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Euro Crisis - Impact on India

And the mirror cracks from side to side

After months of haggling, many nail-biting moments, two bailouts (for Greece) and 1 trillion in cheap credit by the ECB to prop up European banks, the crisis is back with a vengeance. Greek voters in a recent election voted for a hung parliament. The two main political parties, the New Democracy and Pasok, lost appallingly, garnering between them only 30% of the vote. A fractured result will make it impossible to form a government and Greece may have another election in June. The absence of reform will deter European lenders from extending the bailout. It now seems conceivable that Greece will default and depart from the Eurozone. The financial markets have begun to panic and yields on Spanish bonds are rising. A contagion will be hard to prevent, as the rescue fund does not have ammunition to cover more countries.

But the unfortunate saga only begins here. Another anxiety for the markets is the outcome of the French presidential election. Francois Hollande will assume residence at the Elysee Palace on the mandate of ‘replacing austerity with growth’ and may want to renegotiate fiscal agreements with Germany. Mr Hollande has promised the creation of new jobs and an increase in government spending, but has been unable to explain where the money will come from. In Europe, it appears, things are back to square one. Ultimately, it boils down to the stance Angela Merkel, the German Chancellor, takes. She could validly argue that German taxpayers no longer have an appetite to fund indulgences of their southerly neighbours. Ms Merkel, could on the other hand, relent towards a more accommodative position, allow more time to the Greeks, fund further bailouts and effectively encourage insolence by other countries. Domestic political compulsions are likely to force her to stand firm and tolerate a disorderly exit for Greece from the euro. The problem is, there is neither the time nor a consensus to agree (largely with Mr Hollande) on how the crisis will be contained from spreading, first into other European countries – such as Spain, Portugal, Ireland – and subsequently harming international financial markets and the global economy.

All of this has a grim bearing on India. In the first instance, domestic liquidity will come under pressure. As the crisis progresses, European banks may tighten their balance sheets and hasten the pace of deleveraging. Credit offered to Indian institutions may not be renewed. This would draw liquidity out of Bombay’s money markets towards redemptions on offshore borrowings. An estimated USD 78 billion could be soaked out – impacting both domestic liquidity and exchange rates. The rupee could hastily fall. Second, several institutional investors in the capital markets may make a quick exit. Such is the ritual – when global markets get into trouble – investors flee to the safety of the US dollar. Trade finance will be squeezed and with that, the quantum of global trade. Europe will almost certainly slide into a recession and America’s fragile recovery will take a hard knock. And the effects will not go away in a hurry. Inflation will rise (as exchange rates adjust) and economic growth fall. The government burdened with a fatter fiscal deficit no longer has the ammunition to prop up the economy as it did in 2008 (the deficit is 5.9% of GDP today compared to 2.8% in 2008).

None of this may happen as Ms Merkel and Mr Hollande may come to some understanding on how to manage the situation. But if that fails, the global economy will be far worse shaken than it was four years ago. The failure of a sovereign followed perhaps by another and another, will be a harder knock to stand than the failure of an investment bank.


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