The Greek Prime Minister on his visit to India in 2008 had commented that he expected the volume of Indo-Greece trade to double by 2010. He further mentioned that the Greek economy was open, dynamic and competitive. The absolute numbers seem to lend support to the Greek PM’s claim. FDI had reached $5.3 billion in 2006, from $607 million in 2005 and $2.1 billion in 2004. This spectacular rise in FDI did not sound ominous but natural at that time and not many questioned the level of fluctuation.
However, it is interesting to see how things stand in 2010. The Greek government posted a budget deficit of 32 billion euros or 13.6 per cent of gross domestic product in 2009, not the 12.7 per cent it had reported earlier. This led to concerns on the quality of data Greece uses for accounting.
On 23 April, the Greek government requested a bailout package (made of relatively high-interest loans) be activated. Consequent to this, Greek debt rating was reduced to BB+ (a 'junk' status) by Standard & Poor's amidst fears of default by the Greek government. The yield of the two-year Greek bond reached 15.3 per cent in the secondary market.
As we see, the European Central Bank (ECB) and International Monetary Fund (IMF) have convinced Germany to expedite a bailout for the debt-stricken country. Repercussions have been felt across the Eurozone. Greece bond status has been downgraded by S&P to junk. Both Portugal, Spain and more recently Hungary are also facing liquidity issues. The German Chancellor had even suggested that the initial decision for Greece to join the Eurozone may have been erroneous. All this uncertainty does not bear well for the European Union (EU).
The Greek economy had traditionally been stable. In the past, there has been a certain degree of attractiveness in Greece as an investment destination. The country has a robust legal and tax framework offering incentives, such as subsidies or grant exemptions for attracting foreign investors. More importantly, it was a part of the EU and therefore considered a safe market. This crisis brings to the forefront thoughts on how fragile the economy really was.
As we are seeing, the effects of this crisis have been felt throughout Europe. The financial health of weaker regimes within the EU is being questioned now. Investors worry that a $144 billion aid package for Greece won't be adequate to keep debt problems in Europe from spreading.
It is important to gauge the effect of this crisis on India. Various commentators have referred to this issue. Finance secretary Ashok Chawla recently stated that he expected the crisis to have a minimal impact on India, while one of the deputy governors at Reserve Bank of India Subir Gokarn said, there may not be any impact in the long term.
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It is important to study this a bit closely with a focus on three aspects, mainly the internal markets, external trade and the currency effect.
Markets
If one looks at market sentiments, the euro insecurity managed to wreck havoc on global markets, including India, and the euro instability has become a larger issue than expected. Particular areas of worry are not countries such as France or Germany, but the mid-tier euro regimes such as Portugal, Spain, Ireland and Italy. For example, exposure by European banks to Spanish debt (at approximately $800 billion) is considerably higher than their $200 billion exposure in Greece.
It is important to note that these countries had already faced a crisis a few years back during the global financial meltdown. Without having recovered fully, this is the second crisis within a span of two years. The EU members have amassed large deficits in the last recession itself. With high public debt and stagnant growth, pressure is now on the euro as a stable currency in itself.
If the Eurozone is adversely affected, global economic growth would take a hit resulting in deflationary pressures, eroding wealth and falling prices. With stock markets at a crisis due to the combined debt and currency effect, there is a worry that the crisis will spill over to India. Traditionally, India has prided itself on the fundamentals of its domestic economy. During the global financial meltdown, the Indian government intervened through short term corrections in the money market. Such intervention and control helped contain the effects of a much larger crisis.
India has recently been riding on positive domestic data with the Sensex and the Nifty recovering from the earlier crisis. Fiscal deficit has been met with domestic borrowings and stated controls on government spending reducing exposure to the global markets. However, it should be noted that no market is fortified enough to overlook international pressures. Global credit ratings agency Standard & Poor's has commented that a prolonged and widespread debt crisis in Europe could have a substantial negative impact on the Indian economy.
This concern for India is not due to the economics of trade, but mainly global market sentiments. Weak global markets lead to drying up of foreign capital. Despite eurozone countries and the International Monetary Fund (IMF) pledging a 110 billion euro bailout package for Greece, world markets are still worried about the viability of the proposed rescue effort and there has been a recent flight of investors’ wealth into the dollar as a repository for tiding over the current wave of uncertainty.
Market sentiments affect India in two ways. In the short run, the impact is likely to be direct. If the debt crisis spreads to other nations in Europe and their banking systems, a possibility is that European entities could start withdrawing funds from Indian stock markets. This will negatively impact the Indian stock market and lead to lower reserves as well as depreciation of the Indian rupee denting the growth prospects in the export sector. This situation may take some time to correct.
Then again, the long run outlook remains positive. From an investment destination perspective, if the Eurozone becomes unattractive given debt servicing and currency concerns, India stands to gain. Investors may shift their attention to emerging markets such as India and China. While this has already happened over the past two decades, with a weakening Eurozone, the choice for investors would have narrowed. The focus may move to products such as commodities, an area which is still untapped in India. Secondly, bond markets in India remain more attractive than their European counterpart. India, of course, needs to do its part in relaxing external commercial borrowing norms and implementing a robust monitoring mechanism. However, exchange control and rigid taxes (eg withholding on interest payments) remain an area of concern.
While investors exit stocks in Europe, India may just look logically as the next favourable destination. It is however on India to take advantage of this.
Trade
It is expected that the effect on trade will be lesser than that on the markets. During the global financial crisis, world trade grew by only 2.8 per cent in 2008 compared to 7.3 per cent in 2007, with trade growth falling from September 2008 onwards. The crisis seems to have been largely contained in the second half of 2009 and beginning of 2010 with global trade recovering marginally and the IMF projecting a better-than-expected growth in world trade volume of 5.8 per cent and 6.3 per cent for 2010 and 2011 respectively. The compound annual growth rate (CAGR) for India’s merchandise exports for the five-year period from 2004-05 to 2008-09 increased to 23.8 per cent from the 14.0 per cent of the preceding five-year period. This was before the Greek crisis.
As a result of the deepening global financial crisis in 2008, India’s export growth rate started plummeting from the high 40 per cent to 63 per cent range witnessed during April to August 2008 to 26.1 per cent in September, turning negative from October 2008 to October 2009 with a low 4.2 per cent. As per the Economic Survey 2010, this type of situation has not been witnessed in the last 24 years. Therefore, the effect of trade cannot be wholly ignored but needs to be managed appropriately.
The question one needs ask is whether Greece matters from a trading perspective. Greece is not one of the larger trading partners of India. Only 0.05 per cent of India's exports go to Greece and Indian banks have virtually no direct exposure to Greece. Therefore purely from a trade perspective, the direct effect is expected to be minimal. Subsequent concerns of the crisis spreading to Spain and Portugal may result in larger ramifications for India. Importantly, the focus should be India’s trade with the Eurozone region. One of the largest trading partners of India is Germany which incidentally is also one of the rescuers for Greece in this crisis. If Germany suffers, the effect on India is going to be harsher. Couple this with the fact that of the top ten trading partners for India, at least three are directly from the Eurozone. Any long term economic downturn or instability in Europe is bound to affect India’s trade position.
It may be expected that if Europe does not recover, the macro-economic impact could have a more severe effect on the Indian economy than the financial impact.
Currency
The short term effects of the Greek crisis are primarily being felt through currency fluctuations. Interestingly, the Greek crisis is not just restricted to Greece but to the currency value of the Eurozone. Most of the European continent is linked to the fortunes of one single currency through multiple markets. This, perhaps, is the most important implication of this crisis.
While markets and trade effects are already being felt, the accounting effect should not be ignored. The fair value of tangible assets, securities, intellectual property is linked with the euro. Cash flows of banks and companies have been impacted. For example the Indian rupee has appreciated from Rs 70 to Rs 56 vis-a-vis the euro in just a few months. In addition to trade-based earnings, mark-to-market losses can have important ramifications. The impact of this variation on the fair value of securities and inventories can be substantial. Banks, for example, are affected on mark-to-market losses on the sovereign assets they own. Credit losses can lead to drying up of bank funding raising solvency and liquidity concerns.
Overall, the complete effect of the crisis is yet to be felt. While one can be content with the defence that Indian fundamentals are strong, it will be wise not to ignore some of the ominous warnings. Indeed if the government reacts to this crisis similar to how it had two years earlier, it will help negate the plausible adverse impact on the Indian economy substantially.
(The author is a director with Deloitte)