Treaty of Westphalia ended attempts to impose a supranational authority on Europe. Merkel lost elections here last week
The current spell of currency volatility across several emerging market economies is clearly on account of the manner in which politics is unfolding in the euro area. It is not about Greece any more. Politics in core euro nations like Germany and France is showing all signs of unravelling in a manner that could undo the European Union experiment.
There is a special historical significance to the German Chancellor Angela Merkel?s party, Christian Democrats, losing elections this week in Germany?s most populous state of North Rhine Westphalia. The famous Peace Treaty of Westphalia was signed here in 1648 in which major European countries agreed to respect the principle of sovereign existence of each state with territorial integrity. The ?Westphalian doctrine? of states as independent agents had laid the foundation for the rise of the idea of nationalism in the 19th century Europe. The ?Peace of Westphalia? had effectively ended attempts to impose supranational authority on European states.
In a somewhat interesting repeat of history, many European nations, reeling under heavy austerity programmes imposed by the EU authorities, are reasserting their economic sovereignty. The rise of the ultra-nationalist right in Greece is a classic sign. Merkel has been resisting tremendous pressure from German voters who may eventually prefer to withdraw from the eurozone rather than endlessly bail out other economically-distressed states. Merkel has been championing the cause of keeping the EU experiment going and, in fact, strengthening it further. Does the defeat of Merkel in Westphalia at the hands of Social Democrats mark the revival of the old Westphalian thought process? The rise of Socialists in France who say they will have nothing of the big austerity measures imposed by the EU is also worrisome.
All these developments do not bode well for the world economy which is already reeling from a double-dip deceleration in growth. The further bad news from the eurozone is the prospect of Germany?the engine of EU?slipping into a mild recession. Growth in Germany is already close to zero. Nouriel Roubini, the economist who had clearly predicted the 2008 global markets meltdown, is now saying with certainty that Greece will exit the euro currency arrangement within a year. There could be some other not-so-peripheral economies in the eurozone who may have to leave the common currency in the event they officially choose to inflate their way out of the sovereign debt crises by letting their respective currencies depreciate dramatically.
The fresh uncertainty, triggered by the rise of ultra-nationalist right and assorted socialists who do not support any significant cut back in welfare programmes, will continue to spook the markets for some time to come. This week the stock markets and currencies across emerging markets fell in response to the developments in Europe.
For India, the next 12 months are likely to feel more vulnerable than the previous year. There would be more speculative attacks on the rupee as seen in the past two weeks. RBI appears to be defending the rupee in a half-hearted manner at a level of about R54 to a dollar. Dr C Rangarajan, who is the Prime Minister?s closest advisor today, declared that the rupee should be defended to the extent its value does not get distorted by ?temporary ebbs in capital flows?. Dr Rangarajan is perfectly rational in what he is saying but what happens if temporary ebbs in flows actually take on a semi-permanent character. What if there is a new normal in the deceleration of various forms of capital flows from abroad, especially Europe.
At a current account deficit of close to 4% of GDP, India needs about $75 billion to fill this gap. Are conditions conducive enough for India to receive FDI, FII, ECB and NRI flows of that order? What is the new normal for capital flows from the euro region? These are questions that cannot be easily answered.
RBI estimates that Indian corporates and banks have about $60 billion debt exposure to European banks. Psychologically, that appears manageable, given the current level of forex reserves. But then the reserves are also not growing for the last year and a half. Dr Rangarajan?s thumb rule is during normal times we must add about $20 billion every year to the RBI reserves after meeting the current account gap. But the situation in 2011-12 and possibly in 2012-13 will be very different where a lot of reserves will be used up to fill the negative balance of payments gap as also in defending the rupee which may come under constant attack.
This is not a 1991-like situation. But surely, history does not repeat itself in an identical fashion. In 1991, India was a small economy, with less than $300 billion GDP, and not among the rising economic stories. In 2012, India is a $2 trillion economy with a place on the high table of leading world economies. Expectations of India are also commensurately high. So, in 2012, India need not go back to a 1991-type situation with not enough forex reserves to pay for even three weeks? imports. This time around it will be bad enough if our reserves drop below $200 billion over the next one year, in trying to defend the currency and paying for other urgent foreign capital requirements. That will be the new 1991! Policymakers who think Indian fundamentals are still great must wake up now.
It is possible that the exchange rate hurtling towards R57 to R59 to a dollar will eventually unite our fragmented political class to take some urgent decisions on easing inward foreign capital flows in restricted areas. Sending a strong signal is most crucial at this stage. The government should also consider imposing some more barriers to gold imports. In 2011-12, the growth in gold imports itself amounted to about 2% of GDP. If policymakers anticipate that capital flows are going to decelerate dramatically then allowing free gold imports is tantamount to wasting precious dollars. Besides this, India must be ready with a comprehensive contingency plan to defend itself against a precipitous worsening of the euro situation.
mk.venu@expressindia.com
