British voters elected to leave the European Union (EU) in a referendum earlier this week. We are not sure how a whole nation can suffer from delirium at the same time, but the vote seems to be irreversible. The vote will have a huge impact on (the economy of) Britain, as the plunging pound indicates, and on the EU, or what remains of it. Of course, we are mostly interested in what Brexit means for Emerging Markets.

Down and Out…

The direct impact of Brexit on Emerging Markets is probably limited. Property prices will fall but ownership of property by Emerging Markets investors (mostly London trophy assets) is limited to Russian oligarchs, sovereign wealth funds and Chinese property developers (think of Dalian Wanda’s One Nine Elms development). Emerging Markets corporates have gone on a shopping spree but, again, there are few companies with an outsized exposure to the UK. Tata comes to mind. The Indian conglomerate bought Jaguar Landrover. But, if anything, the carmaker will become more competitive thanks to the weakening pound (although this advantage may be undone by duties for exports to the EU). Tata also owns steel mills (formerly known as Corus), but these assets need to be written down regardless of whether Britain stays in or out of the EU. Another large investor is CK Hutchison (part of Li Ka-shing’s empire, Asia’s richest tycoon), which owns a mobile telecom operator (Three), operating in Britain and Italy, and retailers and ports across Europe. China is the largest investor in Europe with FDI reaching USD 23 billion in 2015 (of which USD 17 billion in the eurozone). For example, ChemChina, a state-owned enterprise, bought Pirelli and Fosun acquired Club Med. These companies may get into trouble but, in our view, this has more to do with aggressive debt financing than anything else.

Brexit also will have consequences for EU accession talks, although these talks didn’t proceed smoothly in any case (witness Turkey’s struggle to get past the goalpost), especially if you have a nuthead like Jean-Claude Juncker trying to make a convincing case for enlargement. Alternative frameworks of cooperation within the EU should be developed. Brexit makes clear that this task is long overdue. But Brexit itself is not the cause, this should have happened anyway.

The main impact of Brexit on Emerging Markets will largely be indirect. Firstly, financial markets sold off as investors went into “risk off” mode. This is probably a temporary phenomenon and, at least for investment grade credits, is mitigated by the now highly likely decision of the Federal Reserve to leave interest rates unchanged. Dollar swap rates already declined by 20 basis points across the curve. Secondly, and more importantly, growth in Britain and Europe will likely be negatively impacted by Brexit, simply because nobody is likely to make substantial investments whilst the divorce is being negotiated (and banks have another excuse to lay off staff). The damage is difficult to assess at this stage as this is a function of, for example, how heavy-handed the EU will treat Britain, which trade model Britain will choose (e.g. WTO or EEA), whether Britain remains an united kingdom (will Scotland seek independence?) and whether other EU dissidents (e.g. Marine Le Pen in France and Geert Wilders in the Netherlands) will try to force a bigger break-up. The OECD believes that the difference in real GDP relative to Britain staying in the EU might cost 3.3% by 2020 (or about 1% per annum) and 5% by 2030. Growth for the EU is projected at 1.8%-1.9% for 2016-2017. The OECD estimates that the EU’s GDP might be 1% lower by 2018 under Brexit (i.e. lower annual real GDP growth of 0.5%). If we look at trade flows, then China stands to lose out most. Imports by the EU from China reached USD 400 billion in 2014, according UN Comtrade data. Another large exporter to the EU was Russia with USD 221 billion, but that was when crude still sold at USD 100 per barrel for most of that year. Other large exporters are Turkey (USD 72 billion), South Korea (USD 52 billion) and India (USD 49 billion). Loss of exports will, in our view, not be large enough to destabilize any of these countries.

However, heightened uncertainty in financial markets coupled with negative growth numbers in itself might be a trigger for an Emerging Markets crisis. As we have pointed out in previous blogs, imbalances are building up in several large Emerging Markets. Especially China is at risk as its (corporate and local government) debt is spiraling out of control, whereas Turkey is highly dependent on foreign funding to roll over short-term debt and Brazil still is in a deep recession. If investors become more risk-averse and turn to dollar assets as safe haven, a stronger dollar could result in, amongst others, capital outflows and increasing leverage in China, a funding crisis in Turkey and lower oil prices (affecting Brazil and Russia, amongst others). Not our base case but also not a scenario to rule out: in any case, who had correctly forecasted Brexit…

Success is stumbling from failure to failure with no loss of enthousiasm (Winston Churchill)