India: trade wars, capital flight and… Formula One?
Also published on Bloomberg, April 18, 2018
What are the similarities between trade wars, capital flight from emerging markets caused by an acceleration of the Fed tightening cycle and… Formula One?
Let’s talk about Formula One. Not just because I’m Dutch and Max Verstappen has boosted 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 (i.e. economic growth), crashes and collisions, investment, drivers (i.e. 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 RBI Governor Urjit Patel being the drivers of both cars. If I had to make a comparison with the actual drivers in F1, I would say Modi bears most resemblance to German driver 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 demonetization. Patel is more the Kimi Räikkönen type, the skilled and experienced Finnish driver 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. A problem for both Modi and Patel is that they are not the only ones driving the Force India cars. 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 US policymakers are in control.
Driver 1: Donald J. Trump
US president Donald Trump is driving the first Force India car. It is hard to grasp what kind of driver Mr. Trump actually is. Either he is the brilliant strategist, bolstering his negotiating power in order to maximize the economic benefits for the US. 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 90s that is 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 for the Force India car.
In the current trade spat between the US and China, countries like India could end up being caught in the middle. In case India sides with either the US or China and it would run the risk of facing 20% tariffs on its exports by either of these countries, our calculations show that this would shave off between 0.4ppts and 0.9ppts of GDP up to 2022 (see here). 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% tariff, however, the economy could face GDP losses as large as 2.3% up to 2022 (figure 1). Higher tariffs on US or Chinese products would result in higher import prices and, consequently, higher prices for both Indian consumers and producers using US 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 tire or a broken gearbox.
 Keep in mind that in these calculations, we abstract from possible adverse effects from financial market turbulence, political turmoil, a shake-up of integrated international value chains or a sudden stop of capital flows. Therefore, the impact assessment presented here should be regarded as a rough estimate.
Driver 2: Jerome Powell
As chairman of the FOMC of the Federal Reserve Bank, 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 collision. Indeed, financial market expectations about possible US 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 (see here), 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% of the variation in the series (figure 2).
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 INR 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 elections 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 USD 22bn of missed (cumulative) portfolio investments until 2022 (figure 3 – orange line). In case political risk increases as well and the INR depreciates faster than expected, losses would even add up to USD 32bn (figure 3 – 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 USD 16.8bn this year and USD 12.3bn in 2022 (see blue dots in figure 4). And if FDI follows a less attractive trajectory than the one shown in Figure 4, 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 USD 425bn of foreign exchange reserves, which it could use to plug its shortfall in investment sources and to prevent the INR from plunging. However, as argued on Bloomberg (see here), 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 USD 300 bn 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 driver of the day?
Ultimately, to avoid the grim outlook sketched in the different scenarios above, all India needs now is 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 Mr. Michael Patra, the only MPC member who has voted for a rate hike twice in a row now.