Will Europe lead us to recession? Financial Express 2nd June 2010

How serious is the Euro crisis for the rest of the world? The initial concern when the Greece crisis erupted pertained to the financial markets and sovereign credibility. These are still serious issues as there are apprehensions of other countries joining the fray, with Spain now becoming the epicentre of the crisis. But the real concern is, how will growth in the real sector be affected? The EC says that there has been positive growth in this region in the first quarter, thus dispelling the fear of a recession. The IMF has projected a growth of 1% for the year after a negative growth number last year. However, all the bailout packages for these countries, starting with Greece, have a commitment of fiscal tightening. A rollback in spending levels will have an impact on demand.

The PIIGS nations have a share of around 35% (18%, excluding Italy) in total GDP of the euro-currency countries, while the entire region of 16-member countries account for around 20-22% of world GDP. But, considering that all these nations will have to look closely at their fiscal deficits and begin the process of correction, demand will be affected. However, with the euro now beginning to appreciate and there being talk of the parity level being reached with the dollar (the rate being 1.21 currently), these countries would have a distinct advantage in terms of export competitiveness and can hence leverage this depreciation to substitute domestic demand. The accruing advantage in terms of export competitiveness from a weaker euro can turn out to redeem growth prospects. Hence, growth prospects in other nations become critical.

The decoupling theory would provide support to lower growth in the euro region, with China, India, Brazil and Russia taking on the lead role in fostering growth from the emerging economies. China may still register a growth rate of 9-10%, notwithstanding the tightening of monetary policy witnessed in the recent past. The US economy has shown a growth rate of 3% in Q1 2010, which combined with similar trends in the developing countries, promises strong demand during the year. Therefore, the negative impact on global growth could be limited and may, in fact, assist a faster growth process in the euro region through the trade route as consumption increases.

India, in particular, is placed differently. Being a domestic demand-driven economy, the real economy has been generally insulated from global crises, be it the Asian, dot-com or financial crisis of 2007-09. The connection with the world economy is through the trade route and here, exports have been driven more by competitiveness rather than demand as the composition of our exports tends to be relatively inelastic being in the areas of textiles, handicrafts, chemicals, gems & jewellery, etc. The electronics and engineering goods that are being exported in relatively larger numbers are directed more towards the GCC and other Asian regions. The share of the euro area would be around 15% in total exports while exports would be around 13% of India’s GDP. Therefore, the impact of any slowdown in exports to this region would be marginal on the Indian economy as a whole.

The euro crisis, however, will have an impact on the monetary side that can feed into the production processes. To begin with, the flow of funds could get diverted back to the US despite low interest rates as funds move to the more secure Fed treasury bonds. These bonds have become progressively attractive as investors are moving their money to these avenues. Second, with the risk premium on loans rising, raising funds from the euro markets will become more expensive. This is important as there could be a liquidity problem in the face of the 3G auctions funding as well as steady industrial and investment growth with a higher cost being incurred here. Euro markets are a viable option for Indian corporates in the event of liquidity becoming scarce during the year. Third, the exchange rate will continue to be volatile with the rupee being driven by developments in the euro region. Therefore, the importance of economic fundamentals of the economy could get displaced in the process of exchange rate formulation. This could have an impact on exports indirectly. Last, stock markets would continue to be jittery with daily bad or good news having their impact on the indices, which will make raising money in the market a bit tricky.

On the whole it appears that while the euro crisis will create distortions, it will culminate in a neutral manner, with a proclivity towards the positive.