A rapid rise over the last few months has taken the Sensex beyond the 20,000 mark, even as economic data from other parts of the world show mixed, often disappointing, signs. Such buoyancy is puzzling, though it has been accompanied by the customary sophistry that supports market climbs. The buzz in this case focuses inordinately on viewing the economic world in terms of a tug of war between the US and China, at the risk of ignoring other factors that might influence global markets. Usually left out of this discussion is the European Union (EU)—the other elephant in the economic room—except in rare cases such as the recent Greek farce.
Yet it would be wrong to miss the EU. Too many countries of the EU now have extraordinary levels of economic stress. In Portugal, combined public and private debt is twice the country’s gross domestic product (GDP). In Ireland, debt is more than one-third of GDP. In Greece, currently undergoing a fiscal adjustment programme, there remain doubts about how the current level of debt will be paid off in the near future. Europe, therefore, faces several sovereign risks—a fact that European bond markets have noticed. As a result, spreads between the 10-year bonds of these countries and safer German bonds have ranged between 3.5% and 7%. At these levels, the countries would need to grow at historically unprecedented rates to pay off their debts.
The institutional response to these problems in the euro zone has been less than transparent. Banks were subject to stress tests in June, but the tests were engineered in such a way that failure was almost impossible. Financial Times columnist Wolfgang Munchau indicates that these tests excluded certain important institutions such as German non-banking financial companies, defined tier 2 capital loosely to permit some non-equity-like elements to be counted for capital adequacy purposes, and generally assumed that sovereign defaults could not take place. That virtually no major bank failed these tests at a time when they were drowning in toxic assets, is inexplicable.
In an attempt to sustain the banking sector, the European Central Bank (ECB) has chosen to purchase bonds. It is uncertain how long this will continue, and the extent to which banks will continue to trust that the three most risky European nations will not be forced to default on their loans. This position is compounded by the fact that the external environment is not neutral. Faced with reduced growth in many parts of the world, currency fixing is likely to be one of the tools that will be ruthlessly used by different economies in the coming years as they try to boost growth. By the very nature of its complex political and decision-making structures, the EU is somewhat less able to fight such a currency war. A situation fraught with so much uncertainty would be a haven for speculators.
The regulatory response in Europe is not particularly coherent. At the recent Group of Twenty summit, ECB president Jean-Claude Trichet expressed his desire for greater fiscal reform. Almost as if to prove how difficult this will be, France witnessed violent protests against pension reform aimed at reducing government expenditure. One cannot, therefore, assume that fiscal reform in Europe will happen smoothly.
Herbert Stein, who was chairman of the council of economic advisers under former US presidents Richard Nixon and Gerald Ford, famously said: “If something cannot go on forever, it will stop.” So it is with these unsustainable deficits in Europe. In the meantime, it would pay to be cautious. Not so long ago, a combination of fortuitous circumstances ensured that India remained relatively unscathed as a financial crisis roiled world markets. The precarious state of Europe’s economy could result in another flight of capital from India such as the one we saw two years ago. It would be worth India’s while to be wary.
Govind Sankaranarayanan is chief financial officer and chief operating officer, corporate affairs, Tata Capital. He writes on issues of governance.
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