At last the chickens have come home to roost. The so-called advanced economies, in International Monetary Fund phraseology, are in danger of going into prolonged recession. The IMF World Economic Outlook April 2012 does not say so explicitly but certainly implies it. The WEO April 2012 Figure 2.4 carries the following explanation to the charts.

“Europe tipped back into recession, resulting from renewed escalation of perceived euro area crisis risks in late 2011. The aggregate masks growth divergences in the region, with sharp recessions forecast for the euro area crisis economies. Strong regional trade and financial linkages imply a weaker outlook for the rest of Europe as well. Credit conditions are weak and may tighten further. Inflation is expected to retreat throughout the region, as domestic demand remains weak.”

The European Financial Stability Facility, set up to bail out European Union member countries from collapsing, has already pledged €750 billion in assistance to the beleaguered countries. Along with the IMF’s €250 billion that adds up to €1 trillion. In addition, the European Central Bank has made available close to €1 trillion to several hundred endangered banks in the eurozone. The total will be more than US$2 trillion, equivalent of the projected Indian GDP at market prices for the year 2012-2013. But this is what the World Economic Outlook has to say about the Euro crisis:

“The euro area crisis is the product of the interaction among several underlying forces.

“As in other advanced economies, these forces include mispriced risk, macroeconomic policy misbehaviour over many years, and weak prudential policies and frameworks.

“These interacted with EMU-specific flaws, accelerating the build up of excessive public and private sector imbalances in several Euro area economies, which were exposed in the aftermath of the Great Recession. The resulting crisis has had drastic consequences.”

The IMF is happy that Europe has erected a firewall to contain the epidemic within its eurozone with the establishment of European Stability Facility and the ECB credit for beleaguered EU banks.

The EU countries had a veritable boom run from 1980 till 2007, fuelled by cheap funds as there was considerable liquidity owing to the export surpluses that China, and other countries were having. India had also managed to increase its reserves. These funds were there for the asking. It is strange that the emerging market economies, on the one hand by their sweat produce and sell to these countries, and the surpluses so generated round trip back to them for borrowing in the international market.

It looks like a Ponzi game that had approval everywhere. In all these countries there was a build-up of household debt, built on a housing price boom with banks lulled into comfort by the housing price increases.

It looks like a Ponzi game that had approval everywhere. In all these countries there was a build-up of household debt, built on a housing price boom with banks lulled into comfort by the housing price increases.

For example, Greece with a population of only 11 million had a debt of €347 billion in the third quarter of 2011. It is expected to increase to about €425 billion at the end of 2013. Portugal with a debt of €189.7 billion is similarly placed. Italy has a debt of €1.7 trillion and so is well ahead. Even France has a public debt of €1.8 trillion.

The prosperity of all these countries was built on credit. Households pushed up their demand with increasing bank credit. The total household debt of these countries is estimated to be over 300 per cent of their GDP, with Japan at 475 per cent, UK 466 per cent and Italy at 315 per cent at the end of 2011(estimate by Global Finance magazine).

As compared to these figures India has a total debt of 129 per cent of GDP, the US 296 per cent and China 159 per cent. As per the latest figures of the Bank For International Settlements for end of December 2011, the outstanding assets of the banks in the EU are formidable. The UK leads with US$ 5.754 trillion, France $2.336 trillion, Germany $2.517 trillion, Italy $640.8 billion, Ireland $574.2 billion, Greece $144.8 billion, Japan $3 trillion as compared to India’s $30.8 billion.

It is abundantly clear that countries in Europe had a free run in the debt market both at the sovereign level and also at the household level. Some of the outstandings of the banks in the EU may be due to the holding of government securities. 

Something like delayed repayment of a loan or a default by a recognised company triggers a movement to the exit by bankers and other financiers. This sets the ball of panic rolling and the consequences are a chain of events leading to recession, explained first by Hyman Minsky. It is incorrect to assume, as many do, that household debt within a country is debt that is owed within the country. Many of these countries’ banks have borrowed heavily across the border from other banks, and the funds are used for lending in the domestic credit market.

If these are short-term borrowings used for the creation of long-term assets and there is a fall in assert prices, the repayment problem starts. This is reminiscent of the East Asian crisis of 1997-1998 when many of the countries, including South Korea, lost most of their exchange reserves within days. The IMF intervened with special advances and also intervened with the major lending banks to stop their withdrawals.

IMF projections of GDP for eurozone countries for 2012 and 2013 do not give rise to any optimism that Europe will be anywhere near a recovery. The IMF table in the WEO April 2012 shows that the GDP of Italy, Spain, Greece and Portugal will be contracting. If their economies contract, their intra-European Union trade will also be affected. So will their trade with the US and other Asian countries. These countries have been chewing more than they can swallow by resorting to unrestricted borrowing to oil the wheels of their economies.

When trade contracts, then the liquid funds available in the international market also shrink. While this is one danger ,the fiscal and other tightening measures adopted by these countries may not last long in view of the hardships being endured by people accustomed to living on borrowed prosperity.

Spain has depression-like unemployment at 23 per cent, with almost 50 per cent of their youth looking for jobs. There are frequent violent clashes between the people who resist austerity measures and the governments.

A small country like Greece has faced immense problems trying to straighten out things through various fiscal and other measures. GDP is contracting in these countries, which is due to banks deleveraging and government belt-tightening. These countries have to generate some surplus each year to bring down the debt to manageable levels so that credibility is once again established. The surplus generated will first go to the repayment of debt contracted from the IMF and the European Fiscal Stability Facility. Investment for growth will be the last priority.

Coming to India, the Annual Report of the RBI 2010-2011 says that there are 37 bank branches in Europe of Indian banks, of which 30 are in the UK.

There are none in the most troubled economies of Greece, Spain, Portugal, and Italy. Credit exposure is also too limited to cause any immediate concern. The RBI is cautious, inasmuch as it says that the recession in Europe could lead to tightening of credit and the Indian corporate sector and banks may find it difficult to get refinance or rollover facilities from the European banks which may be deleveraging. Secondly, credit may become costly.

A further effect would be on trade, as purchasing power in these countries shrinks. Our exports to EU, which is about 36 per cent of the total exports, may take a hit. The ministry of commerce is doing a great job by diversifying our trade into other growing economies.

But this does not leave any scope for relaxation. An export drive has to be undertaken on a war footing. Subsidy on PDS kerosene should be through a cash transfer basis after the kerosene is sold at market price to the people below BPL. Subsidy on POL products, except PDS kerosene, should be withdrawn.

There is always a sympathetic vibration when a whole set of advanced countries goes into recession. Indian stock markets may react violently, though there may not be any logic in their concerns. New IPOs in India will probably get stalled. This will certainly affect investor sentiment and consequently the start-up of new projects.

There are no estimates available of Foreign Institutional Investors from these countries.

They may be required to pull out if they are to repay what they have borrowed from the EU banks for simple carry trade with India to gain advantage from the difference in the interest rate regimes. There could be a slowing down of Foreign Direct Investment from Europe. All these could cumulatively affect growth, but only to a small extent if we are able to get our domestic act together.

What has gone wrong recently with the announcement of several changes to the Income Tax Act 1961 to prevent evasion and black money is that government seems to have signalled that even its low-paid income tax officers will have the discretion to question with impunity anything and everything a company does or does not do.

It appears to be revenge for what previous governments did not do to prevent flight of capital. These changes give the impression that everyone is crooked and that IT officers are the divine interveners to prevent black money generation, when every other day one or other officer is taken into custody by the CBI for corruption.

This fear has affected business sentiment more than any fear of a potential recession in the EU countries. It is heartening to note in this context that the Finance Minister has postponed the enforcement of the GAAR provisions and put the onus of proving evasion on the revenue department.

FDI and foreign credit play an insignificant role in India’s growth. In the best of times they contribute no more than 2 per cent of GDP to total investment. So India can sustain a high rate of growth with internal demand and domestic savings if the economy is managed well and Indian investors are assured that they will not suffer anywhere.

But that assurance is what is missing. Even ordinary individuals have to become tax collectors under the new law whenever they sell or buy property more than Rs 20 lakh. This situation in India is what is going to affect its growth more than any recession in Europe. What is required of a government with a fractured mandate—such as UPA II—is to move major policy changes after a thorough discussion with the leaders of all parties in Parliament, and not adopt a confrontationist approach.

For example, everyone knows that allowing FDI in retail is ornamental. There is widespread criticism of Wal-Mart even in the US on its labour-hostile policies. There is no proof that it has done well by anybody.

The only objective is for an American corporation to spread its wings all over India, including in the rural areas. No Wal-Mart store deals extensively in agricultural products. If at all, it is less than 25 per cent of total sales.

Supporters of FDI in retail believe that these foreign retailers will establish cold chains, buy directly from the farmers, paying them a high price and also eliminate wastage as the singular benefit for India. This is unlikely.

They are not coming into India for the purpose of helping our farmers, but because they expect to benefit from them. Such complex issues are coming in the way of normal domestic investment.

As far as China is concerned, according to their figures they have a trade deficit with the EU27 amounting to €82 billion in 2011. Exports have come down from €128 billion in 2010 to a mere €82 billion in 2011.China will still manage a high growth rate if it allows domestic consumption to increase.

In any case, China will not fall below India’s growth rate in the immediate future given the autocratic decision-making process, and the political and national commitment to making China the greatest power in the world.

Moreover, China does not have infrastructure problems. Its interest rates and inflation levels are also lower and hence the Chinese have a major competitive advantage over India.

When Indian politicians refrain from playing politics with our economy perhaps we will still be able to grow comfortably at 7 per cent to 9 per cent per annum even if Europe goes into recession again.