FINANCIAL MARKETS

PRIYANSH MODI 19 ARPIT SHAH 26 KRISHNA BHAVSAR - 29 ZEAL SHAH 31

Why is Euro depreciating against dollar?

What Does a Euro Depreciation Mean for the US?

The euro has been depreciating against the dollar over the past few weeks. The implications of this development for the US depends critically on (1) The extent of the depreciation, (2) The duration, and (3) The source of the depreciation.

Why Is The Euro Dropping?

The Euro is dropping fast right now, dragging other risk assets with it.With so many governments and international agencies involved, leaks are to be expected, and since all that the EU has done is to paper over the problems, it isnt hard to believe that it is about to crumble again. Well, maybe as the banks and sovereigns become fully integrated someone has realized how bad the average European sovereign is.

Maybe the games played by the Italian banks (to get a government guarantee on their own debt that they issued to themselves so they could take it to the ECB to get money to buy Italian government bonds) are being noticed by the rating agencies. Maybe even the market is paying attention to that convoluted trade. As banks and countries become completely intertwined, it is not the sovereign ceiling the markets need to worry about (where a corporation shouldnt trade tighter than the sovereign), but the race to the bottom we need to worry about.

Causes of crisis
1. Confidence in the prospects for growth and stability of the economies of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) surged when the euro was introduced, causing their interest rates to decline to those of Europe's more stable members. 2. Improved confidence and lower interest rates drove up domestic demand in the GIIPS and investors and consumers were emboldened to increase spending and run up debts, often owed abroad as foreign capital flowed in. 3. Growth accelerated and the prices of domestic activities (i.e., those least exposed to international competition, such as housing) rose relative to the price of exportable or importable products, attracting investment into the less productive non-tradable sectors and away from exports and industries competing with imports.

4. Meanwhile, exports rose sharply as a share of GDP in Germany, the Netherlands, and other historically stable countries in the European core. Growing demand in the GIIPS enabled these core countries to increase exports. The adoption of a common currency whose value was based on broader European competitiveness trends that made it lower than the deutschmark or guilder might have been, made their exported goods more affordable. 5. The domestic demand boom in the GIIPS induced rapid wage growth that outpaced productivity, increasing unit labour costs and eroding external competitiveness further. This trend was reinforced by especially rigid labor markets in most of the GIIPS. The emergence of China, as well as currency depreciation and rapid labor productivity growth in the export sectors of the United States and Japan, added to the competitiveness problems of the GIIPS. 6. The single European monetary policy was too loose for the rapidly growing GIIPS (Spain, Greece, and Ireland) and too tight for Germany, whose domestic demand and wages grew very slowly compared to the European average. This reinforced the loss of competitiveness in the GIIPS. 7. Lower borrowing costs and the expansion of domestic demand boosted tax revenues in the GIIPS. Instead of recognizing this as temporary revenue and saving the windfall gains for when growth slowed, GIIPS governments significantly increased spending. Blatant fiscal mismanagement added to the problems in Greece.

8. The financial crisis in 2008 brought an abrupt end to the post-euro growth model in the GIIPS. As they plunged into recession and tax revenues collapsed, government spending was revealed to be unsustainable and their loss of competitiveness dimmed hopes of turning to foreign demand for recovery. The GIIPS are left with high public and private debts and weak long-term growth prospects, unless they make difficult adjustments to cut deficits and restore competitiveness. Trade is the primary channel through which the U.S. economy is hit. The euro zone is the United States' third largest export destination, accounting for 15 percent of total U.S. exports. But the U.S. economy is relatively closed and euro zone exports accounted for only 2.1 percent of total U.S. economic activity in the second quarter, according to the latest available figures from the U.S. Commerce Department.

Global Economy
Euro zone debt problem is likely to remain a concern in the near future. Further, the European banks withdrawing credit in order to shrink their balance sheet would deepen impact of the debt crisis on the other economies. Near zero level interest rates are to continue in the advanced countries in the immediate future. Rising fiscal deficit in US and uncertainties over the economic conditions in most developed countries are adding to the worries.

Impact on India:
Though India is primarily a domestic economy, India's exports are positively linked to the global economic growth.

This is likely to adversely impact India's export growth in the coming months. However, growth will be only marginally affected by the slowdown in the euro region debt stricken countries as our exposure is low. Software services and other export oriented sectors would benefit from the rupee depreciation. FDI has not been significantly affected by the crisis while the FIIs are showing outflow in the last couple of months. International commodity price moderation is not being translated in domestic prices. Further, exchange rate depreciation would worsen the inflationary conditions in the economy. Therefore, the RBI would have to continue with its anti-inflationary stance in the near term if domestic conditions do not improve.

Conclusion:
Assessing the impact of the global activities on India, we can conclude that with the continued uncertainties in the global economy as illustrated by the rising CDS spread, slowdown in economic activities pressure is felt on the FII inflows in India. The exports and the software services earnings are marginally impacted by the slowdown in the world GDP. On the other hand, export oriented sectors are likely to benefit if the rupee continues to depreciate or remains in the current band. FDI flows have been less volatile to the euro zone crisis.

Thank you.