Phase-II of the global recession was always going to hit the global economy. That Greece took the honours was purely incidental. The bigger issue is whether in saving the too-big-to-fail banks of the world, governments have overstretched themselves . This is the nagging fear that is disquieting the markets. Let’s hope that Greece was the whole iceberg, not just its tip.
Unfortunately, that hope seems a little misplaced right now given the economic prognosis of other countries and of Greece itself. The central question is whether European governments have done enough to stem the tide. Is there a sufficient firewall against market attacks that will inevitably come as players punt that the future of the euro will unfold negatively?
At issue is whether European governments now have the stomach to carry out the dramatic cuts required to get their fiscal numbers back in sync. For example while Greece’s budget deficit is 9.6% of GDP, UK’s is 12%, Spain is 9.8% and even France is at 8.2%. These are extremely high and unsustainable deficits. At the very minimum, it will take years of drastic belt tightening on the part of governments and the people to get back in some shape. This can only happen if taxes are raised while simultaneously curbing spending.
However, no government can take such drastic steps and hope to maintain its popularity. Given the fact that elections are due in most European countries in 2012 and ’13, it will be difficult for most political parties in government to take the measures needed given that they will be shortly jockeying for power at the hustings . Typically new governments, as in the UK, would find it easier to start afresh and not be wedded to old positions.
Blame can then more be easily assigned to outgoing governments. But given the absence of such a change, whether the incumbent governments have the stomach for difficult measures is a real question mark. This likely lack of willingness to take the right but difficult steps is a significant risk to global markets, as is the collective ability of the European Union to get it right.
As the euro depreciates, European exports do get more competitive but it throws the world economy out of kilter. China is re-evaluating the revaluation of the renminbi as Europe is its biggest export market. At the same time, there is a flight to safety to the dollar, making it harder for the US economy to maintain its own recovery . On the flip side, interest costs on its deficit financing will decrease as Treasuries strengthen due to the flight to safety.
But the biggest dangers still lurk in Europe . If speculators come to the conclusion that key European governments such as Spain, Italy, Ireland, Greece or Portugal (the so called PIIGs countries) lack the political will to implement the required tough measures, then those countries will find it harder and harder to borrow at reasonable rates. It will also be difficult for the European Union to backstop the larger governments even though the stakes will be huge.
For example, the total debt of Greece is $226 billion while that of Spain is $1.1 trillion — almost four and a half times larger. Of that, about $220 billion is owed to French institutions, a similar number to German institutions and about $120 billion to British firms. With 20% unemployment, Spain has one of the weakest economies in Europe. Meanwhile of Italy’s gross debt of $1.4 trillion, about 40% is owed to France , which amounts to almost half of the latter’s GDP. The interconnectedness of these economies is such that the weakest link will determine the strength of the EU.
WHAT does all this mean for India? The Indian economy continues to do well on the back of its strong domestic economy. Also, the Indian development story is independent of the global story and is one of the major underpinnings of the global economy — the others being the US recovery and naturally China. However, a continued global risk aversion would mean continued outflow from the Indian equity markets which continues to remain very sensitive to FII flows.
For example , in May we had almost $2 billion of outflows (a scant 0.2% of the total Indian market cap) and yet the market lost close to 12% of its value. Second, access to cheaper external debt capital will diminish as happened in the second half of 2008. This will put more pressure on the Indian banking system as the primary provider of liquidity, and thereby make it harder for Indian corporates to invest to capitalise on the growth opportunities in the domestic market. Meanwhile, export-oriented companies will continue to suffer as overseas markets remain sluggish at best for the next several years.
Clearly risks remain embedded in the global economy and it will be a while before this plays out. The best case scenario is for slow growth in Europe, a continued slow pick up in the US, and stronger growth in the rest of the world. The worst case is outright recession in Europe for many more years, which pulls the US back into a double dip recession as its own stimulus fades in the second half of the year, with growth in other parts of the world also getting impacted.
Corporates therefore need to have plans in place for a wide range of possible outcomes . At the very least a tight focus on costs needs to continue, judicious expansions mostly based around domestic demand and very, very conservative balance sheet management with the bias being to raise capital whenever available. At the same time, assets will be available cheap in the developed world but the temptation to acquire must be carefully tempered.
There is no certainty that current forecasts of western market demand will be accurate going forward. Overseas talent — both expats and diaspora — will also be keener to work in India allowing companies to selectively upgrade their management pools. We will see more outbound M&As but increasingly to other emerging markets — corporates should carefully build cash for such opportunities. India’s voice in the world will carry more weight.
History teaches us that rich economies go soft over time. The process of transition is gradual and hard to identify as it is happening . We are witnessing just such a tectonic shift. There will be many ripples in the global economic waters and Indian corporates will need to manage nimbly to sidestep the dangers while taking advantage of the opportunities. The good news is that they have the management quality and world view now more than ever to do so.
Source: Economic Times