And the mirror cracks from side to side
#AditJain
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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