Crisis In Eurozone Its Impact On Indian Economy Economics Essay

The study is about the euro debt crisis and how it impacts the Indian economy. The crisis of European Union 2010 is the result of overindulgence at the expense of caution, greed, due diligence and regulation. The crisis was mainly felt in the PIIGS, members of the European Union which included Portugal, Ireland, Italy, Greece and Spain. These members of the European Union faced sovereign debt crisis and resulted in large current account deficits. These led to the loss of confidence in the European economy between these countries. These countries had to face a bailout. Like a “stone dropped in a pond would lead to ripples”, similarly the Euro crisis would impact other economy and hence the Indian economy as well.

LITERATURE REVIEW:

Overview of Euro Zone Economy:

The economy of the European Union generates a GDP of over â‚¬11,805.66 billion according to the International Monetary Fund. It is the largest economy in the world.

Crisis in Euro Zone:

The major reason for the crisis in the Euro Zone was that the countries in the European members have breached the imposed rules on them.

According to the economic and monetary union of the European Union, the government debt must not exceed 60% of GDP at the end of the fiscal year and the government deficit must not exceed 3% of the GDP. But only two countries in the Euro Zone area have followed these norms set by the European Union. These two countries include Luxemburg and Finland. The national debt as a percentage of GDP in the year 2009 is shown in the map below as follows:

The above data also indicates that Greece shows a high debt of 115.1% of GDP and a deficit of 13.6% of GDP. Italy shows a debt higher than Greece as a percentage of GDP and Spain with a deficit of 11.2% of GDP. The government deficit as a percentage of GDP is given below in the figure:

Sovereign debt crisis:

All the major economies have felt a global meltdown because of the sovereign debt crisis. Debt is an integral component of any economy but it has to be limited to a certain extent. Financial or public debt is essential in order to fund various growth and development projects namely to run public welfare schemes and other infrastructural projects. Sovereign debt crisis arises when the debt is payable in a different currency other than the debtor’s currency.

According to Standard and Poor (S&P), “Sovereign debt crisis is a repercussion of debt default”. The default arises when the government issues sovereign bonds and defaults in paying back the amount to the investors. Sovereign bonds are bonds which are issued by government of an unstable economy in a currency of a stable economy.

The government could respond in order to eliminate the sovereign debt crisis. They can arrive at a settlement or budgetary allocation with the external creditors (lenders). This involves allocating parts of the budget to debt servicing and providing debt relief programs. These relief programs are provided by IMF or World Bank and this entirely depends on voluntary debt restructuring.

The PIIGS were identified by business analysts in the year 2008. Ireland has been the recent addition to the debt crisis. The PIIGS were the most troubled nations of the Euro Zone as they were the heavily indebted countries of Europe which is evident from their high external debt, high government debt levels and high current account deficit.

Greece:

Greece has a high budget deficit. The entire financial market-the banks and investors that buy government bonds are reportedly worried. Greece was incorporated into the European currency union on January 1st, 2001. Euro became the common currency in 2002.

Greece replaced with a reliable currency lead to increased government and business borrowing at lower interest rates. The real GDP growth increased to 3.8% leading to a growth in its economy. Greece had a huge government spending on unproductive sectors like building houses, which lead to huge deficits even during their boom years. This was the reason that they had to cope up with huge debts which they found it very difficult,

This overspending by the government of Greece was due to their spending on all the welfare benefits provided namely unemployment insurance, old-age assistance, health insurance etc provided by the modern governments. This spending by the government would result in slowing down the economy or triggering a recession. If Greece government inability to service their debts, the lenders accept to lend only at high rates. Cutting down the welfare benefits or raising taxes would weaken the economy.

According to macroeconomist Krugman and Samuelson, the Greece debt crisis was the cause of adopting Euro as their currency by replacing drachma. Greece cannot devalue its currency to boost its economy. It also could not withdraw from the euro zone, because that would cause a huge run against Greek bonds and stocks. Greece also could not raise its interest rates because it was controlled by the European Central bank. In order reduce government spending Greece has to lower wages, prices and costs of goods to remain competitive.

In early 2010, it was discovered that the Greek government had constantly misrepresented the country’s economic statistics and had even paid Goldman Sachs and other banks hundreds of millions of dollars for arranging transactions that hid the actual borrowing levels. These misrepresentations resulted in excess spending by the Greek government which hid the actual deficit levels. Greece was identified as the worst case of reporting irregularities, usage of derivatives, and fudging statistics, among rest of the European Union countries.

Greek debt was downgraded to Junk status by Standard and Poor’s (S&P) due to fear of sovereign default. According to S&P, investors would lose 30-50% of their money in case of sovereign default in Greece.

In order to avoid sovereign default, a bailout package was arranged for Greece and the loan agreement was reached between Greece, other Euro zone countries and the International Monetary Fund. The total loan agreement was for a sum of €10 billion.

The increase in bond yields was a major reason for the crisis and after Greece bailout the European financial stability facility (EFSF) has been put in place.

Portugal

Portugal is facing enormous economic challenges. The budget deficit has raised to 9.3% of GDP in 2009. Additionally, the public debt is nearly 77% of GDP, which is near to the European average, and also it is expected to raise more than 85% by 2011.

Although the government has reduced civil service jobs and salaries, there is little prospect of legislative reforms or structural reorganization. Despite the short-term focus of the recent reform measures, critics have speculated that more economy would decrease.

Economists, politicians and commentators feel that despite serious problems, Portugal would not follow Greece into the economic quagmire.

In 1986, Portugal joined the European Economic Community (EEC), one of the predecessor of European Union. Portugal contributed stable economic growth in the EU , largely through increasing trade fostered by low labor cost in portugal and an inflow of EU funds for infrastructure projects.

Subsequent entry of portugal into EMU brought stability in exchange rate, lower inflation, and lower interest rates. The service sector is now Portugal’s largest employer, by overtaking the traditional and predominant manufacturing & agriculture sectors. EU expansion in the Eastern Europe has negated Portugal’s historic competitive advantage is low labor costs.

The International Monetary Fund encourages Portugal to embark on a program of comprehensive reforms to raise its longer-term growth potential, correct its imbalances, and to restart the convergence process. According to the IMF, the reforms should concentrate on the efficiency of firms, labor productivity, flexibility, and encouragement of households to save more. In terms of Portugal’s public finances, current policies might not be enough to achieve a 3% deficit target by 2013, and additional consolidation measures may be needed

Spain:

Spain is the most indebted country which likely to become, overtaking Greece, in the next couple of years. Although the country’s debt is low at 54.3 percent of GDP, there is a fear that if the country goes into a recession the situation could be more disastrous than the one in Greece because the Spanish economy is four times as large.

Through the mid 2000s, the Spanish economy growed in a healthy manner because of a boom in the real-estate sector, which has been destroyed by the financial crisis. But, since the burst of the housing bubble, the budget deficit raised to 11.2 percent of the GDP in 2009 and is only forecasted to increase.

Growing reduction of European Union funds:

Capital contributions from the EU, which contributed significantly to economic empowerment, Spanish since joining the EEC, decreased considerably in recent 20 years due to economic standardization in relation to other countries and effects of EU enlargement.

On the one hand, agricultural funds the Common Agricultural Policy of the European Union (CAP) is spread across many countries, on the other, the structural and cohesion funds have declined inevitably due to the Spanish economic success and due to the incorporation of less developed countries, lowers the average income per capita (or GDP per capita), so that Spanish regions relatively less developed, have come to be in the European average or even above it. Spain gradually become a net contributor of funds for less developed countries of the Union.

Employment crisis:

Spain suffered a severe setback in October 2008 when it saw its unemployment rate surging to 1996 levels (high unemployment problem in 1996). During the period October 2007-October 2008 Spain had its unemployment rate raising 37%, exceeding the rate of past economic crisis like 1993. In particular, during the month of October 2008, Spain suffered its worst unemployment rise ever recorded and, so far, the country is suffering biggest unemployment crisis in Europe. By July 2009, it had shed 1.2 million jobs in one year and was to have the same number of jobless as France and Italy combined. Spain’s unemployment rate hit 17.4% at the end of March, with the jobless having doubled over the previous 12 months, when 2 million people lost their jobs; with the oversized building and housing related industries contributing greatly to the rising unemployment numbers.

2008-09 financial crisis:

The Spanish government official forecast the GDP growth for 2008 in April was 2,3%. This figure was successively come down by the Spanish Ministry of Economy to 1.6 .This figure looked better than most other developed countries.

In reality, this rate effectively represented stagnant GDP per person due to Spain’s high population growth, itself is the result for a high rate of immigration. Retrospective studies by independent forecasters estimate that the rate had actually declined to 0.8% instead far below the strong 3% plus GDP annual growth rates during the 1997-2007 decade.

In July 2009, the IMF worsened the estimates for Spain’s 2009 contraction, to – 4% of GDP for the year (close to the European average of minus 4.6%), besides, it estimated a further 0.8% contraction of the Spanish economy for 2010, the worst prospect advanced economies.

The estimation of the IMF was proven to be somewhat too pessimistic, as Spain’s GDP sank less than the most advanced economies in 2009 and by the first quarter of 2010 had already emerged from the recession.

Italy:

Compared to that of the rest of the indebted Euro-zone countries, Italy’s economy is rather stable because it has been suffering since 2006, long before the outburst of the crisis. Italy’s financial sector has managed to remain relatively unaffected by the economic crisis. Additionally, unlike that of Spain and Greece, Italy’s economy will probably not get worse in the near future. In fact, despite a national debit of more than 100 percent of GDP, its economy is on the upswing from its troubled economy of the past several years.

Effects of economic crisis on Italian economy:

The economic recession has affected the Italian production system in its entirety, differing extents according to the economic sector, geographical area and company characteristics. In 2009, the Ministry for Economic Development (Ministero dello Sviluppo Economico) conducted more than 150 discussion tables with the social partners with the aim of finding solutions to sectoral and corporate crises involving more than 300,000 workers. In many cases, these crises have affected large-sized companies, with damaging effects on subcontractors and suppliers.

Negative economic performance:

The marked downturn in the sales of domestically produced goods and services had significant effects on employment: on average, in 2009, the number of people in employment declined by 380,000 (minus1.6% on an annual basis), while the unemployment rate rose to 7.8% ( increased by 1% compared with 2008).

Another indicator of the difficulties of the Italian production system is the number of hours authorised for the placement of workers on the Wages Guarantee Fund (Cassa Integrazione Guadagni, CIG).

Employment trends

As mentioned above, ISTAT(measurement of progress in Italian society) reported that in 2009 the number of employed persons decreased by 380,000: this reduction more significantly affected male workers (274,000 fewer men in employment compared to 2008) than female workers (105,000 fewer in employment).

At territorial level, the decrease in employment has mainly concerned about the south of the country (194,000 fewer workers) and northern Italy (minus161,000 workers). At sectoral level, compared with 2008, employment rate has decreased most in industry (-4.3%) and services (-3.7%).

Impact on India

ƒ˜ India’s Exports to the EU region

Economy is just a market set up where consumers and buyers transact and so any change in economic condition of the country affects the consumer behaviour. As a result of this there will be reduction in demand, which will impact the exports to European countries from India and China. This is because European Union (EU) is one of the largest trade partners for both the fastest growing countries of the world. Though, the impact is expected to be minimal and transient. If the crisis remains restricted to Greece, as India’s exports to this affected country accounts for just 1 to 2 percent of our overall global exports. Further, the impact will still be marginal even if the crisis spreads to other PIIGS countries as India’s export to PIIGS is also limited. However, a generalized and widespread slowdown in the EU region, as expected by a few, would be a negative development for Indian exports as EU region accounts for about a fifth of our total global exports. Europe accounts for 27% of India’s exports; hence, the depreciation of the EUR will result in a downturn for the Indian trade and services sector.

Another issue relates to availability of trade finance in the EU region. As banks in the EU region suffer losses, they could well cut down on their overall operations including the business of trade finance and in case this happens then like all countries India too would see a slowdown in exports to the EU region.

ƒ˜ Capital inflows to India

With deleveraging expected to continue in the global markets, there is likely to be flight of capital from equity markets in emerging economies including India. Further, debt related flows could also be lower as global financial market players hesitate to invest in non- dollar areas. However, inward capital flows started increasing recently because investors find the Indian market an attractive destination.

ƒ˜ Liquidity situation

Capital flows into India is expected to slow down if not completely reverse in the coming six months, the liquidity situation is also expected to be a little tight in the days and months ahead. There will be some amount of capital outflow in the short term as the investors in euro zone would withdraw the funds for their own use invested in India, but some also believe that on the contrary FII’s (Foreign Institutional Investment) may invest in India as they would find India as a safe place to park their funds having high growth potential. There would be short term susceptibility, due to anxiety amongst investors as the risk appetite will reduce.

Large chunk of Indian borrowers who borrow from abroad at the floating interest rate of LIBOR (London Interbank Offered Rate) plus some margin will find an increase in the cost of funds because negative sentiment emancipating from Greece crisis has increased both the LIBOR and the quoted margin over it. This will make the foreign borrowing option less lucrative for borrowers and will thereby pressurize the domestic interest rates.

ƒ˜ Revenue:

The hospitality sector, which was trying to recover from the losses on account of volcanic ash issue, will also feel the heat faced by tourists from Western Europe. Not only is there currency depreciation effect but consumers’ purchasing power has also gone for a tailspin. 30% of foreign tourist arrivals in India are from Western Europe. The depreciation of the euro will lead to a fall in tourists from Europe, resulting in a drastic decrease in India’s revenue from the tourism industry.

There is the problem of capital flight. Foreign institutional investors (FIIs) operating in India are taking money out of India. In 2007, these FIIs brought in 20 billion dollars while in the first ten months of 2008 they have taken out 16 billion dollars. Last year 20 billion dollars plus. Now you have minus 16 billion dollars. This is the order of magnitude of change in the flow of foreign finance. When the FIIs take money out of India, stock markets tend to crash. The foreign institutional investors dominate the Indian stock market. They run the show. They decide what happens. Every time they bring in money and buy stocks, the market will go up. Every time they sell stocks and take money out, the stock market will go down. The FIIs enter the market to make money quickly, and they also quickly take their profits out of the country.

FIIs taking money out currently in order to meet their payment commitments elsewhere leads to a sharp decline in the stock market indices. Secondly, when foreign capital goes out in large amounts, there is a big demand for dollars. This means that the demand for dollars as against the rupee goes up. As a result, the rupee value goes down against the dollar. In last several weeks, the US dollar which used to exchange for Rs. 40 has tended to exchange for Rs. 50. This is a large decline. It means our imports became much more expensive. This in turn leads to a generalized pressure on prices. There is a tendency to inflation. Costs of food and other basic commodities rise whenever the rupee declines in value against the dollar. That is occurring now. So, capital flight means stock market declines and currency value goes down. For common people, this translates into a slowing down of investment and therefore of growth and employment. It also means a rise in prices. This is the crisis we are facing. India will be able to control its fuel subsidy bill, as the crisis has pulled down commodity prices, including petroleum products. Despite the crash in crude oil prices internationally, inflation rates even as officially measured remain high at around 9%. On the ground, we know from daily experience that vegetable and other essential commodity prices are in fact rising much faster.

The current crisis is coming to India on top of about 20 years of neo-liberal policies. In 1991 a crisis in the global economy would have had much lesser impact on the Indian economy. Today it has a much greater impact. In 1991, the Indian economy was much less integrated with the global economy than it is today. The combined value of India’s imports and exports as a proportion of GDP was not even 10% in 1991. Today, if we add imports and exports, the figure comes to over 40 % as a proportion of GDP. So, our economy today is much more vulnerable to global commodity prices than it was 20 years ago. More important, it is much more vulnerable to financial flows. So, both in terms of commodities and in terms of capital, the Indian economy is today much more vulnerable to changes in the international economy. So, the global crisis impacts much more strongly on India now than it would have in the period prior to the implementation of neoliberal policies.

METHODOLOGY AND RESULTS

MAJOR FINDINGS AND RECOMMENDATIONS:

Recommendations:

ƒ˜ The Government is pursuing further liberalization of the financial sector to address the problem of ‘liquidity’. i.e., of making more funds available to the financial system so as to encourage private investment. Foreign entities not registered in our stock markets are allowed to participate via FIIs already registered here which is allowed by India through instruments like participatory notes (PNs). The government, in a panicky effort to attract foreign finance capital, has now diluted the regulations governing PNs.

ƒ˜ The government has also introduced a Bill to raise the ceiling on FDI holding in the insurance sector from 26 % to 49 %. The government is also planning on some more deregulatory measures opening up the Indian financial system to external penetration, all of which will increase the external vulnerability of our economy.

ƒ˜ The government has announced a fiscal stimulus package which falls far short of what is needed to deal with the likely impact of the global crisis on the Indian economy. As the crisis and its impact on the Indian economy unfold, it is clear that our exports are declining despite the fall in the value of the rupee against the US dollar while our import costs are going up. There is pressure on our balance of payments, especially with FIIs exiting the country’s financial markets, exports declining and imports going up. 

ƒ˜ One of the key issues in the context of the present economic crisis is the extremely slow growth of food grain output over the last decade. With global food grain markets tightening, and our balance of payments coming under pressure due to slowing down of export growth, imports will not be a viable option. This has implications for where government expenditure to revive the economy should go. The State must spend money to actively promote food grains output. It can do so in two important ways. One is to ensure inputs at reasonable prices, by restoring subsidy on fertilizers and other inputs. And the second is to procure the outputs at remunerative prices. So reasonable input prices, remunerative procurement prices and importantly extension of procurement to all major crops and across the country are essential to enable rapid recovery of the rural and agrarian economy. However, to ensure food security in the country, we need to improve food grain production as quickly as we can. For this purpose, increased government expenditure should go to enhanced allocation for agriculture and rural development including irrigation and infrastructure. This is the area where expenditure as a share of GDP had fallen steeply between the late 1980s and early 2000s. 

ƒ˜ The complete reversal of neoliberal policies; putting in place careful regulatory oversight of the financial sector; massive fiscal stimulus through expenditures directed at improving the purchasing power of ordinary people and the economic viability of peasant agriculture, small and medium industry and small retail trade; and measures to control prices by importing essential commodities from time to time. Besides the above, protection must be provided to domestic agriculture and a massive effort to increase the output of food grains. None of this will happen unless we put in place an alternative policy regime.

CONCLUSION:

The Euro debt crisis has influenced and also has an impact on other economies. The European Union and the IMF have taken steps to save the failing economies of countries like Ireland and Greece with their bailout packages. A sovereign debt crisis can affect the borrowing conditions of the financial sector negatively. Thus, the European Union has set up a European financial stability fund (EFSF) as a relief for the member countries facing the debt crisis. The EFSF is a special purpose vehicle which was set up by the member states of the European Union in order to preserve the financial stability in Europe. The main purpose of this fund is to provide financial assistance to Euro Zone states which they are faced with economic difficulty. The European Union must ensure that they provide stricter rules and regulate the member states on a regular basis in order to bring such crisis under control. This crisis would not only have an impact on the member states of Europe but on other country’s economies as well. This crisis would also be a lesson learnt for all the economies and help ensure better regulatory practices in place.