Bracing for hard landing

Standard & Poor's decision to strip France of its top AAA credit rating confirms one thing. The effects of the European sovereign debt crisis are no longer confined to just the so-called PIIGS economies of Portugal, Ireland, Iceland, Greece and Spain. They now seem to be spreading to the ‘core' of the euro zone as well. The rating agency's downgrade on Friday, of France and Austria by a notch and deeper cuts for Italy and Spain, is a clear pointer to this. This comes even as global investors had grave misgivings over the efficacy of last month's ‘fiscal compact' agreement reached between European Union (EU) member states — barring the United Kingdom — in addressing the immediate liquidity needs of the most indebted borrowers. Also, there were doubts whether these nations can really put through the structural reforms necessary to balance their budgets and to promote productivity improvements in their economies.

The cash needs are by no means small. Italy alone has some 130 billion euro of debt maturing in the next three months. Nobody really knows how it (or Greece and Spain) would refinance these amounts, more so if the rating downgrade only adds to borrowing costs. Short of their defaulting or abandoning the euro, the only viable option is for banks to accept massive debt write-downs. The alternative of extending financial assistance in return for these countries undertaking austerity measures is simply not workable: Raising tax rates and slashing spending in the middle of a recession would only weaken growth further, making it still more difficult to pay back debts. A single currency makes matters worse. Not having the flexibility to devalue necessitates much greater levels of austerity, which cannot possibly be implemented in advanced western democracies. The fact that the industrial output in the euro area fell for a third straight month in November — with even the region's economic powerhouse, Germany, reporting a 0.6 per cent production decline over October — will not help things either.

The current situation in Europe points to an extended period of low growth, if not recession. Even if that is averted through creditors taking huge haircuts, there would be implications for countries such as India. The EU accounted for nearly $ 47 billion out of India's total exports of $ 254 billion in 2010-11 – making it a larger destination than even North America ($ 27 billion). But no less important is Europe's role as a financier. European banks accounted for almost $ 148 billion out of the total foreign claims of $ 325 billion on India, according to the Bank for International Settlements' latest data for June 2011. The stress on their balance sheets from exposure to PIIGS debt may force these banks to refrain from fresh lending or even rolling over existing debt in other geographies. That could hit Indian companies in the near term as well.

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