Europe's crisis can hurt India

Publikováno: 16.2.2012

Often, difficult times throw up innovative solutions, which at first may not be obvious and could even appear to be contradictory. For instance, in the context of fixing the complex Euro Zone problem, given excessive government debt, one phrase that has cropped up is ‘expansionary austerity' or ‘expansionary contraction'. Doesn't the call for fiscal tightening fly in the face of economic logic if the European governments are, at the same time, trying to stimulate the economy and create more jobs as well?

Fiscal consolidation

This issue was also discussed at the RBI's Second International Research Conference at Mumbai recently. Fiscal consolidation is widely seen as a necessary condition for long-term growth, but is it also a sufficient condition? While there is enough theoretical and empirical evidence to show the positive effects of fiscal consolidation on long-term growth, the present situation also demands some fiscal leeway to support the fragile recovery.

It was pointed out by some speakers at the conference that focusing on fiscal consolidation by cutting unnecessary expenditure and improving efficiencies in spending with better targeted spends on, say education, transfers, and healthcare, along with selectively cutting taxes to stimulate demand, could achieve the same objective. Ultimately, the problem of debt overhang can only be resolved through growth which can be achieved by improving efficiencies and eliminating flab, but not clamping down on government spending altogether. So fiscal consolidation in this sense is seen as supporting austerity while remaining kind-of expansionary.

ECB's intervention

Another unorthodox development has been the swift and aggressive intervention by the European Central Bank through its three-year LTROs (long term refinancing operations) in December 2011 and proposed second tranche later this month, to prevent immediate and sharp deleveraging by European banks.

The ECB awarded €489 billion ($643 billion) in 1134-day loans on December 21, 2011 (maturing on January 29, 2015) to prevent credit markets from freezing up as Europe's debt crisis made banks wary of lending to one another and drove up borrowing costs. Takers included 523 banks (but not Deutsche Bank), whose wholesale funding needs were met with their LTRO cash at ECB's benchmark interest rate (currently 1 per cent) over the period of the loans.

The ECB's latest monthly bulletin shows that refinancing needs was the main motive for banks taking the funds, and the amount a bank borrowed under the December LTRO was found to be positively co-related to the amount it has to pay its own creditors in the next few years.

Some estimates suggest that around €1,700 billion of bank debt will be maturing from 2012 to 2014; so European banks are borrowing to refinance these loans rather than taking in new investments that have to be funded. Moreover, as regulators tighten capital requirements, some estimates suggest European banks may have to offload assets worth $1.3-6.6 trillion for maintaining their capital adequacy levels, affecting their capacity to grow their loan book. The second tranche of LTROs for 1092 days is to be allotted on 29 February 2012 (maturing on February 26, 2015) and is expected to be around the same size (at least) as LTRO-1.

So, despite this flood of money being released by the ECB, there is every possibility that European banks could turn off their credit taps in Asia. Quite likely too, if one goes by the ECB's latest bank lending survey published on February 1, 2012. The survey finds that banks across the euro area see improvement in access to wholesale market funding, reflecting the effectiveness of ECB's LTRO. However, notwithstanding this, European banks in the survey have reported tightening their loans to companies as well as households. This increases the risk of further cut in credit lines to Asia. BIS data also show that European bank claims on Asia (ex-Japan), which stood at 54 per cent of total foreign bank claims on the region, fell 4.2 per cent in Q3 2011, against a 4.2 per cent rise in Q2 2011.

Weak exports

What do these developments imply for India? Overall, exports from Asia are showing considerable weakness while those from Latin America and Eastern Europe appear to be holding up. One reason could be that most lending by European banks to Asia is direct bank-to-bank lending in the form of trade finance and is thus closely related to the region's exports. Deleveraging by these banks in tandem with a slowing economy in Europe may be showing up in weak export performance in Asia.

EU is India's largest trading partner accounting for around one-fifth of India's total exports. With exports set to moderate on the back of slowing demand from EU, aggravated by government budget cuts and bank deleveraging, our current account deficit could widen. As over three quarters of India's exports to EU emanates from the manufacturing sector, this likely dip in export demand could put pressures on domestic industrial production.

Markets world-wide remain edgy and future trade and investment flows will depend on how the Euro Zone debt crisis gets resolved. Capital inflows into India could be affected as European banks continue to borrow to meet their maturing obligations rather than expand lending for fresh investment. Therefore, the fear that India could be swamped by global liquidity as central banks in advanced economies eye the quantitative easing route, may not materialise, but we still need to be alert to hot money flows and their propensity to create asset bubbles.

Author: Brinda Jagirdar, GM & Head, Economic Research, State Bank of India