By John Richardson
IN normal global economic, social and geopolitical circumstances, Narendra Modi’s decision to overnight remove 86% of the cash from the Indian economy would have been a major risk. But these are not the normal global circumstances that most of us are familiar with. They are instead very much like the 1930s.
This is why India could end up being the 2017 equivalent of the 2008 Lehman Bros moment. For India itself, a country of 1.3bn, the scale of the damage could be enormously, almost incalculably, greater than the loss of one investment bank. But it is the potential knock-on effects that are even more worrying. Because of India, everyone may end up realising this painful truth: Most of today’s global debt is not going to be repaid because there is not enough demand.
We have to divide how this could unfold into First Order and Second Order effects. The First Order is the effects on India itself, which could be in these three phases:
- Prime Minister Narendra Modi wins the Uttar Pradesh state elections, which are likely to take place in February. As he result, he feels able to carry on with his reforms. The full extent of the economic damage from demonitisation might not become clear until after the end of the April 2016-March 2017 financial year. Until then, the perception that his policy is helping to boost equality by targeting the rich may help him in the Uttar Pradesh polls.
- But then the trickle of negative short term data (e.g. auto sales down by 40% and textiles sales by the same amount; food prices down by 25-50%) turns into a flood of very bad long term data. Job losses will be the key, particularly amongst average and low-income earners as they live amongst entirely in a cash-only economy.
- India enters a recession, the Rupee weakens further against the US dollar on capital flight. Inflation rises because of India’s heavy dependence on imports, particularly hydrocarbons. The Reserve Bank of India raises interest rates or lets the Rupee fall even further.
The Second Order is the shift of global investor attention onto India. India has stood out as major economic success story since Prime Minster Modi was elected. “If India of places has problems, what about the problems everywhere else?” will be the conclusion.
Investor attention focuses on all the debts built up globally since 2008 because of misguided policies in the West and in China. The US dollar strengthens and global interest rates rise with the focus shifting to a return of capital rather than a return on capital.
The stronger dollar and higher borrowing costs drag us into an emerging markets debt crisis at least as bad as 1997-1998. Meanwhile, dollar strength threatens the fulfilment of Mr Trump’s election promise of more jobs. So he launches a trade war against China that becomes global as developing countries line up on the side of China.
A note on what could happen to oil prices. The burden of supporting global demand growth rests on India and China, according to the International Energy Agency. Indian crude demand falls first of all, followed by China because of the Second Order effects. OPEC and non-OPEC producers realise that chasing market share in this weak growth environment is the only sensible option. Crude is at $30/bbl or lower.
As always, I hope I am wrong about how demonitisation could affect India. I hope for a positive outcome and that Premier Modi is proved right when says that things will start improving from the end of December.
But in today’s New Normal – because the Economic Supercycle is over– if it is not demonitisation in 2017 it could well be something else that tips the global economy over the edge.