Apocalypse Now?

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The Eurozone has held global markets to ransom for several months now. The trouble began with some of the peripheral economies, but is now increasingly becoming a contagion that threatens the political and economic stability of Europe.

Gross domestic product (GDP) will contract 4.7 per cent this year in Greece and 3.3 per cent in Portugal, according to an International Monetary Fund estimate. There is 24 per cent unemployment in Spain, 22 per cent in Greece and 15 per cent in Portugal. Public debt already exceeds 100 per cent of GDP in Greece, Ireland, Italy and Portugal. These countries, along with Spain, are now effectively shut out of the bond market.

As for banks in the peripheral economies, traditional sources of bank financing have had to be substituted by financing with external commercial bonds, while money held by high net worth individuals has slowly been exiting. And if Greece were to exit the Eurozone, a deposit freeze would occur and euro deposits in Greece would be deemed much riskier than in other Eurozone countries.

More worryingly, there was a surge of withdrawals from some Spanish banks last month.

The credit crunch in the Eurozone banks on the periphery remains severe. Unable to achieve the new nine per cent capital target by raising private capital, banks are selling their assets and contracting credit, thus making the Eurozone recession more severe.

Spain’s borrowing costs reached around seven per cent this week, the highest ever since the birth of the euro. Spain’s financial woes were compounded after Moody’s downgraded its debt rating to near‘junk’ status. Italy, widely considered the next victim of the crisis, has its yields trade well above six per cent.

So what are the solutions? There are no easy ones. Key steps would include bank re-capitalisation, European deposit insurance and debt mutualisation – which involves euro bonds being issued guaranteed by all European Union member-states. This would set a ‘risk-free’ interest rate and bail out weaker economies.

Germany, one of the few European economies that remain robust, is not convinced. Chancellor Angela Merkel has repeatedly warned against overburdening the German economy in efforts to save the Eurozone. In a speech to the German Parliament recently, Merkel reiterated her refusal to back calls for common Eurozone bonds and a Europewide deposit guarantee scheme for banks. While most analysts believe Germany will eventually come around, for now the German Chancellor seems convinced that Germany does not have infinite resources to keep underwriting the obligations of one troubled European country after another. Instead it seeks negotiations towards a ‘fiscal union’ that would bind the members’ budgets closer together.

What next? Rating agency Standard & Poor’s has said the Eurozone has entered “a crucial phase” in which the outcome of Greece’s elections on June 17 and upcoming policymaker meetings “will play a significant role in defining its future direction”.

While the global mood is very cautious, Greek stock markets gained 10 per cent on unconfirmed rumours that pro-bailout parties were gaining ground and that the EU was now more prepared to renegotiate the recent rescue deal.

On balance, while Germany insists that austerity is the only way to go, there is a case for not front-loading too much austerity, lest it lead to much slower growth. Any major growth slowdown will hurt Germany too – it sells almost 45 per cent of its total exports to other countries in Europe. Urgent structural reforms are needed to jump-start growth. Without growth, the social and political fallout of austerity will be terrible. Lastly, monetary policy in Europe needs to loosen more and the euro needs more weakening against the dollar. These steps are needed to keep the current situation from leading to a full-fledged banking crisis that could even disintegrate the EU.

Apart from the Greek vote, investors have to be prepared for a number of other generally negative catalysts. Recent data from the US has been mixed and the market is keenly awaiting next week’s Federal Reserve monetary policy decision. Consistently worsening economic data is actually driving up market expectation for more monetary easing, driving prices of precious metals and high yielding currencies up in the bargain.

So how will all of this impact India? Badly, to say the least. India has had a double whammy of poor overseas investment interest as a result of weak global economic outlook, and serious domestic issues spanning poor governance, lower investment demand and sharply slowing GDP. Growth hit 5.3 per cent in last quarter of the last fiscal year, inflation remains sticky at 7.5 per cent and the Indian cur- rency is 26 per cent weaker in a year, the steepest fall ever. While there is a silver lining in the 20 per cent fall in crude prices recently, it is too early to cheer. A lot depends on the shape the Eurozone crisis takes from here, and more importantly, how the government extracts itself from the policy paralysis and takes some credible steps to get growth back on the agenda.

The recent spate of weak economic indices coupled with a severe global slowdown led by Eurozone concerns does not bode well for this year’s growth either. The average of various estimates put India’s growth in 2012/13 at around 6.5 per cent this year which a far cry from the momentum of eight to nine per cent achieved just a couple of years ago.

If Greece actually makes a disorderly exit from the Eurozone, no economy will emerge unscathed, least of all India’s. Whether the pro-austerity parties get voted in or not, Greece’s exit leading to market turbulence is in no one’s interest. Elections everywhere have endorsed an anti-incumbency wave, which must worry the Barack Obama administration as well, since the US goes to the polls in November this year. Political stability and economic stability of the Eurozone is equally important to the US.

The sword of the Eurozone’s debt crisis hanging over the world is a well-known fact. It remains to be seen if the stronger European economies do all they can to save the EU from a full blown crisis. The road ahead is very rough, though we remain hopeful.

The author is Founder and Managing Director of FICC Capital