If the U.S. and EU slide into recession

October 15, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

There are apprehensions that the U.S. and EU could drift into recession again. The economic crisis of 2008 unnerved every country, with growth either turning negative or falling drastically. The recovery from that recession was weak and any relapse could be prolonged.

Following the crisis, the Federal Reserve and the U.S. government infused liquidity and banks and companies were flushed with cash, with interest rates close to zero.  In debt-ridden Europe, sovereign default was postponed with compulsory adoption of austerity measures.

But the U.S. and EU have maintained an uneasy growth for the past last three years with low investment, low consumption and high unemployment. And they are once again gravitating towards recession.

In the second quarter of 2012, the U.S. economy underperformed with only 0.4 percent growth. The EU is not technically in recession, though growth had receded to 0.2 percent. Only Germany could show positive growth.

The IMF has predicted worse times ahead for developed countries and warned emerging market economies to be on their toes to counter the negative impact of an expected recession. In 2008 develping countries were taken by surprise and their economies had no time to adjust to the shock. But this time they have a chance to manipulate their policies to insulate themselves. However, the effectiveness of their measures will depend on their dependence on exports and external funding.

Countries like China and Singapore which depend overwhelmingly on exports will find their growth slump much more than countries like India which depend on domestic consumption for growth. But the integration of world economies is such that complete insulation becomes impossible.

India has an advantage. Exports, though important, do not drive growth. They are about 16 percent of GDP, and in terms of value addition about 8 percent or so. Therefore, even a 10 percent fall in exports will bring down growth by less than 1 percent. But what matters more is the possible drop in foreign investment, both FII and FDI.

The stock market will be the first victim of a new financial crisis. When it is in retreat companies are not be able to raise equity. But if retained earnings are adequate and debt market active, capital can still be raised if domestic consumer demand is strong. Consumption is really the key.

India did not fare too badly in the aftermath of the 2008 crisis because the RBI perceived the situation correctly and brought down the repo rate to half the level of what it was before the crisis. Equally important, the government too assessed the need to stimulate consumption and cut excise duties. The combined effect was remarkable. Within a year growth bounced back from 6.8 percent to 8.2 percent. India can substantially insulate itself from a new U.S. and EU recession if the RBI and the government act in time to counter its negative fallout.

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