Opinion The silver (and oil) lining

While Germany is taking these emergency measures to prevent the “entire financial system from becoming endangered”,the global market is clearly reading this as a panic-ridden move. Many leading financial analysts have described the German regulator’s step as a serious mistake. It appears to be an impossible attempt to “control financial markets across the globe just as they also plead investors to provide more funding.”   

Now,there is this fear among global investors that something is fundamentally wrong in the EU which is still hidden from everyone. This is what has led to the euro going for a tailspin.

Germany’s move appears to be motivated by two clear objectives. As the engine of EU it has the responsibility of pulling together the weaker European economies in this crisis period. The fundamental weaknesses seen in Greece and other EU economies are already threatening to tear asunder the monetary union. The bearish sentiment gets even more acute when bigger economies like the UK start resembling the smaller ones with grave structural problems.

The second aspect of Germany’s move is to prevent the toxicity of other weak economies flowing into its own through a financial markets contagion. Therefore the regulator has also banned the short sale of shares of some top German banks who are large traders of sovereign debt. The regulator also does not want CDSs from the rest of the eurozone to become a liability of German entities. All the defaults in housing loans originating in Greece,Spain,Italy,Ireland,etc could get pushed into German financial entities. This seems to have motivated the ban on trading of CDS.

At a broader level,the current eurozone crisis masks a deeper structural malaise that an aging Europe will have to deal with in the decades ahead. Unemployment levels as high as 20 per cent-plus exist in some European economies because the labour markets have also become very rigid even as future growth potential has declined. Mobility of labour is possibly the weakest in the eurozone. This,in turn,affects mobility of capital.

The Economist has argued that long-term structural weaknesses in the labour markets have also set in,in the US economy. People stay unemployed for much longer periods now after losing their job. In spite of this,labour is much more mobile in the US compared with what one sees in the EU.

The government debt in the EU is mounting at a much faster pace than its GDP. This is happening because Europe has to take care of the welfare needs of an aging population. Since GDP is not growing at a commensurate pace,the debt-to-GDP ratios are mounting in many economies,running at well over 100 per cent. In fact,the aggregate of government,corporate and household debt in many euro economies had exceeded 300 per cent in recent times. The global financial markets have also figured that there is no automatic bailout mechanism for economies that are so weak structurally. So the markets tend to become more severe in creating selling pressure on bonds and currency.

What are the lessons for India from the crisis in Europe today? The positive outcome of the crisis is that global commodity prices,especially oil,have moderated considerably. Crude oil,which touched $ 87 some months ago,has fallen about 18 per cent. High oil prices were actually threatening to derail India’s fiscal consolidation programme. An average crude price of over $ 82 a barrel,which seemed plausible until last month,would have caused a fiscal deficit slippage of over 2 per cent of GDP. This would have created a disruption in the government borrowing programme,driving up interest rates further.

Of course,high commodity prices also heighten inflationary expectations and cause various other policy distortions,as a consequence. Immediately after the Wall Street collapse in September 2008,I had argued that the net impact on India in the medium term would be positive as we are a predominantly commodity-importing country. So it is good for India if the current European crisis results in a sustained moderation of oil and other commodity prices.

The falling euro and the need to attract global investors into the EU will also result in interest rates going up in the eurozone. Besides,the IMF will insist that excessively cheap money is not going to help the euro economies recover. This will be another positive because it is cheap money which has been distorting the global commodity markets,especially oil,in recent times. Many experts believe that on the basis of actual demand on the ground,crude oil should be no more than $ 70 a barrel. Anything beyond that is purely speculative. In this regard,the substantial fall in property and stock prices in China,a result of the massive overinvestment in the last two years,is also good news. Much of the speculation on oil and other commodities was riding on the assumption that China would continue to guzzle them. That is also getting moderated as the Chinese economy is cooling off.

For India this is good news provided our policymakers continue some of the structural reforms to better harness India’s inherent strengths — the domestic growth story — as against the weaknesses that plague much of the developed world.

The writer is Managing Editor,‘The Financial Express’

mk.venu@expressindia.com