Clearly, an anti-austerity vote by the Greeks on 17 June is likely to trigger a bout of nervousness in risk-asset classes around the world. The Indian market is unlikely to be exempt from the negative impact of such nervousness.

With the Greek elections approaching on 17 June and the Spanish banking system facing a crisis, all eyes are now, rightfully, turning back to Europe rather than trying to over-analyse “policy paralysis” in India.

Given the multi-dimensional uncertainties around the Greek election (will the pro- or anti-austerity camps win? Will the winners take the country out of the Euro? Will the EU try to appease sentiment by offering a sweetened bailout package?), we will not go into the various scenarios which might unfold over the coming weeks. Instead, we will focus on how, regardless of how the Greek vote goes, the EU will have to step up dramatically in the coming weeks to save the Euro (and hence, by extension, the Union).

There are three profoundly negative and interconnected dynamics tearing the peripheral EU countries apart at present:

Rise in peripheral sovereign bond yields (again): As the peripheral countries struggle to meet their self-imposed budget deficit targets and with the positive effects of the December 2011 and February 2012 bouts of LTRO (long-term refinancing operations) gone, Government bond yields in the peripheral countries are rising to damaging levels yet again. In the last two weeks of May, 10-year Italian, Spanish and Portugese bonds rose by 70 bps, 70 bps and 200 bps respectively.

Erosion of bank balance sheets: Besides the damage caused to bank balance sheets by rising yields, the sclerotic growth rate of the peripheral economies (Italy and Spain are expected to grow at -1.9 per cent y-o-y and -1.8 per cent y-o-y respectively in CY12 according to the IMF) is exacerbating loan losses and thereby weakening their banks' balance sheets further.

Capital flight: Depositors in the peripheral countries are taking matters into their own hands and are moving their cash to safer places such as Germany. For example, in Q1 CY12 around €100 billion of capital has fled from Spanish banks and Spanish bonds. This is creating a liquidity crunch for the peripheral countries' banks and making it increasingly difficult for them to support their national economies.

The EU/ECB will have to take decisive action over the next month or so to stop the negative spiral highlighted above. If the Greeks do decide to leave the Euro, the EU's actions might be preponed but even if the Greeks stay, we think the following is likely over the next month or so:

Bank recapitalisation: The peripheral sovereigns simply do not have the means to shore up their banks' bruised balance sheets. Spain, Portugal, Greece and Ireland have already been extended bank bailout packages by the EU in association with the IMF.

LTRO: The December 2011 and February 2012 three-year loans given by the ECB to European banks allowed these banks to: a) access liquidity at a time when the short-term money market had shut them out; and b) buy European sovereign debt and thereby stabilise bond yields. The need for such intervention has come again and it looks highly likely that the ECB will step up to the plate again.

Securities market programme (SMP): Given how quickly the positive effects of LTRO petered out earlier this year, the ECB is likely to reinforce LTRO with its own programme for buying sovereign debt in the open market.

Capital controls: To stop capital from exiting the peripheral countries' banks, the EU might advocate that these countries impose capital account controls to protect their economies.

Even if the EU does not advocate this, the peripheral nations might on their own accord move in this direction if their banking systems cannot be stabilised in the next few months.

Fiscal union: The sums of money required for the above mentioned measures are large: bank recaps could cost between €150-200 billion, the LTRO rounds in December 2011 and January 2012 totalled around €1 trillion, the SMP would have to be at least €100 billion to have any effect. It is unlikely that the EU and the ECB can continue accessing such sums without some form of fiscal union.

Clearly, an anti-austerity vote by the Greeks on 17 June is likely to trigger a bout of nervousness in risk-asset classes around the world. The Indian market is unlikely to be exempt from the negative impact of such nervousness. However, to the extent that a Greek exit prepones the five-part intervention highlighted above, the EU seems likely to act very swiftly to stabilise risk appetite. In fact, if the fifth element of the programme highlighted above — fiscal union — does get a blessing from Germany, at the 28-29 June EU Summit, it could trigger a significant relief rally in risk asset classes.

Indian policymakers' ability to shield India from the impact of this once-in-a-generation crisis in Europe is limited. To the extent it can, the RBI is likely to try to soften the blow for India by cutting rates on June 18 — our base case is for a 25 bps rate cut on that day.

Clearly, an anti-austerity vote by the Greeks on 17 June is likely to trigger a bout of nervousness in risk-asset classes around the world. The Indian market is unlikely to be exempt from the negative impact of such nervousness.

(Mr Saurabh Mukherjea is Head of Equities, Ambit Capital, and Ms Ritika Mankar Mukherjee is Economist, Ambit Capital. The views are personal.)

(This article was published on June 16, 2012)
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