CRISIS IN THE EURO ZONE

LEARNING FOR INDIA

IMPACT OF THE EUROZONE CRISIS ON THE INDIAN ECONOMY

The immediate concern for India is to reduce the current account deficit from its present high level. Oil and gold are the two major items of our imports. With regard to oil, the domestic pricing has increasingly been made market determined. It is expected that this will help economizing the domestic oil consumption. Recently import duty on gold has been raised and bank finance against pledge of gold has been restricted. The efficacy of these measures, however, is yet to be tested. Inflation Indexed Bonds have also been introduced, which should help contain gold demand to the extent these bonds are used as an investment hedge against inflation.

India needs to take a more fundamental lesson from the European debt crisis. The European sovereign debt crisis is not an overnight development. Globalization of finance; string-less credit conditions during the 20022008 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 bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing 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 are pegged at Rs 796,740 crore. This works out to a difference or fiscal deficit of Rs 521,980 crore. Now in 2007-2008, the fiscal deficit stood at Rs 126,912 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 India draw the right lessons from this.

The Euro Crisis has casted its spell on Indias growth sectors. Capital flows into the economy and exports are likely to take a slump. The sudden surge in Foreign Institutional Investor (FII) has left India grappling with high inflation. Adding to the woes the Central Bank has raised the key interest rates.

The quantum of impact of Euro Zone Crisis on Indian markets is yet to be measured. The inchoate European economy has resulted in a slump in domestic industrial growth. Unaddressed agricultural woes, rising interest rates and escalating fuel cost have compounded the global factors. A series of scandals emerging from under the carpet have diluted the faith of foreign investors. The volatility in Indian Markets will persist till the European Crisis is resolved.

There were other very serious impacts of Euro crisis that have compounded and magnified as a challenge to Indian economy. They are as follows: Depreciation of rupee Slow growth in Europe has coaxed the investors to invest in US dollar. This refuge to US dollar has enabled the US dollar to appreciate as compared to other currencies in the world. Dropping exports coupled with rising crude oil prices has created immense pressure on Indian rupee, which in turn has deprecated with respect to US dollar. Slowdown in the manufacturing and services sector Due to the contraction in European and American markets, the demand of goods and services from countries like India and China have slowed down considerably. Inflationary pressure has made the cost of products sky high thereby discouraging the consumers. Market visibility The global financial markets are volatile which in turn have impacted Indian Financial markets too. High rates of inflation have forced Reserve Bank of India (RBI) to raise interest rates. Prices of Gold and Silver have spiraled up, pushing the inflation rate still higher. Cash Hoarding Various Indian firms have cut down on expanding. They are holding their cash and saving it for loan debts as well as shielding them from financial crunches.

HOW WILL THE EURO CRISIS END ?

European leaders, with the exception of the UK, have backed a tax and budget pact aimed at solving the Eurozone debt crisis and preventing the implosion of the single currency. Moving from left to right goes from worse to better outcomes for the survival of the euro. Moving from top to bottom goes from not-so-bad to much worse outcomes for Europe's economy.

The various outcomes possible are as follows: 1. 2. 3. 4. 5. 6. 7. Phoenix from the ashes Union Inflation Depression Unraveling Meltdown Divorce

1. PHOENIX FROM THE ASHES

THE LEAST-BAD OUTCOME, WHERE EVERYTHING GOES TO PLAN This is the scenario that Germany and France are hoping for. All Eurozone governments agree and stick to the strict new borrowing rules. Italy and Spain get bailouts financed by the European Central Bank. Most importantly, confidence returns. Financial markets are willing to lend to Eurozone governments and banks again. In turn, the banks start lending more. Consumers (especially German consumers) start spending again. Businesses start investing again. Europe suffers only a light recession, but then recovers, and slowly but painfully grows its way out of its debt problems.

2. UNION
THE EUROPEAN UNION TURNS INTO A POLITICAL FEDERATION As the financial malaise keeps doggedly returning, so the Eurozone governments call more and more summits and come up with more and more proposals for closer union. Eventually they agree a complete political union - a democratically-elected government in Brussels that can borrow with the backing of all 17 member countries, and can spend money wherever needed - rescuing banks, paying unemployment benefits, financing investment in the more recession-mired countries. The UK and other EU countries not signed up to joining the euro are asked to exit the EU altogether and join a looser free trade area, with much less political influence.

3. INFLATION
THE ECB PRINTS MONEY, PRICES RISE, DEBTS AND SAVINGS WITHER AWAY The euro plummets, making the cost of imported goods much more expensive. A strong recovery in the rest of the world pushes up the price of energy, food and raw materials even more.

Meanwhile, the European Central Bank prints money to pay for one government or bank bailout after another. The ECB tolerates higher inflation - breaking its mandate - as its bankers secretly believe this is the only way to make the Eurozones enormous de bts more repayable. They also want to see wages rise rapidly in Germany, so that workers in struggling southern European countries can regain a competitive edge. But governments continue to spend freely, expecting the ECB to keep lending them newly-printed euros. When a big government breaks the borrowing rules, the rules are simply abandoned. And so the inflation gets out of control.

4. DEPRESSION
THE EUROZONE STAYS TOGETHER, BUT THE PRICE IS YEARS OF ECONOMIC HELL Governments stick to their commitments, and all cut spending at the same time. This causes a deep recession. Consumers and businesses lose confidence in the economic outlook and cut back their own spending, making the recession worse. The European Central Bank cuts rates to zero, but still finds it almost impossible to stimulate the economy. The recession makes it very hard for governments to actually cut their borrowing, because they are spending more on unemployment benefits and earning less in income tax. Companies and mortgage borrowers find it harder to pay their debts, putting the banks in trouble, who cut back their lending even more, undermining the economy further. Eventually borrowers, including governments, have to write off their debts, and many banks and businesses go bust.

5. UNRAVELING
THE WEAKER COUNTRIES DROP OUT ONE-BY-ONE Fearing exit from the euro, ordinary Greeks empty their bank accounts in droves. The European Central Bank insists that Athens freezes people's accounts, or else it will pull the plug on the Greek banks. The Greek government falls, and its replacement decides enough is enough, announces a stop to all debt payments and a unilateral exit from the euro. The newly reintroduced drachma plunges in value. With widespread anger at spending cuts and recession, there are growing calls in other, bigger, southern European countries to follow Greece's example. That sparks bank runs in the other countries, who in course do end up following Greece. At best a rump Eurozone of Germany and France - and possibly Finland, the Netherlands and Austria - is all that remains. There is a risk this could lead to a "meltdown" scenario.

6. MELTDOWN

2008 AGAIN, BUT WITHOUT THE LAST-MINUTE BAILOUTS Financial markets lose confidence that the Eurozones problems are solvable. The Eurozones plan - stricter controls on government borrowing - is not credible. Anyway, government borrowing wasn't the real reason the euro got into trouble. It was all the private-sector borrowing that did the real damage. Workable solutions to the economic problems are not politically acceptable. And politically acceptable solutions make no economic sense. Investors stop lending to all Eurozone banks and governments alike - except perhaps Germany. Banks collapse. Governments run out of money. Stock markets and the euro plummet. And the politicians run out of ideas and time.

7. DIVORCE
THE EUROZONE DECIDES BREAK-UP IS THE ONLY OPTION Any solution that might save the euro proves impossible to agree. Irish voters would block any treaty change put to them in a referendum. Along with the southern Europeans, they want to escape the seemingly endless cycle of spending cuts, tax rises, wage freezes and recession. They are angry at the seeming lack of solidarity from the northern Europeans. Meanwhile, voters in Germany, the Netherlands, Finland and elsewhere are incensed by the spectacle of their tax money being used to rescue southern Europeans from the consequences of what they see as laziness and overspending. Governments eventually agree this cannot continue, and negotiate a controlled break-up of the Eurozone - perhaps a split into northern and southern European currencies. But this will be hard to do without triggering an "unraveling" scenario.

8. WHO KNOWS?
ANYONE WHO SAYS THEMSELVES If anything is certain about this crisis, it is that nothing is certain. A big bank could suddenly fail. A government could fall, or announce a surprise referendum. Governments or central banks could conjure up a plan that might, just might restore calm (as in 2008). The economic data could turn out much better, or much worse, than expected. Public protests could explode - demanding exit from the euro, or demanding a democratically elected government in Brussels. Leaders could resign or be removed. Everything could be overshadowed by a crisis in an entirely different part of the globe (Russia? China? Iran?). THEY KNOW HOW THIS WILL END IS DELUDING