Emerging markets like China and India coped with the collapse of Lehman Brothers, as the right policy stimulants were present along with booming domestic demand. But a double-dip recession could have more serious implications on investment, growth and employment in emerging markets.
A double dip recession may be more worrying than the 2008 global financial crisis (GFC) due to the economic situation in key countries: China’s growth is showing signs of slowing; India is sacrificing growth to fight inflation; US markets are weak due to efforts in debt-reduction and reduced government spending; and Japan is experiencing negative growth, resulting in an overall drop in investor and consumer confidence. If a second recession takes full effect, emerging countries like India will be affected. The initial symptoms are already evident in stock markets, where share values and wealth are eroding.
Why the present crisis?
The Eurozone debt crisis was partly caused by sustained budget deficits and high government debt without structural reforms to improve productivity growth in European countries such as Greece, Ireland, Portugal and Spain. The GFC shook investors’ confidence in the ability of these governments to manage the economy, and they dumped government bonds. More significantly, investors deserted these troubled European countries during the GFC.
After the Euro was introduced as the common currency in 1999, investors found it very attractive to buy assets in these countries. The huge capital inflow created the high current account deficit in addition to a high fiscal deficit. The simultaneous twin deficits were manageable as long as there were huge capital inflows, but the sudden end to capital inflows and the dumping of government bonds created the present debt crisis.
The Euro was created to unify the European market and to create better investment opportunities. But the EU failed to stamp authority in these countries to follow structural reforms and tight fiscal discipline. Though 17 countries have the Euro as a common currency, each country has its own political dynamics and pursues socio-economic reforms in its own interest. As such, the present danger to Europe is the Euro itself.
To rescue Greece, Ireland and Portugal, a coordinated effort led by rich European countries like Germany and the Netherlands, and the G20 countries, is urgently required. This will help investors regain confidence, preventing a banking collapse in Europe. In this context, the offer of G20 countries, including emerging markets, to assist international financial institutions is a welcome step. In times of crisis, stressed economies often need funds to stabilise domestic demand and financial markets. This adds pressure to bank funds whose capital is already depleting fast in managing the debt crisis in Europe. Though in the near future multilateral financial institutions and developed countries (along with emerging markets) may bail out the Eurozone countries, the long-term plan should be to help these economies achieve growth with structural reforms and liberalisation.
Impact on emerging markets, including India
European banks have higher exposure than banks in emerging markets, the US and Japan put together. If European banks collapse due to exposure to countries such as Greece, Ireland and Portugal, the supply of foreign credit to emerging markets will dry up. That will put pressure on investment spending in emerging markets — already struggling with high capital costs due to tight monetary policies — impacting investment, growth and employment. Early warning signs, such as low investor confidence and falling consumer demand across the board, signal a crisis at India’s doorstep which it cannot completely avoid. So it is imperative that emerging markets, including India, look inward and boost domestic demand to compensate for the shrinking world market.
Europe is one of India’s largest trading partners. Austerity measures in European countries and falling consumer expenditure may affect Indian exports, especially in services. Though China is India’s largest trading partner, it mostly imports raw materials for manufactured goods produced for the rest of the world, now facing recession. So, the Eurozone crisis does not bode well for Indian exports. The Indian stock market has already fallen substantially, and if European banks become insolvent capital may return, leading to a sharp depreciation of the rupee, which is already in turmoil. Given increased intra-industry trade, and the import intensity of Indian exports, a rising rupee would hurt industries both within and outside the country.
But in every crisis is opportunity. Indian policymakers need to maintain domestic demand and work towards gaining investors’ confidence. The government must explore export markets like Africa and the ASEAN countries, and continue to reduce dependence on Europe and the US. Special tax incentives for exporters to Europe and the US may help them retain their competitiveness in these markets. Some of the pending reforms, whether they are FDI in retail, labour or financial and insurance sector reforms, need to be pushed ahead to maintain growth and investment. It is time to show that India is a safe haven for investment, and to do this bold governance reforms are needed to improve the overall competitiveness of the Indian economy.
Pravakar Sahoo is Associate Professor at the Institute of Economic Growth, and Visiting Researcher at the East-West Center. An Earlier version of this article was first published in Business Line, 10th October 2011.