Pharmaceuticals

Brexit: Impact on India

27-JUN-2016

To understand the potential impact of Brexit on the Indian economy in general, and specific sectors in particular.

Brexit impact on India limited, but some sectors will hurt

Rates could fall more, no significant downside to exports; wider yield differential can stoke flows

Auto components, IT, textiles, leather & metals most vulnerable sectors

Britainâ????s decision to move out of the European Union (EU) comes at a time when the global economy is not in a great shape and growth forecasts for 2016
have been marked down. â????Brexitâ????, therefore, has added to the weakness, fragility and uncertainty, and not surprisingly, roiled markets.

Although Britain will remain a full member of EU for at least two more years, divorce negotiations with the European Commission could commence under Article
50 of the Lisbon Treaty soon. How soon and how much these will progress is anybodyâ????s guess.

â????The market reaction was more severe because in recent days most polls had suggested that the â????Remainâ???? camp would win. This very strong
reaction, more fundamentally, illustrates that we are moving into completely uncharted territory, where the only certainty will be uncertainty,â???? said Jean-
Michel Six, Chief Economist, Europe, the Middle East, and Africa of S&P Global, in a note titled â????Why Brexit Is Rocking Global Marketsâ???? released on
Friday.

â????The political situation in Europe at the moment adds to the economic and financial uncertainty. This is because important elections are due in France in
May 2017, and in Germany in June 2017. More immediately, the October referendum in Italy will likely turn the Italian government's attention to more domestic
issues. What's more, crucial elections take place on Sunday in Spain, the outcome of which remains uncertain. What this all means is that from a European
standpoint, one can fear that the real negotiations between the UK and the EU may not begin in earnest before the middle of 2017, after the political air has
cleared,â???? Jean-Michel Six said.

These developments will shape the direct and indirect effects of Brexit and its short- and medium-term dimensions. S&P Globalâ????s preliminary estimates
suggest Brexit will knock off 100 basis points (bps) from the UKâ????s growth and 50 bps from the EUâ????s growth in 2017.

A weaker pound will help reduce the UKâ????s current account deficit (CAD), currently around 5% of GDP, by supporting exports and lowering imports. But
other forms of capital flows such as foreign direct investments are bound to suffer as investors postpone their decision or relocate due to heightened uncertainty.

CRISIL takes a look at both the macro and corporate level impact here:

MACROECONOMIC IMPACT ON INDIA

The channels through which global shocks get transmitted to India include trade, credit, investments and capital flows. Also transmitted is the element of
confidence. During the peak of global financial crisis in 2008-09, and also at the height of the Greek crisis, we saw all of these at play. Given the uncertainty with
the Brexit process, it should not be merely viewed as an event but as a process that will gradually unfold -- with intermittent mini-frights thrown in -- as
negotiations proceed. We have already seen how capital flows affect the stock and currency markets. So how are these developments likely to impact the Indian
economy in fiscal 2017 and the corporate sector in the medium term? We take a look:

We donâ????t presage big change in GDP growth this fiscal

Brexit is unlikely to have a notable impact on GDP growth in fiscal 2017, and we retain our forecast at 7.9%, with agriculture as the swing factor. The spatial and
temporal distribution of rains in July and August will matter more to domestic growth.

No significant downside to exports

In the short run, we do not see a significant downside to India's exports. UK accounts for 3% of merchandise and 6% of services exports from India. Further,
Indiaâ????s total trade (exports + imports) with the UK is only 2% of its external trade. Over the medium term, Indiaâ????s exports, especially in consumer-

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 oriented sectors (auto components, textiles, leather and footwear and precious stones and metals, which together comprise nearly 45% of exports to the UK),
and also in services, will depend on the severity of slowdown in the UK and ructions in the exchange rate.

Peer currencies key to Indiaâ????s trade competitiveness

Indiaâ????s trade competitiveness with the UK will not just depend on how rupee behaves versus pound, but also on what happens to the exchange rate of
Indiaâ????s competitors. If their currencies also appreciate against the pound, Indiaâ????s relative competitiveness will not be impacted much. Indiaâ????s
trade competitiveness will also be shaped by the movement on domestic costs and productivity.

CAD seen up 20 bps at 1.3% this fiscal

We forecast CAD at 1.3% of GDP in fiscal 2017, 20 basis points more than the 1.1% seen in fiscal 2016. Overall, we expect export growth to be tepid through
calendar 2016 given that global growth forecasts are edging lower. For yet another year, low imports (due to subdued oil and commodity prices) will shield
Indiaâ????s CAD. But there will be some upside from core imports (non-oil, non-gold), which are expected to rise on the back of a pick-up in domestic
consumption and to some extent investment demand. This will put upward pressure on CAD.

Re seen 50 paise weaker at 66.5/$ by fiscal-end

The rupee could see volatility in the coming weeks as global markets remain angsty. We expect the local currency to settle around 66.5 per dollar by March 31,
2017, with a downward bias (our earlier forecast was 66).

The good thing is that over the medium term, subdued global outlook â???? more so in Europe after Brexit â???? could divert investments to India because of
stable outlook and higher-growth prospects compared with other emerging markets. It is very likely that the world will once again be awash with stimuli-driven
liquidity and monetary policies will remain accommodative for even longer than previously anticipated.

Inflation seen flat around 5%

We maintain our inflation forecast of 5% for fiscal 2017 as domestic factors such as the monsoon remain favourable. Global growth will be subdued, keeping oil
and commodity prices benign, which is a positive for inflation in India. Also, we expect lower food inflation resulting from a normal monsoon to offset higher
services sector inflation. Proactive measures taken by the government and continued fiscal consolidation will keep inflationary pressures at bay in fiscal 2017.

Interest rates could fall more

The Reserve Bank of India (RBI) is likely to reduce its policy (repo) rate another 25 bps in the second half of this fiscal. We expect the RBI to intervene and
manage liquidity through open market operations and use its foreign exchange reserves to tackle currency volatility and capital outflows. So far this year, the RBI
has already conducted Rs 700 billion of open market operations.

Yield differential improves in Indiaâ??¦

Brexit also creates a downward bias in domestic rates. While the Sensex and the Nifty fell ~2.5% each on Friday, the rupee slipped as much as 1.5% against the
dollar before recovering. On the other hand, 10-year G-sec yields remained stable ~7.48% after opening at 7.50% on Friday. The fact that yields in major
advanced economies have fallen more means India offers greater yield differential, making its bonds attractive to foreign investors in the near term. The
possibility of the US Federal Reserve slamming the brakes on rate hikes for now improves the prospects of fresh foreign portfolio flows into Indian debt, which, in
turn, will put downward pressure on local yields.

â??¦as yields plunge in developed markets

The yield on 10-year US treasury fell to a four-year low of 1.47%, while the German bund and Japanâ????s JGBs hit record lows of -0.17% and -0.19%,
respectively, in the immediate aftermath of Brexit.

Central banks cock liquidity guns

Mark Carney, governor of Bank of England, has said he is ready with a £250 billion bazooka. He also said the capital requirements of Britainâ????s largest
banks are now ten times more than what it was before the crisis, thanks to stress tests. As a result, banks in the UK have raised over £130 billion, and currently
have more than £600 billion of high-quality liquid assets. Carney hopes this will help banks to continue lending in the UK.

Meantime, global central banks, including the European Central Bank, the US Federal Reserve -- are expected to do whatever it takes to avoid a liquidity freeze,
including opening up swap lines. The RBI has also assured its preparedness for any eventuality.

IMPACT ON INDIA INC

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 Indian companies are likely be impacted in multiple dimensions such as:

Demand weakness on account of potential slowdown in the EU and the UK;

Volatility in commodity prices; currency impact on account of the potential depreciation of the rupee, euro and the pound;

Translation losses for companies with significant operations in the UK and the EU; and,

Balance sheet impact on account of exposure to unhedged overseas borrowings.

Hereâ????s how we see the implications:

Auto, IT, textiles, pharma, leather & metals are the most vulnerable sectors

Companies in sectors such as automobiles, auto components, information technology services, textiles, pharmaceuticals, gems and jewellery, leather, and
leather products are most vulnerable to changes in demand and currency value. Metal companies would be hurt by the likely downward pressures on prices and
potential slowdown in demand, at least in the near-term. Sectors such as shipping and ports that are reliant on global trade will also have to grapple with lower
growth and consequently lower freight rates and utilisation. Further, companies with unhedged overseas borrowings will be affected by volatility or temporary
sentiment-driven weakness in the rupee.

Compliance, administration costs to rise for companies

The impact of Brexit on global growth and trade in the long-term would depend on how negotiations between the UK and the rest of the EU-member countries
pan out â???? something that is difficult to quantify at this juncture. Companies may also, over the long-term, have to grapple with increased administrative and
compliance costs, as they may have to set up base in other countries also in the EU. Currently, most companies set up their European headquarters in the UK,
and use London as their gateway to the European market.

Auto parts makers in line of fire, but limited impact on OEMs

Within the automobile space, component suppliers will be more adversely impacted compared with original equipment manufacturers -- with the exception of the
JLR business of Tata Motors. The impact on the JLR business will depend on how trade agreements between the UK and other EU countries are rewritten. On
the positive side, a depreciating pound will make JLRâ????s exports from the UK more competitive, at least in the near-term.

A quarter of auto parts exports are to Europe

Around a quarter of Indiaâ????s auto component exports are to Europe. The UK has a share of ~5% in overall exports. Any dampening of prospects due to
economic uncertainty and depreciation of the pound would have a corresponding impact on the revenues of these companies. Furthermore, companies with
plants in the EU/UK would also have to contend with translation losses. Some auto component companies with significant exposure to Europe include
Motherson Sumi, Bharat Forge, and Apollo Tyres.

Price volatility, demand slump to dent metal companies

Global steel and aluminum markets are already grappling with overcapacity and concerns on demand growth in China. Demand in the EU was already very
weak, and the new bout of uncertainty means demand will slump further, putting downward pressure on prices and profitability of manufacturers. This comes at a
time when leverage is high for many companies and some of them have significant overseas debt.

Garment exporters in the eye of the storm

Europe is the single-largest market for Indian garment exports, accounting for around 35% of such revenue. Garment exporters are, therefore, bound to feel the
pinch, in spite of tax and production incentives announced by the Narendra Modi government recently. In 2015 as well, these exporters were impacted by a 4.5%
decline in demand from the EU. The weakening of the euro against the dollar affected revenues in dollar terms.

Double whammy for IT: fall in discretionary spending, rise in administrative costs

For IT services, Europe (including the UK) accounts for around 29% of total exports. The UK alone accounts for ~17% of overall exports. The economic
uncertainty in the EU and the consequent impact on discretionary spends such as IT would, therefore, hurt domestic software companies. Expenses of these
companies may also go up if mobility of professionals between the UK and the EU is restricted. On the positive side, however, large IT service providers in India
do not have much exposure to the pound and the euro. For example, revenue denominated in pound and euro accounted for only 6.6% and 9.3%, respectively,
of Infosysâ???? revenues in fiscal 2016. The corresponding percentages are a tad higher at 13-14% and 7-8% of revenues, respectively, for TCS and Wipro.

Pharma largely unaffected

The European market accounts for around 12% of Indiaâ????s total exports of pharmaceuticals. Of this, the share of the UK is 3.5%. Therefore, the sector is
unlikely to be significantly affected, but companies such as Aurobindo and Wockhardt, with higher exposure to Europe, will see some impact.

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