Living beyond our means = European crisis

In early 2010 economic activities of the PIGS (a group of 4 nations in Europe namely Portugal, Italy, Greece and Spain) have come under increased scrutiny from the international investment community, with the threat of “Sovereign default” lurking around the corner. Sovereign default refers to a situation when government of particular country is unable to repay its debts. This situation of default payments by governments lead to European crisis. With onslaught of the recession and subsequent introduction of various financial stimulus packages, the government expenditure like public job creation, pensions, social benefits etc ..on various countries took on gargantuan proportions to support these packages. To support these packages government was forced to borrow heavily consequently generating high fiscal deficicts.Most countries had manageable fiscal deficit, the government of PIGS nations mopped up a huge debt bill. The state of affairs in Greece which was epicenter of the sovereign default malaise is shamboic as country was known to live beyond its means.

Debt Skelton of PIGS

Role over risk in EURO ZONE

It is one element played a role in the crisis is “roll-over risk”. Countries involved are exposed to a fiscal crisis (the “bad equilibrium”) to the extent that they are forced to rely on the market to roll-over their debt. Thus, much depends on the amount of public debt coming to maturity in the next months. This in turn depends on the maturity structure of the public debt. If public debt mainly has a long-term maturity, then the amount of debt to be rolled-over in a certain time interval is small and the burden of a high interest rate might be sustainable. In these cases, the risk of a fiscal crisis is ruled out. If instead the debt has mainly a short-term maturity so that the amount to be rolled-over is large, then a fiscal crisis can occur

Europe's Sovereign Debt Crisis and its international impact

A deepening crisis of confidence in sovereign debt within the euro zone is prompting institutional and retail investors to rethink their investment strategies. The crisis of sovereign default by Greece had been simmering as a European concern for a few months since last quarter of 2009.This fortnight it threatened to burst into a full blown global conflagration that has been checked only by the direct and indirect participation of most countries of the world In December 2009 several international rating agencies mislead international finance community by a junk rating to Greek bonds .In April, the world knew some of the real world implications of Greece’s sovereign debt. It owed external lenders some $190 billion and was unable to continue making even interest payments.

By the second fortnight of April ,the EU and IMF – the multilateral agency with primary role to help nations with problems related to currency and BOP had cobbled together a $ 40 billion solution. However financial market round the world had pressurized for more relief packages, thus package was increased to $ 1 trillion. By now it was clear that package was designed for more than just the Greek risks , it was actually about the EURO , the EU economy , as well as the US.Moreover, with the IMF whode key donors include countries like China and India. – ( providing some $350-$ 250billion); thus we can say that the India also played a major role in mitigation package to Europe .

EU debt crisis and its impact on Global markets

Most attention continued to center on the European debt crisis as investors fretted that efforts to cut deficits and debt will kill growth by withdrawing government stimulus from economies in Greece, Spain and Portugal.

The biggest casualty over the last week from the eurozone debt crisis has been the euro, which was down 0.1 per cent on the day at $1.2334. Earlier it had fallen to $1.2237, its lowest level since April 2006 and down from $1.51 late last year.Fitch Ratings said investors are deeply skeptical about the ability of governments to get a handle on their huge debt burdens.``While the package of measures announced will moderate euro area governments' vulnerability to 'confidence shocks' and extreme market volatility, investor confidence will remain fragile until European governments, including the UK, are seen to be delivering on fiscal consolidation and the economic recovery is secured,''

US MARKET REACTION

US Stocks took their deepest plunge in more than a year as fears grew that Europe's debt crisis could spread around the world and undermine the U.S. economic recovery. The possibility has been brewing for weeks, but analysts said some investors are just waking up to it.

The Dow Jones industrial average fell 376 points, its biggest point drop since February 2009. All the major indexes were down well over 3 percent and are now showing losses for 2010. Interest rates fell sharply in the Treasury market as investors once again sought the safety of U.S. government debt.

The number of people applying for unemployment benefits last week rose unexpectedly and the Greek government's response to its debt crisis sparked new protests in Athens, but analysts said neither event appeared to set off Thursday's selling.

They said more insvestors seemed to be grasping the possibility that the U.S. recovery could be in jeopardy, and that many were realizing that the stock market's big rebound since March 2009 might not have been justified. The Dow fell 376.36, or 3.6 percent, to 10,068.01. The S&P 500 fell 43.46, or 3.9 percent, to 1,071.59. The drop was the worst for the Dow since February 2009, and the S&P's worst since April 2009.

Indian market reaction

Indian stock markets have corrected 10% from its recent peaks on the back of the jitters from the Greece-led European crisis. In fact, the concerns about the stability in the European region have once again resurfaced with the latest down grade of Spain by the Fitch.

However, India has out-performed the global indices during this correction phase. India has not corrected as much as have other global markets, during the phase of European debt crisis.

The recent healthy correction in the stock markets is happening constantly trembling under the fear of worsening of the European crisis and a possibility of a double dip recession in the US.

Why is India an Out-performer?

Indian economy is far less dependent on exports to Europe. Indian IT companies have a lower exposure to European clients to the extent of roughly a quarter of their revenues. Add to that India’s exposure to debt-stuck economies such as Greece, Spain, Italy and Portugal is far more limited to 4% of total exports.

According to the latest macro-economic figures, India’s IIP data has registered a growth of 5.1% compared to 3.7% witnessed during April 2009. The Central Statistical Organization has pegged India’s GDP growth for 2009-10 at 7.4%.

Thus, there are various parameters on which Indian stock markets have out-performed the global indices while going passing through the turmoil phase of European crisis. Investors waiting on sidelines should use every dip from here to create a portfolio for long-term duration.

Some questions arising in minds of global investment community are: -

1. What should be the next course of action for the markets from here?2. Will the European crisis worsen even further?3. Will Greece eventually default even after a 110 billion euro bailout?4. Will $1 trillion European rescue package stop the ravage of the contagion of the

PIIGs nations

How European crisis could impact India?

Impact on exports

The European Union accounts for nearly 21 per cent of India's total export and Exports to Greece, Spain and Portugal, including Italy, is only 4%.Indian finance minister rightly said that’s Indian export to PIGS are marginally low and will not have any impact on it ..India export mainly textiles, pharmacy products, Gems etc to European countries but these sectors were not effect much on crisis

Increase in foreign fund inflows

International investors lost trust in world markets because of series of crisis in US and Europe. But a majority of FII and other individual investors choose Indian markets to invest as showed its stability in their economy with a strong fiscal policies . since the start of 2010, the time when fears of sovereign debt crisis in Europe especially in Greece .. There was net inflow of foreign institutional funds into the domestic capital markets since the start of 2010 till April-end, which was Rs 54,606 crore and the stock market barometer Sensex rose 93.9 points in the four months to close at 17,558.71 on April 30

Lessons learned from Euro zone crisis

1. Can’t manipulate the numbers to hide the reality

The Greek tragedy has opened our eyes to many things. No one can any longer mock the critics of high fiscal deficits. Not only was the fiscal deficit of Greece high but that there were attempts to manipulate the numbers to hide the reality. It took a long time before this could be uncovered.

2.Too much dependency on foreign institutions to raise funds

The debt problem of Greece is compounded by the fact that a good part of the government debt is held by foreign institutions, particularly foreign banks. It is estimated that E106 billion of government bonds may be held by foreign banks. A default by Greece will have serious consequences for its economy. It will dry up all sources of external funding which will then weaken the economy even more

3. Government driven crisis than a market Failure

The 2008 financial crisis was triggered by the excesses of financial institutions and financial markets. On the other hand, the current Greek episode has been triggered by the excess of a public entity, which is the government of Greece itself. Thus, it is a case of “government failure” as opposed to “market failure”. However, the reactions of private financial markets and financial institutions have aggravated the crisis. It is also not clear what role investment banks have played in misleading investors into investing in government bonds of Greece

4. Failure of credit rating agencies to discover financial viability

The rating agencies took a long time to discover the correct fiscal position Greece. This proves to be very costly to all entities deals with them

5. Importance of fiscal prudence One of the main lessons from European crisis is that all countries have to maintain fiscal prudence.

How can Euro zone recover from this crisis?

As the origin of the problem lies in fiscal policy, confidence needs to be re-established there: strong and coordinated signals must be sent about the ability of the weak states in the Euro zone to put their fiscal situation in order, accepting the imposition of strong monitoring and discipline on fiscal policy by the Union’s institutions. This implies a significant limitation on the fiscal sovereignty of member states, which comes on top of their delegation of monetary sovereignty to the ECB. Member counties in EU have to implement strong fiscal policies to protect themselves from all kind of risks they may face .EU must have an over archiving mechanism to monitor the fiscal performance of member countries.A simple Maastricht rule regarding fiscal deficit is not enough . EU must also think in terms of creating a fund which can come to the aid of the member countries at the time of crisis.