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The sovereign domino effect

The sovereign domino effect
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First Published: Sun, May 02 2010. 08 51 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Sun, May 02 2010. 08 51 PM IST
At the height of the Cold War, the US was afraid that if one country fell prey to the Communist virus, it would set off a chain reaction where other countries, too, would fall—like dominoes.
Communism may be long dead, but the new virus on the block—sovereign risk—is prompting similar fear and loathing in markets. So with rating agency Standard and Poor’s downgrading Greece, Portugal and Spain in quick succession last week, the concern is that these three dominoes will knock others down.
Illustration: Jayachandran / Mint
Here, after Greece, Portugal and Spain, we could see Italy and Ireland under pressure. The crisis already appears to be heading to Eastern Europe with Hungary’s currency under attack. The worst-case scenario here involves the UK: Investors were lining up last week to buy credit default swaps, or insurance, on UK debt.
Commentators are already making comparisons with the chain reaction the market saw in 2008, when Lehman Brothers collapsed. Greece’s slow but steady fall—it’s been struggling since November—is eerily reminiscent of that.
But history more often just rhymes than repeats: Greece—the supposed first domino—may not be another Lehman.
First, cross-border firms such as Lehman, better connected to the financial system, wreaked havoc for more investors. Second, Greece’s debt is 120% of its gross domestic product (GDP); Lehman, levered at 3,200% to its capital base, had a steeper fall. Third, few European leaders will stomach the consequences of one member of the euro zone defaulting, let alone four others. Fourth, optimism about a genuine US recovery, as Friday’s GDP data suggested, means the contagion won’t go far.
So the chances of a stop in capital or trade into India—as in 2008—are slim, though the tremors from global stock markets, as a matter of confidence, could be felt here.
What’s more at stake here is that, in the medium term, more capital—not less—will come to India’s shores. Investors may already be pulling out of Europe, and what better place to find higher yield than emerging markets—that too by taking advantage of the liquidity spigots still open in the West. With this crisis, the European Central Bank isn’t going to be tightening liquidity anytime soon; the US Federal Reserve too insisted on keeping interest rates low “for an extended period” last week.
That’s why India had better have a holistic strategy for capital controls ready. Unlike the US in the Cold War, which could directly intervene to halt the dominoes, India can only protect itself against the fallout.
How does Europe’s debt crisis affect India? Tell us at views@livemint.com
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First Published: Sun, May 02 2010. 08 51 PM IST
More Topics: Ourviews | Cold War | Communist | US | Greece |