The Effect of Euro Crisis on India Essay
EURO CRISIS: The European debt crisis is the shorthand term for Europe’s struggle to pay the debts it has built up in recent decades. Five of the region’s countries – Greece, Portugal, Ireland, Italy, and Spain – have, to varying degrees, failed to generate enough economic growth to make their ability to pay back bondholders the guarantee it was intended to be. Although these five were seen as being the countries in immediate danger of a possible default, the crisis has far-reaching consequences that extend beyond their borders to the world as a whole.As the world braces for a probable Greek exit from the Eurozone as part of the latest development in the Eurozone sovereign debt crisis, it is prudent to take stock of the situation and of the effect it might have on India.
It is only wise to be prepared for the worst after the unsavoury experience of 2008 and 2009 during which many professionals were laid off in different parts of the country though the economy was not significantly affected.The resilience of the Indian economy is very often cited by many in advocating the ‘India is insulated from the Eurozone crisis’ theory. In my view, that is a myopic view. The 2008-09 global meltdown was a fallout of corporate greed, malpractices and lack of government control. Banks and companies collapsed for their own fault.
While the band-aid came in the form of government bail-outs or, in simple terms, socialising private losses, one has to bear in mind that we are no longer looking at the prospect of failing companies or banks.We are looking at prospects of collapse of countries altogether. If Greece exits Eurozone, the Euro area national central banks and the European Central Bank would stomach big losses, threatening their solvency. Greek debt to these entities total almost 57 billion Euro. There will be a sudden flight of capital from Spanish and Italian banks. Both Madrid and Rome have repeatedly issued fresh government bonds with the promise of high returns (ranging between 5 and 7 per cent).With their economies supposed to experience de-growth (and officially Spain is in recession now), pre-mature exits from the bonds will be the most obvious panic reaction as most of these bonds are held domestically. So, rescuing the European banking system will involve pouring more money into Greece even after the Euro is out and the severely devalued Drachma is in.
The European Financial Stability Facility, the instrument for fixing the European liquidity crunch, is authorised to borrow up to 440 billion Euro, of which 250 billion Euro remained available after the Irish and Portuguese bailout.A separate entity, the European Financial Stabilisation Mechanism (EFSM), a programme reliant upon funds raised on the financial markets and guaranteed by the European Commission using the budget of the European Union as collateral, has the authority to raise up to another Euro 60 billion. But with negligible growth in two of the ‘most developed countries’ (Germany, France, Italy and Spain which shoulder most of the guarantee commitments) and two of them in deep trouble themselves, such an eventuality seems remote if not impossible.In such a situation, the US Dollar will emerge as the most secure currency. With the collapse of the Euro, Dollar’s rise against the Indian Rupee, which has already fallen to historic lows, will be meteoric.
This will lead to less capital inflows as foreign institutional investors would tend to be more conservative. The fall of the rupee will make exports and services theoretically cheaper. But since India depends on imports to meet its fuel demands (generally paid for in US Dollars), fuel prices would go through the roof, making everything costlier.As forex reserves will dwindle fast, input costs will continue to rise and margins will drop drastically. Trade deficit with China, which in all probability will keep the Renminbi at an artificial low, will increase and manufacturing could be hit badly. While prices of food, fertilisers, fuel and other essential items will skyrocket, companies will of course look at cutting costs.
And that may lead to lay offs and pay cuts. But India needs to take another more fundamental lesson from the European debt crisis. The European sovereign debt crisis is not an overnight development.Globalisation of finance; string-less credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices; international trade imbalances; real estate bubbles that have since burst; slow economic growth since 2008; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bailout troubled banking industries and private bondholders, assuming private debt burdens or socialising private losses have all contributed to this development. In India, unfortunately, successive governments have sacrificed fiscal consolidation at the altar of growth.The Union finance minister, for the financial year 2011-2012, announced that the fiscal deficit of the government of India stood at 5. 9 per cent of GDP. But this number somehow hides more than it shows.
Fiscal deficit, by the way, is the difference between what the government earns and what it spends, the latter being typically more. The expenditure for the year 2011-2012 has been estimated to be Rs 1,318,720 crore. The government’s earnings for the year is pegged at Rs 7,96,740 crore. This works out to a difference or fiscal deficit of Rs 5,21,980 crore. Now in 2007-2008, the fiscal deficit stood at Rs 1,26,912 crore.So within five years, the fiscal deficit has shot up by more than four times though in the same period, the government’s earnings have only increased by 36 per cent. It is fiscal mismanagement that has spelt trouble for Europe. It is imperative that we draw the right lessons from this.
We will tide over small crises but if we don’t cut our coat according to our cloth, we may be in for bigger trouble. When industry lobby groups from Assocham to Ficci were seeking policies in a meeting with commerce minister Anand Sharma on June 1 to counter a possible full-blown crisis in eurozone, a lone voice said it may even turn out to be an opportunity.It is anybody’s guess what will be the shape of global trade if banks in the continent and the eurozone blow up, but Indian exporters may be better positioned than a few years ago to move on to other growing markets in Africa and Asia, which the Europeans dominate now. “The Indian government has introduced focused market schemes (special incentives) to diversify exports. So the crisis in Europe should be seen as an opportunity for India to break into the markets where they export,” says Ramu Deora, chairman, All India Shippers Council.
If the eurozone crisis is not averted, India which has about a sixth of its total exports to the European Union, will face unemployment in the lower income category, such as textiles, one of the biggest employers. Textiles, including readymade garments, account for about a fifth of the total exports to Europe. The eurozone crisis has eliminated the benefits of a weak rupee, which is down 20% in a year, to Indian exporters as the spend-thrift consumers in the continent do something they are not used to in three decades – save.The slump in spending by the Europeans will aggravate the Indian economic slowdown where growth rate has already dipped to a near year-low for the March quarter. Companies that enjoyed cheap money from European banks, such as Deutsche Bank and BNP Paribas, for expansion and acquisitions are beginning to feel the pinch as battered lenders in the continent slam the doors on Indian firms. Even if the weekend elections in Greece bring in a coalition that would ensure the beleaguered nation stays in the European monetary union, it may be long before the demand for Indian goods and services rise in Europe.Individuals, companies and nations will first use the opportunity to repair their balances sheets with an austere life before getting to the old splurging habits amid high unemployment, which in countries such as Spain is as high as 25%. “The growth rate in India is slowing down, it will slow down further,” says Enrico Atanasio, senior vicepresident, commercial, Fiat India Automobiles Ltd.
“If it (the eurozone collapses) happens, the implications will be very strong. ” Given that European banks which lent liberally during the boom period are advocating belt-tightening, the market growth for Indian products and services may be delayed. Europe is finding itself at the crossroads and there is only one way forward, and that is reduction of deficits,” said Anshu Jain, Co-CEO of Deutsche Bank. “We are experiencing one of the worst financial crises in the history of modern Europe and its end is open,” said Jain. As per the CARE rating agency export oriented sectors are likely to benefit if the rupee continues to depreciate or remains in the current band. CARE Ratings has come out with its report on impact of Euro Crisis and global slowdown on India.As per the rating agency export oriented sectors are likely to benefit if the rupee continues to depreciate or remains in the current band. Global Economy: * Euro zone debt problem is likely to remain a concern in the near future.
Further, the European banks withdrawing credit in order to shrink their balance sheet would deepen impact of the debt crisis on the other economies. * Near zero level interest rates are to continue in the advanced countries in the immediate future. * Rising fiscal deficit in US and uncertainties over the economic conditions in most developed countries are adding to the worries. Impact on India: Though India is primarily a domestic economy, India’s exports are positively linked to the global economic growth. This is likely to adversely impact India’s export growth in the coming months. However, growth will be only marginally affected by the slowdown in the euro region debt stricken countries as our exposure is low. * Software services and other export oriented sectors would benefit from the rupee depreciation.
* FDI has not been significantly affected by the crisis while the FIIs are showing outflow in the last couple of months. * International commodity price moderation is not being translated in domestic prices.Further, exchange rate depreciation would worsen the inflationary conditions in the economy. Therefore, the RBI would have to continue with its anti-inflationary stance in the near term if domestic conditions do not improve. What is happening around the world? Credit Default Swaps (CDS) provides a unique window of viewing the state of uncertainty in any country. Table 1 provides information on the CDS for a set of countries at two points of time. Table 1 shows the severity in the crisis which has eroded the creditworthiness of various countries as the euro crisis spread.
The CDS spreads have increased for countries which have now come in the forefront of the crisis like Italy, Hungary and Spain. They have increased 4-fold in case of Greece and remained at higher levels for the others. This reflects that the crisis is still some way from being resolved. An important outcome of the developments in this area and the solution being worked out is that European banks have to improve their capital ratios and would have to either: raise new equity, use retained profits or shrink the balance sheet. Raising new capital is a challenge given the rising distrust amongst investors continuously.Increasing profits is difficult as the outlook deteriorates as illustrated by the CDS spread.
Therefore, the banks appear to be left with little choice but to shrink their balance sheet. This would lead to lowering credit which will further exacerbate the crisis. Inflationary scenario: Global inflation (CPI) in 2011 so far increased to 4. 2% from 3. 3% seen for the same period in 2010. Inflation in the advanced economies rose sharply from 1.
6% in 2010 till Jul to 2. 6% in 2011. Similarly, inflation in the emerging economies increased to 6. 5% in 2011 from 5.
% in 2010. Since May 2011 with an exception in July 2011 international commodity prices and metal prices in particular are moderating. Compared with Apr 2011 the international metal index showed a decline of 19. 7% with copper declining by 22%, aluminium 18% and zinc 21%. Headline inflation in India (WPI) has been outside the comfort zone of the Indian Central Bank since late 2010.
Therefore, the RBI has been increasing interest rates in order to curtain the rising inflation. RBI has increased interest rates 5 times (175 bps) in the current financial year.The RBI has maintained time and again that the high headline inflation would start to decline from Dec 2011 and would sttle at 7% by the end of the fiscal. Domestic inflation for the month of Oct 2011 stood at 9. 7%, while the international commodity prices where moderating. This implies that the moderation in the international commodity prices has not been translated in to the domestic commodity prices. Exchange Rate Depreciation could worsen the outlook: Since the global uncertainties aggravated, the Indian exchange rate has depreciated 17.
4% against the US Dollar during the current financial year.This has been higher than that observed in other markets like Euro and Pound depreciated by around 5. 3% each against the Dollar during the same period. The depreciating rupee is likely to add further pressure on domestic inflation and India’s import bills. The rupee depreciation will particularly hit the industrial sector and put higher pressure on their costs as items like oil, imported coal, metals and minerals would get affected. However, it is believed that the IT services sector, textile sector and other such export-oriented industries in India are likely to benefit from the depreciating rupee.Conclusion: Assessing the impact of the global activities on India, we can conclude that with the continued uncertainties in the global economy as illustrated by the rising CDS spread, slowdown in economic activities pressure is felt on the FII inflows in India.
The exports and the software services earnings are marginally impacted by the slowdown in the world GDP. On the other hand, export oriented sectors are likely to benefit if the rupee continues to depreciate or remains in the current band. FDI flows have been less volatile to the euro zone crisis.