Even as the recently announced bailout package by an EU?IMF combine has managed to provide some comfort to markets and investors, there is a continuing sense of unease about how, where and when the next set of troubles might erupt. A combination of high interconnectedness of debt holdings within the entire Eurozone and high levels of sovereign debt has heightened risk perceptions and eroded investor confidence in these papers.
Some potential consequences for India begin to follow immediately. The fiscal haircuts that are the key components of the bailout conditionalities will weaken the impact of the impulses that government spending programmes. This will further shift the onus of global recovery on to monetary policy authorities, forcing them to maintain low rates and high liquidity levels for periods much longer than markets had started anticipating even as recently as a month ago.
All of this raises questions of the effects, not just of contagion risk arising from the financial market volatilities, but of other macroeconomic fundamentals spreading to other Asian economies, particularly India. The bottom line? Overall, the developments in Europe are likely to be more beneficial than adverse to India, with moderate increases in commodity prices more than offsetting the policy headaches created by high capital inflows.
Bank of International Settlements data show that Europe has a very significant share of the external bank loans flowing to emerging Asia, accounting for over two-thirds of the $ 1.6 trillion of outstanding claims as at end December 2009. In addition, both the outstanding debt and shares of European banks have risen in 2009. The good thing about this is that Asian countries are the borrowers and consequently not exposed to credit risk of defaults that they would be had they been lenders. However, they are quite exposed to liquidity risk, ie, the risk of funds flows drying up just as they had in the aftermath of the Lehman collapse. In other words, if European banks start taking a hit following potential defaults by the affected sovereigns, they might cut credit lines in a bid to preserve liquidity and to bolster capital. The effects on trade credit might be particularly adverse, similar to the sharp squeeze observed in late 2008.
This brings us to the specific effects of the European turmoil on India. India is not likely to be greatly impacted, at least on first order effects, via exports, of an economic slowdown in the affected European markets. India’s exports to the so-called PIGS group of countries is as low as around 4%of total exports. Neither are capital pools likely to be seriously affected; the PIGS countries account for just over 1% of India?s FDI flows.
On the contrary, a subdued economic recovery in Europe is likely to confer significant advantages on India, particularly if it happens in tandem with a policy induced cooling off in China. For one, a strengthening Dollar following diminishing risk appetites and the consequent movement of investor funds to US Treasury safe havens, is likely to slow the US economy down, with US exports losing their currency competitiveness. This will have a continuing moderating effect on prices of crude and other industrial and metals prices. In an environment where India is likely to suffer rising structural inflation in food prices, sharply rising prices of these commodities are likely to create large problems for policy authorities trying to contain inflationary expectations.
There are always jokers in all economic packs. Here, it is excessive capital inflows into emerging markets. Although excessive volatility and risk aversion are likely to drive capital into US treasuries and safe haven assets like gold, moderate risk might result in investors seeking higher returns in emerging markets. The policy interventions and bailouts in Europe are likely to help the troubled countries gradually stabilise. With liquidity infusions by global central banks remaining high, and yields in developed markets low, the likelihood is that emerging markets will receive large portfolio attention; the fastest growing of these more so. The impact on the Rupee will diminish India?s export competitiveness, likely forcing the RBI to intervene in the forex markets, with probable follow-up sterilisation operations, thereby incurring fiscal and other transactions costs.
?The author is senior vice-president, business and economic research, Axis Bank. The views expressed are personal