There have been so many red herrings in the past that we are a little squeamish about passing judgement too soon on Friday’s supposedly path-breaking European Union (EU) summit. What we can certainly say is that there were no obvious disappointments. The UK refused to play ball, but then the Brits have a long history of Euro-scepticism. Besides, markets weren’t quite expecting a sudden change of heart.
What has the summit delivered? Quite a bit if one cares to list the proposals. The big bazooka announcement was the establishment of a “fiscal compact” that will enforce fiscal discipline among member nations. Besides, EU countries will, through their national central banks, provide an additional funding of ¤200 billion to the International Monetary Fund to provide emergency funding to stressed economies. The establishment of the European Stability Mechanism with a corpus of ¤500 billion has been brought forward to June, 2012. This will run alongside the temporary ¤440-billion European Financial Stability Facility (EFSF). Banks can breathe easy — private sector participation (techno-speak for the losses that they need to bear in the bailouts), as in the Greek case, will be treated as exceptional cases.
This could lead to the “sequenced path” towards recovery that EU policy wonks like to talk about. As a Goldman Sachs reaction report puts it, “This will gradually lead the ECB [European Central Bank] towards more proactive purchases on a larger scale (after national governments commit to additional fiscal adjustment, and future rules for the ‘fiscal compact’ are agreed on).” In short, the central bank could unleash its own avatar of quantitative easing, buying back sovereign bonds to ensure that yields do not explode to levels that would make it impossible for some member nations to finance their deficit, especially Italy.
It doesn’t take rocket science to figure out that there will be a rally in financial markets in the near term. But after the thrill is gone, there are a number of things about which one could fret. For one thing, the proposals are still tentative and need to be signed and ratified by March, 2012. Hence, implementation risks are likely to remain in place. It is not difficult to conceive of a situation in which other EU members take a cue from the UK and decide to drop out. Besides, the ECB has in the recent past been, at best, half-hearted about a large bond buyback measure, and its reticence has had Germany’s support. Unless the central bank agrees to come on board, it will be difficult to make progress down the “sequenced path” of recovery. Some “critical” details, such as a comprehensive plan to “leverage” the EFSF perhaps by borrowing from sovereign wealth funds, seem to have been left out. The amount allocated for emergency funding to the IMF also seems to be a little paltry.
However, the fundamental problem remains the philosophy of austerity that underpins the entire strategy. Europe is already in recession and the effort to willy-nilly get deficits and debt-ratios down could just exacerbate the problem. The joint-statement released on Friday evening threatens “steps and sanctions” against member states if they run excess deficits. (The details about how these will be enforced are, incidentally, left fuzzy.) There is no discussion of how they will dig themselves out of their economic holes, raise revenues and comply with norms. Economic history has shown that fiscal compression can be dangerous in times of an economic downturn. For a region that faces the prospect of clocking a growth rate of 0.5 per cent in the best case and is saddled with an overvalued currency, an inflexible fiscal compact might just make matters worse both for economic growth and the debt burdens of the peripheral economies. An RBS analyst puts things rather succinctly: “The Summit has not delivered a solution to the debt crisis even if there is progress to remove sovereignty in budget matters. This problem here is that budgets are not the problem — the macro imbalances are much wider and a policy of austerity will cripple growth for many countries without major stimulus offsets from the rest of Europe.”
Tailpiece: The rupee stabilised last week on the back of an oversubscribed foreign institutional debt auction of around $10 billion conducted by the Securities and Exchange Board of India. The fact that six central banks introduced low-cost dollar swap-lines to pre-empt a “Lehman moment” for dollar-starved European banks also hurt. However, there are concerns. Though the debt flow has yet to physically come in, currency markets tend to price this well in advance. The fact that, despite this hefty anticipated flow, the rupee remained close to 52 to the dollar suggests that the underlying sentiment on the rupee remains bearish.
This bearishness, clearly visible in the stock markets, where investors are losing nary a chance to dump local stocks, will continue to weigh on the rupee. Thus, even if global financial conditions improve, the growing despair about the domestic economy and policy-making could keep the rupee offered. Two scenarios are possible. One, if the international environment again takes a turn for the worse, the rupee could under-perform its peers. Two, if there is a sustained improvement in global markets, the crosswinds of positive global factors and domestic gloom could keep the rupee in a range. A sharp reversal seems unlikely.
The authors are with HDFC Bank. These views are personal
