Today is a critical day for the global markets. Over the weekend, European policymakers resolved to defend the euro and ready a package of measures to combat the Greek contagion. The markets will deliver their verdict on these measures today.
During the previous weekend too, European policymakers and the International Monetary Fund (IMF) had announced a large programme of financial support to Greece. The markets, however, gave it the thumbs down and the result was last week’s bloodbath. But there are plenty of short positions on the euro and if the markets are convinced the authorities are going to adopt a “whatever it takes” approach, we could have a strong rebound driven by short-covering.
Are we at another Bear Stearns moment? The risks are very high—it’s not just Greece that is on the verge of a meltdown, it could spread to Portugal, Spain and other countries. European banks could be affected and US banking analyst Dick Bove told CNBC that US banks are heavily exposed to Europe.
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To be sure, if the European Central Bank is quick enough—although it hasn’t shown signs of being that so far—a liquidity crisis can be averted. But here’s the fundamental contradiction: This recovery has been built on a foundation of public borrowing. But the markets are now saying that, for quite a few countries in Europe, governments will have to put their fiscal house in order. That will mean lower growth. As IMF’s most recent World Economic Outlook says, “Activity remains dependent on highly accommodative macroeconomic policies and is subject to downside risks, as fiscal fragilities have come to the fore.” The markets have priced in a V-shaped recovery so far. But if fiscal problems start to impinge on growth in the euro zone, that assumption will go out of the window. The Indian commerce secretary, for instance, has warned that export performance this year will depend on what happens to Europe, with the region accounting for 26% of Indian exports.
In March, the Bank for International Settlements had published a paper titled The future of public debt: prospects and implications by Stephen G. Cecchetti, M.S. Mohanty and Fabrizio Zampolli. They warned that “in the baseline scenario, debt/gross domestic product (GDP) ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the UK; and 150% in Belgium, France, Ireland, Greece, Italy and the US.” And, very presciently, they said, “The question is when markets will start putting pressure on governments, not if. When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?”
Policymakers might shore up the markets for the time being. But in the longer term, while the liquidity issue may be taken care of, the question is one of solvency. Many analysts believe that the only alternative for the fiscal problem is for their central banks to monetize the deficit, or print money. That may not fuel inflation in a situation of widespread overcapacity, but it does mean continued liquidity and high asset prices. Fund tracker EPFR Global points out that in the week to 5 May, flows to global and emerging market bond funds were robust, with the latter attracting $1 billion-plus for the fourth week in a row. This is only the fifth week since 2001 that emerging market bond funds have attracted over $1 billion (Rs4,560 crore).
What of the short term? This column had pointed out on 14 April that “Low cash with funds signals fall in markets”, citing a Bank of America-Merrill Lynch survey that said cash levels with fund managers and risk appetite are back to levels reached in January. So how does the current panic compare with the January scare? Well, at that time we didn’t have the Chinese economy to worry about. The Reuters/Jefferies CRB index was at 261.32 on Friday, a tad above the 258.55 it plunged to on 5 February. The US dollar index is much higher than in January/February. The Dow has taken out the February lows, but that could have been due to a technical glitch. The Shanghai Composite, beset by its own homegrown problems, is already far below its February lows. The Sensex, however, is still well above the lows it tested in February. The India volatility index (VIX), at 27.4, is still below the 32.13 it touched in February, although it has risen very sharply from the low of 17.07 it touched at end-March.
The Chicago VIX, though, closed at 40.95 on Friday, its highest level since May 2009. Interestingly, in the run-up to the Bear Stearns collapse on 14 March 2008, its level was 31.16, much lower than what it is now. If it’s not fixed in time, this could get far worse than January’s correction.
Graphic by Yogesh Kumar/Mint