Trade Wars, Capital Flight, And... Formula One
Let’s talk about Formula One. Not just because I’m Dutch and Max Verstappen has boosted the popularity of F1 in the Netherlands considerably. No, I want to talk about this sport as there is quite some resemblance with economics. Both F1 and economics feature competition, speed (economic growth), crashes and collisions, investment, drivers (policymakers) that have to make the right decisions under stress, technological progress and, as always, foul play. Coincidentally, there are two cars on the grid that compete under the flag of Force India. Now, let’s pretend these two cars are a metaphor for the performance of the Indian economy, with Prime Minister Narendra Modi and Reserve Bank of India Governor Urjit Patel being the drivers of both cars. If I had to compare the two with actual drivers in F1, I would pick Ferrari’s two drivers.
Modi bears most resemblance to the German Sebastian Vettel. Vettel is very popular with the fans, has won four championships and shows a lot of courtesy towards the press. At the same time, Vettel is also known for pulling unexpected moves during a race, for instance crashing into Lewis Hamilton in the Azerbaijan Grand Prix last year, which reminds us of Modi’s announcement in November 2016 on demonetisation. Patel is more the Kimi Räikkönen type, the skilled and experienced Finn that doesn’t want to say more than necessary and just can’t hide the fact that he doesn’t like speaking to the media.
One could even say that both are currently in the backseat (which an F1 car does not have, so that would be the rear wing) and two important United States policymakers are in control.
Driver 1: Donald J. Trump
U.S. President Donald Trump is driving the first Force India car. It is hard to grasp what kind of driver Trump actually is. Either he is the brilliant strategist, bolstering his negotiating power in order to maximise the economic benefits for the United States. This would make Trump the Alain Prost of the racetrack, whose nickname was ‘Le Professeur’ for his calculating and smart approach to F1 racing.
However, an alternative view is that Trump is applying primary school economics to trade, would make Trump look more like Taki Inoue.
Taki Inoue was a Japanese driver active in the 1990s, generally considered to be one of the least talented in the history of F1. He even managed to get knocked off his feet by a medical car checking up on him after his car retired from the Hungarian race in 1995. Let’s see what implications Trump’s driving could have on the Force India car.
In the current trade spat between the United States and China, countries like India could end up being caught in the middle. In case India sides with either the U.S. or China and it would run the risk of facing 20 percent tariffs on its exports by either of these countries, our calculations show that this would shave off between 0.4 percentage points and 0.9 percentage points of GDP up to 2022. Hence, the impact is relatively limited and such scenarios would only result in a broken headlight and minor scratches on the paintwork.
If India chose to retaliate against one of these countries with a 20 percent tariff, however, the economy could face GDP losses as large as 2.3 percent up to 2022.
Higher tariffs on U.S. or Chinese products would result in higher import prices and, consequently, higher prices for both Indian consumers and producers using U.S. or Chinese intermediates. The cost-push inflation would eat into private consumption and investment and would reduce export and import volumes even further. So paradoxically, if the Force India car would try to defend its position against one of its stronger opponents in the race, it would end up with at least a flat tyre or a broken gearbox.
Driver 2: Jerome Powell
As chairman of the U.S. Federal Reserve, Powell and his team are responsible for decisions on the Fed Funds Rate and the Fed’s balance sheet, which has an impact on capital flows which India needs to plug its current account and budget deficits.
Powell’s car, however, has a strange feature. If the crowd expects Powell to take a turn, the car immediately responds without Powell even touching the steering wheel.
It is not hard to imagine that this could easily end up in a collision. Indeed, financial market expectations about possible U.S. rate hikes are at least as important as actual hikes. Recently, we have developed a portfolio flow model for the Indian economy which captures exactly these two features, next to a statistically and economically significant impact of the stock market, exchange rate, economic growth, and political risk. Our model has a pretty decent fit and captures 55 percent of the variation in the series.
We have used this model to run two of scenarios: one where the Fed faces faster than expected inflation and needs to accelerate its tightening cycle. And a second one where (on top of scenario 1) political risk in India increases and the Rupee depreciates faster than expected as a result. Higher political risks in scenario 2 might be triggered by Trump’s trade war, Modi losing the general election next year or a flaring up of the dispute with China over the Doklam plateau.
Our calculations show that in case the Fed would be speeding up its tightening cycle, we could be looking at up to $22 billion of missed (cumulative) portfolio investments until 2022. (the orange line in the chart below). In case political risk increases as well and the Rupee depreciates faster than expected, losses would even add up to $32 billion (grey line).
The downward pressure on portfolio flows would also have consequences for India’s finance requirements. In our first scenario, the shortfall in financing sources would be as large as $16.8 billion this year and $12.3 billion in 2022 (the circled blue dots in the chart below). And if FDI follows a less attractive trajectory than the one shown in this chart, problems would be even more substantial.
Fortunately, there is always the safety car. This car limits the speed of competing cars in case of obstruction of the race track or bad weather. For India, the safety car analogy would be its $425 billion of foreign exchange reserves, which it could use to plug its shortfall in investment sources and to prevent the Rupee from plunging. However, as argued on BloombergQuint, using these reserves could push up the entire yield curve (since lower reserves mean reduced domestic monetary liquidity). This effect could take place rather quickly and sharply. Remember for example that China lost about $300 billion in reserves in just three months late 2015/early 2016.
The consequence of lower liquidity and—possibly sharply—higher interest rates, will be damaging to India’s economic recovery and government stimulus plans.
So, even a safety car can experience engine failure…
Who Is The Driver Of The Day?
Ultimately, to avoid the grim outlook sketched in the different scenarios above, all India needs now is the continuation of prudent policymaking. This means that the Indian government should refrain from measures such as the recent tariffs on agricultural and industrial products. Although these seem attractive to bolster approval with voters in light of the general elections next year, they might spook investors as well.
Moreover, the RBI should remain vigilant on inflationary pressure. There is a risk that the current wait-and-see mode will eventually result in action taken too little, too late. In our opinion, therefore, there is clearly one driver of the day among all Indian policymakers and that is Michael Patra, the only Monetary Policy Committee member who has voted for a rate hike twice in a row now.
Hugo Erken is Senior Economist at Rabobank; Country Analyst for North America, Mexico and India — RaboResearch.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.