22: 8.9 per cent, FY2022/23: 4.5 per cent and FY20/24: 5.4 and we believe India’s growth potential is somewhere near around 5-5.5 per cent. This is without additional policy measures.

Expectations from the Reserve Bank of India (RBI) given these assumptions?

Erken: The government does not have much room to launch additional stimulus measures without running the risk of downgrades of the sovereign by rating agencies (resulting in severe capital flight). From a monetary perspective, the RBI has to deal with stagflation conditions. Although food inflation is expected to wane, core inflation remains high due to disrupted supply chains caused by especially local lockdowns. And there is more inflation on the horizon, which would could perhaps even force the RBI to start hiking rate in H1FY22. We strongly advise against unconventional monetary policies, such as debt monetisation or quantitative easing (QE) in a country as India, as it does not meet the proper criteria to adopt these kind of policies without running the risk of massive side effects (sliding rupee and high inflation).

What more policy response do you expect from the government now?

Erken: As said, we do not see much options in the short run, but we do think that policymakers could use the sense of urgency of the current crisis and start focusing on improving the fundamentals of the Indian economy. The government has already taken steps in the right direction, such as the new agricultural and trade bills and that have been passed in Lok Sabha in September and the recently introduced labour market reforms. More needs to be done. For instance, clean up the banking sector – we have not seen any major reforms after the hallmark Insolvency and Bankruptcy Code – broadening the narrow tax base and reforming the education system. This way, India could raise its full potential in the aftermath of the crisis.