Lead Essay Reprinted from The Calibre | Edition August 23, 2011 www.thecalibre.

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The Eurozone Crisis and Impact on India

The Eurozone experiment of different countries coming together to form a common Monetary Union is under a grave threat of disintegrating in the face of severe debt crisis facing several member countries. The welfare-oriented states in Europe have run up huge deficits that are fast becoming unsustainable. In the absence of readily visible solutions to the crisis, management of the issue is going to test European leadership to the limit. India would also not be unaffected from the global contagion that a European crisis might unleash.
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The

Eurozone is an Economic and Monetary Union comprised of seventeen member states of the European Union. Members of the Eurozone have adopted the Euro () as their common currency and the monetary policy of the Eurozone is laid out by the European Central Bank (ECB). Fiscal Policy, however, is the domain of individual member countries.

enough growth to even finance this debt. In addition, due to a common monetary union, woes of countries such as Greece, Ireland, Spain etc are now being transferred to fiscally stronger countries such as Germany, thus impacting the economies of these countries as well. The Euro as a common currency of countries with disparate political and fiscal policies has meant the crisis has spread across the Eurozone. If each of these countries would have had a separate currency and monetary policy, the crisis would have been localised instead of having spread across the Eurozone. Europe represents about one-fifth of the world economy and a crisis there is hence going to have a severe impact on overall global economy. Till the time the debt crisis was confined to a few small countries, they could be rescued by other European countries who gave loans to substitute for the credit denied by private lending markets. For example, Greece, Ireland and Portugal were all given loans by the ECB. However, whereas these countries could be extended some support in 2010, larger countries are now facing a crisis, making it difficult to come out with bailout packages. With Spain, Italy and possibly France now under financial assault, the situation changes dramatically. There are more debtor nations and more debt at risk. In 2010, Italy's debt was 1.8 trillion euros; Spain's 639 billion euros; and France's 1.6 trillion euros. With slowing GDP growth, large welfare budgets and popular opposition to measures towards curbing entitlements, the situation is Europe is extremely difficult. At present, Germany is the only large Eurozone country with

The Eurozone [image courtesy Wikipedia]

The Sovereign Debt Crisis in Eurozone

The crisis now sweeping Eurozone arises from the basic fact that many countries have accumulated too much debt and do not have high-

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a sound economy, and it cannot be expected to bail out all of Eurozone on its own. Efforts at confronting the crisis have also been adhoc and short-sighted. Rather than trying to address the fundamental issues that gave rise to such a widespread crisis, leaders have so far tried to muddle through decisions such as devising rescue packages for Greece et al; However, while these steps were partially successful with the smaller economies, there is no hope of similar measures for the larger economies that now face trouble. First of all, there is not enough money to bail out these countries, and secondly, in the absence of fundamental changes to the economy and drastic restructuring of the welfare-oriented European state model, there is little hope of avoiding a full-blown default, particularly in the face of poor GDP growth across the Eurozone.

governments), tax increases etc., that is a standard practice to deal with high public debt, may work for individual countries or even a few countries at a time. But if most of Europe embraces austerity, it would lead to slowdown of economic growth and possible recession. Lower economic growth translates into lower tax revenues which in turn makes it harder for countries to service their debts. This leads to further worsening of the financial crisis, creating a vicious circle. Countries find it difficult to raise further debt, and have to pay higher interest, again worsening the debt situation. This is the precisely the situation Europe faces at present. Rates on sovereign bonds of the crisisridden countries are steadily increasing with stagnant and even decreasing growth. Under the vaunted "European model" European citizens have become accustomed to one of the most generous welfare packages in the world, one that is now threatening the very vitals of European economy. However, as recent events in France, Greece and other European countries show, there is widespread public opposition to any attempt at cutting the welfare entitlements. This makes crisis management even more difficult. With a common currency and monetary policy, the weaker countries have been trying to shift costs to others, and this is straining the very idea of Eurozone to the limits, with many sceptics now calling for an end to the Euro experiment.

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Possible solutions to the crisis

A number of suggestions have been put forth to tackle the crisis. We examine these briefly. 1. Common European bond: Creation of a common Euro bond that would allow the weaker countries to share Germany's credit rating and hence borrow at lower rates. However, for this, Germany would have to guarantee other countries' debts. This is highly unlikely. ECB buys bonds of weak countries: It has been proposed that the ECB buys bonds of the heavily indebted Eurozone members. The ECB has earlier bought Greek, Irish and Portuguese bonds and is now buying Italian and Spanish bonds. But this is not a bottomless pit and purchases would have to stop at some point. The ECB can

2. 2010 GDP growth rates across the Eurozone [image courtesy BBC]

In addition, adoption of austerity measures through steps such as spending cuts (by

Lead Essay Reprinted from The Calibre | Edition August 23, 2011 www.thecalibre.in

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theoretically keep on printing new currency and buy bonds, but this would lead to an inflationary flood of money, creating another crisis. IMF rescue: Another suggestion is for the International Monetary Fund to organize a global rescue package worth trillions of euros. Europe's debtor nations could borrow at low rates with long maturities. Once debt pressures were relieved, Europe could follow more pro-growth economic policies. However, such a large package would need financing from countries with huge foreign exchange reserves the oil producing countries and/or China (which has reserves of $3.2 trillion). Whether China would bailout Europe remains to be seen, and entails complicated issues of geopolitics other than finance. Partial write-off of debts or outright default: It has also been suggested that some European nations could negotiate write-downs on their debts or default on them. Superficially, this seems a solution. But it would create other problems. Defaults would inflict huge losses on banks, insurance companies and pensions. Many European banks might collapse unless rescued. Who would rescue them? Confidence would plunge. A recession would seem unavoidable. Defaulting countries would also have trouble borrowing in the future.

would naturally have a negative impact on foreign trade and lead to loss of revenue as well as jobs in export-oriented industries. The impact of a slowdown would be much more severe in the service sector (particularly BPO and software) where trade is skewed in Indias favour.
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In addition, if the European contagion spreads and leads to a global slowdown, this would impact Indias trade with other countries as well, and thus hit the domestic economy directly as well as indirectly. Lower incomes, jobloss etc. would also translate into lower domestic demand, thus leading to slower growth even in the sectors dependent on domestic demand. Secondly, the impact of the crisis would be felt in the financial market. The first portends of this may already be visible, with the Indian markets declining by nearly 4% this last week alone. In addition to decline in security markets, one can expect to see a rise in gold prices (gold being the globally-preferred safe asset, its prices show a sharp spike during any crisis), fall in commodity prices (due to lower demand), and depreciation in currency (due to flight of capital). Another way in which India could be impacted is through a slowdown in remittances and NRI deposits. In the wake of a crisis, remittances from abroad could slow down and a significant number of expatriates might even lose jobs and move back to India, thus straining the local economy. Finally, a slowdown would impact global investor confidence and rather than taking even moderate risk, individuals and corporations might prefer to put their money in safe avenues such as gold and government bonds, thus leading to slowdown in capital investment. As a developing country, such a slowdown would adversely affect India which is in severe need of capital for long term growth. This would be another possible negative impact of the crisis. In addition to the possibilities outlined above, the Indian economy could be affected in thousands of other ways, as it is practically impossible to identify all the interlinkages between India and the global economy in this day and age of increasing integration. Another school of thought says that a slowdown in Europe and the US could benefit emerging economies such as India due to fall in commodity

As we have seen, there are no easy solutions to the crisis confronting Eurozone. However, the urgency for solid steps to confront the issue is also increasing by the day, as otherwise, not only could the situation in effected countries worsen, it could also spread to other countries, and lead to a full-blown global economic crisis. It remains to be seen what action the European leadership finally takes to tackle this situation.

Potential impact on India

The Eurozone crisis could impact India in a number of ways. We now examine some potential scenarios. First of all, the EU (excluding UK) accounts for roughly 30% of the countrys merchandise foreign trade (export and import). A slowdown in Europe

Lead Essay Reprinted from The Calibre | Edition August 23, 2011 www.thecalibre.in

prices and flow of capital from those countries to countries such as India. However, in the absence of policy initiatives to kickstart economic growth and overall climate of crisis of governance, it is difficult to see this coming to fruition. Some bold steps on the reform side might induce flow of capital, but that, at the moment, seems like a distant dream. In addition, past experience also shows that while India may not have fared as

badly as parts of the world in time of a slowdown, growth was negatively, and not positively affected by these developments.

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