Coping with turmoil in Europe

It has been a ‘macro week.' It started with a discussion on the drivers of global crude oil demand, the conclusion being that crude oil prices are not likely to head below $80 a barrel despite growth impulses in Europe and the US weakening even further. The burgeoning demand for energy from large emerging economies such as China, India, Brazil and a clutch of others will apparently keep prices from softening any time soon.

Renewables do not yet offer effective substitutes to oil in transport as well as for power generation despite marked improvements in hybrid transport technology and the steep decline in prices of photovoltaic panels. So we in India should reconcile ourselves to high hydrocarbon prices and focus more sharply on improving efficiencies in the power generation and transport sector and on energy conservation measures.

One of the factors that could change the short-term energy price scenario would be a possible break-up of the Euro currency area. This has the clear potential to sharply bring down commodity prices as demand collapses in Europe and its periphery.

This possibility became stronger with the markets severely discounting the ability of the European governments to muster up the required political will to put in place effective measures that would bring down the debt overhang and re-ignite growth at the same time. As a result there has been unremitting pressure on sovereign bond offerings with yields of Italian and Spanish bonds hovering dangerously close to the perilous 7 per cent mark.

In denial mode

This issue was discussed at length at the recent International Capital Conference in Paris co-organised by the Cavendish Foundation, Boao Forum and Ficci and hosted by the French Finance Ministry. It was pre-dominantly a Chinese financial sector gathering with a few Indian delegates and a fairly large European participation.

The delegates were addressed by the French President, Mr Nicolas Sarkozy, and the senior French leadership on the evening prior to the conference. The message put out was, expectedly, that markets were acting irrationally as Europe's fundamentals were strong and the predatory behaviour of the markets needed stronger controls and regulations. Almost as if on cue, the day after President Sarkozy's strong speech in defence of the Euro, conference participants heard the news of the markets having rejected the full offering of German treasury bonds (known as Bunds) with a yield of 1.98 per cent (higher than on US treasuries) at the end of the first day of deliberations.

This should have caused alarm bells to ring and made Europeans sit up and take notice. But the mood at the dinner that evening, hosted by the Chairman of Dassault, principally for the Chinese and Indian participants, was full of bonhomie and good cheer, in total denial of the market sentiment. The mood inside and the amazing Christmas lights on the Champs Elysees, that were switched on that evening and attracted masses of tourists, provided no inkling of any lurking danger.

It certainly did not reflect any kind of concern at the possibility that markets were beginning to consider even German sovereign bonds risky and thereby perhaps accelerating the walk-away from the Euro. To me, this denial reflected an apparent lack of ownership of the Euro and the currency now suffering from the problem of the commons where every party expects the other to do the needful, without taking any responsibility on itself! Maybe every country other than Germany now feels quite helpless about doing anything.

Weak links

This could well be the bane of the Euro area at the present moment. Everyone expects France and Germany to lead the fight to save the Euro. The two do not fully agree on the approach, and have significant differences on the role of the European Central Bank as the liquidity provider of the last resort and the extent of fiscal cuts required to restore market confidence.

Germany is clearly in a more dominant position but cannot be seen to exercise its influence to the extent required because of political reasons and that overhang of distrust from 65 years ago. On the other hand, it knows that the demise of the Euro can be its own undoing but is simply helpless beyond a point as its writ runs only that far. It cannot effectively impose the discipline needed to restore market and investors' confidence in the Euro undertaking.

Other members of the Euro zone are not yet prepared to accept it, though they may have to come around in due course. The markets, on their part, seem to be set on forcing a more expeditious solution for which neither the Germans nor other members of the Euro zone are currently prepared. There is thus a time sequencing problem that is leading to mounting pressure on the weakest links in the chain, which could snap any time.

The result could well be a messy breakdown of the Euro area, for which we should be now prepared. For India, such preparation implies speeding up the stalled structural reform process. All those reform measures that can be undertaken as executive action and do not require Parliamentary approval should be implemented at the earliest.

Investor confidence needs to be restored. India has to present a credible picture to be able to attract capital flows and prevent capital outflow in the coming period of heightened turmoil and uncertainty. The political class must recognise the dangers facing the economy and not let partisan interests prevent effective action. The lesson from Europe is that these are critical times.

(The author is Secretary-General, Ficci. >blfeedback@thehindu.co.in )

COMMENT NOW