If Europe gets into a debt crisis

October 29, 2014

(Any opinions expressed here are those of the author and not necessarily those of Thomson Reuters)

Just over a week back, Europe appeared to be headed for another debt crisis, rattling global markets. Interest on Greece’s sovereign bonds shot up 9 percent. Others followed, including weaker countries like Spain, Portugal, Italy and, shockingly, France. Only Germany offered some protection to investors, albeit with a sharp decline in interest rate.

It appears difficult for countries in the European Union to manage their economies with a common currency.  With no economic instrument for currency adjustment and difficulties in fiscal maneuvering, the most likely outcome is sovereign default for countries with high debt-to-GDP ratio.

The European Central Bank (ECB) has adopted quantitative easing (QE) and announced it had bought 1.7 billion euro of bonds in the first week of the QE. The ECB also has negative interest rate on bank deposits. While this may stave off the debt crisis temporarily, the underlying problem may still force sovereign defaults.

The best protection for investors will be the United States. With money flowing into U.S. institutions and government bonds, the dollar will shoot up against the euro. This reverse flow of money will partly be from emerging markets. Currencies will depreciate sharply, providing an advantage to Europe and emerging economies to export to the U.S.

The Indian economy has high exposure to Europe and the U.S. The huge annual inflow of investments from FIIs has supported the deficit in balance of payments, as also the stock market. In the first six months of the year, FIIs poured in 612 billion rupees.

But with the likely outflow of FII investment in the near future, the balance of trade deficit will have to be funded by drawing down foreign exchange reserves with the RBI.

The rupee will be under pressure. In the financial crisis of 2008-09, the currency was not badly affected because it was the dollar which was under pressure as money was flowing out of the U.S. With the subsequent quantitative easing by the Federal Reserve, the rupee remained fairly stable until 2010. But as GDP growth fell and government inertia set in, the rupee declined to reach 69 to the dollar, only to climb up again this year, partly due to liberal borrowing abroad.

With the debt crisis building up in Europe, the rupee could possibly go down to the level reached in 2013 due to repatriation of FII investment. That is enough for the stock market to plunge because FIIs are critical, being responsible for 25 percent of the market rally in 2014.

While the possibility of a European debt crisis is real, the ECB will use all the tools at its disposal to prevent such a scenario.  One thing, however, is almost certain – weakening of the euro currency, which may help Europe but not India.

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/