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Grexit – an ill-timed tragedy for Indian economy and markets
Thu, Jun 21, 2012
Source : Sanjay Kumar Singh

The European sovereign debt troubles, of which the Greek crisis is the most severe manifestation, havebeen festering since 2010. Now the situation in Greece appears to be coming to a head. Depending on how a slew of events pan out, Greece could default on its debt obligations as early as in end-June or early-July and then exit the euro zone.

What brought Greece to this pass?

The genesis of the crisis lies in the birth of the euro zone and its structure. At the time of the formation of the zone in 1993, a Stability and Growth Pact was formulated that imposed strict limits on the fiscal and monetary conduct of member nations: inflation had to be maintained below 1.5 per cent, budget deficit below 3 per cent, and debt-to-GDP ratio below 60 per cent. These norms were observed more in the breach: member nations, including the biggest and the most prosperous ones like Germany and France, flouted them with impunity from the beginning.

Once the euro zone was formed, the credit ratings of even the weaker nations (what have come to be known as the PIIGS nations) shot up. Rating agencies felt that since they were now part of a currency union, they could not devalue their currencies (a major risk) to repay their debt. A default was considered highly improbable. Private sector lenders then went overboard in lending to these countries, without taking risks into account.

The peripheral euro zone nations, on their part, absorbed the capital inflows but did not invest them in setting up productive assets which would have enabled them to raise their exports, enjoy sustainably high growth, and repay their debts. In some,the capital was used to fuel a consumption binge while in others it created a real estate boom.

The tide turned with the financial crisis of 2008. The easy flow of capital to these countries dried up, the boom ended, asset values plummeted, and unemployment soared.

Beginning 2010, Greece and subsequently other economies admitted to their sovereign debt troubles. Once the crisis began, the flip side of a currency union came to the fore – chiefly, the loss of an independent monetary policy. In a country like India, when the economy begins to slow down, the central bank cuts rates to stimulate economic growth. This remedy is not available to a country that is part of a currency union. In such a union, the larger economies (Germany and France in this case) dictate interest rates. Since those economies were doing well while the peripheral economies were slowing down, they would not allow interest rates to be lowered for fear of stoking inflation in their own countries.

When India encountered a slowdown after the 2008 crisis, the government undertook large counter-cyclical spending to boost employment. Such fiscal transfers from the central government to the states help fight a slowdown and stimulate growth. But such transfers from stronger to weaker nations can’t happen in Europe because they have only a currency union and not a fiscal union.

When a country’s current account deficit becomes large, its currency comes under pressure (as is happening in India today). That does create problems regarding how to pay for imports. But the positive aspect of currency depreciation is that many of the goods produced by the domestic economy then become competitive in the export market. This helps revive growth. This option too is not available to Greece.

Since the crisis began, Greece has received financial aid from the International Monetary Fund (IMF) and the European Union (EU) to help it repay its debt and avoid a default. In return, IMF and EU (under duress from Germany) have demanded that Greece should adopt a fiscal austerity programme that would reduce its debt in due course. According to Keynesian economists such as Paul Krugman, to advocate austerity during a slowdown is a recipe for disaster. In such times, the government needs to spend on large-scale infrastructure projects in order to create employment and stimulate demand within the economy. Ever since the austerity programmein Greece and other economies began, Krugman has been warning that it would prove disastrous. He has been proved right. These economies have slowed down further (UK, a leading advocate of austerity, is now in recession), unemployment has risen, and social unrest has got worse.

Will Greece exit?

According to recent polls, three-fourth Greeks don’t want to quit the euro zone, but the course of events over the next couple of months could well make itinevitable. 

In the electionsheld recently, the parties that were part of the last coalition – New Democracy and Pasok – and had agreed to the aid-for-austerity deal with IMF and EU could not regain majority. No other group could muster a majority either. So elections have been called again on June 17. Meanwhile, as the political impasse continues, Greeks are withdrawing money from banks, fuelling fears of a run on banks. Citizens are also withholding tax payments, thereby worsening the government’s fiscal plight.

It is feared that after the next elections the Coalition of the Radical Left, called Syriza, could come to power. This party could renege on the previous government’s promises to implement austerity measures. The EU-IMF duo would then have no option but to stop payment of the next tranche of aid due in June. If Greece does not receive aid, it will default on its debt repayment obligations and could then exit the currency union. This could happen as early as in July. Clearly, there is not much time left for salvaging the situation.

If the New Democracy-Pasok combine forms a government, the current impasse could then continue for longer. Greece’s exitmight get postponed to 2013 or 2014 but is unlikely to be averted. The current mix of austerity, slowing economy and growing social unrest is untenable. Greece needs higher growth, employment, and higher government revenues to extricate itself from the debt crisis. The current policy mix offers no panacea on this count.

Will an exit be disastrous for Greece?

Fears have been raised that Greece’s default and exit from the euro zone would prove cataclysmic for its economy. This might well be so. The drachma would suffer a steep devaluation, inflation would skyrocket, banks and corporates might go bankrupt, and unemployment might soar. But only in the short run.

In the long run, the devaluation of the drachma would provide just the incentive that Greece needs for boosting its exports and hence its GDP growth rate. Ithas been argued that Greece is not an export-oriented economyand hence will not benefit from the drachma’s depreciation. This may not hold true. When an incentive such as this becomes available, economies can and do re-orient themselves.The Indian economy raised its exports in the aftermath of its 1991 external debt crisis. Moreover, as Arvind Subramanian of the Peterson Institute for International Economics has pointed out, countries like Korea, Indonesia, Russia, etc. which defaulted on their debt obligations in the nineties suffered recessions that lasted for one or two years, but then saw growth of 5 per cent and higher for sustained periods. Thus, contrary to popular perception there is life after a debt default.

Will Greece’s exit unravel the euro zone?

Greek’s exit could prove calamitous if it results in a contagion that spreads to the other weaker euro zone nations. But if it is perceived as a one-off event, then the turbulence arising from it may only be short-lived.

Once Greece exits, the magnitude of the problem will be driven home starkly. The IMF, EU and ECB will do their best and Germany too will shed its current reluctance (to allow more LTRO programmes, for fear that it will stoke inflation) in the face of imminent danger. The ECB will expand its bond buying programme to prevent yields of bonds of other suspect economies (Spain, Portugal and Italy) from soaring. Banks that have suffered steep losses due to their exposure to Greek debt will have to be recapitalised. Thus, swift and timely action could, after an initial upheaval, prevent the contagion from spreading.  

Realisation has now dawned within Europe that the austerity policies of the past are not working. Francois Hollande, the newly-elected President of France, is pushing for spending to stimulate growth. Such policies too should have a positive impact.

Will Indian economy and markets suffer severely?

The Indian economy has slowed down because of a number of factors. Fiscal deficit has ballooned because the UPA I and II governments expanded social spending programmesvastly. The government had thought that growth would continue to be robust and would provide the revenue flow required to fund these programmes. That hope has been belied.

A slowing economy and the policy paralysis of recent times have resulted in private investment -- so essential for reviving growth -- slowing down.

The current account deficit has widened due to slowing exports and inelastic imports (especially of crude that has been on the boil). With faith in the Indian economy evaporating, the foreign capital flows that India needs to fund its current account gap have slowed down. The rupee has depreciated because of the paucity of dollar flows.A weak currency will result in imported inflation. Thus India is caught in that lethalsituation referred to as stagflation: slowing growth and high inflation.

In this fragile situation, an external shock to the economy could prove very negative.Greek’s exit will definitely create a risk-off environment that could cause more capital outflows. The rupee will depreciate further and the stock markets may touch new lows.

The Indian economy has substantial exposure to Europe in the form of loans. Data available for the end of September 2012 shows that European banks then had total loans outstanding against India of $146.6 billion (much larger than the $68 billion loans owed to US banks). The private sector’s borrowings from European banks amounted to $97.7 billion; the public sector’s debt amounted to $12.8 billion, and that of banks amounted to $35.4 billion. Not all of the European borrowings are at risk. Of the $146.6 billion loans, $81.8 billion were from UK and $22 billion from Germany, which are safe economies. But in a liquidity-starved environment, it is difficult to predict which institutions will get into trouble and demand their money back.

When the last crisis (2008) had occurred, there was coordinated policy action from central banks and governments around the globe. Rate cuts, liquidity infusion, tax relief and expenditure programmes had helped stem the crisis. But weakened by the last crisis, both governments and central banks around the world have less ammunition for dealing with a new one. The promptness and magnitude of their response will determine how severe a blow the Greek crisis deals to our already-tottering economy and markets.  

sanjay.singh@citrusadvisors.com
 
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