October has ushered in the conference season. The city’s hotels and of course the red-brick mecca of conferences, the India Habitat Centre, is thronging with suit-clad panel discussants clutching their dockets, brandishing their pen drives and generally looking earnest. I was privileged to have been invited to two last fortnight, one in faraway Bahrain organised by the International Institute of Strategic Studies with the theme ‘Power of Currencies and Currencies of Power’, and another in Delhi organised by Icrier on ‘Global Economic Cooperation—the views from G-20 countries’.
Not surprisingly, Europe’s crisis and the future of the euro got top billing at both conferences. There was a sizeable European presence at both the events. It was also perhaps not surprising that the Europeans (particularly those from government agencies) had a far more optimistic take on the situation in the continent than outside analysts and the financial markets.
Here’s what the European position seems to be. First, the euro project is alive and well. Policies put in place recently, such as the ratification of a permanent bailout facility — the European Stability Mechanism — and the open-ended bond buyback scheme of the European Central Bank called the Outright Market Transactions, have considerably reduced the possibility of an implosion in the region.
Their optimism is not based on these somewhat aggressive policy initiatives alone. Their claim is that there is enough data to support the fact that things are getting better for the euro zone periphery and one just has to look closely enough at the numbers to appreciate this. Let’s take a couple of examples.
The budget deficit in the euro area may go down from 6.4 per cent in 2009 to a (forecasted) level of 3.2 per cent in 2012. This is driven principally by massive reduction in the deficit in the distressed southern European economies like Spain and Portugal. Thus, the “austerity” agenda seems to be well on track. The current account deficits for the region have also showed marked improvement. Spain’s deficit, for instance, is down from 9.6 per cent to two per cent; Greece down from 17.9 per cent to 7.8 per cent. European analysts are quick to point out that this reduction in the deficits is not just the result of a collapse in growth that has reined in imports. There has actually been steady growth in exports across the region.
The final claim is that the periphery is becoming sharply more competitive with unit labour costs plunging in countries like Ireland and Greece. This is bringing about the much needed ‘internal rebalancing’ in the region that economists had been clamouring for.
The European view is of course in sharp contrast to the prognosis for Europe that agencies like the International Monetary Fund and large sections of the financial markets have. Indeed, the recently released World Economic Outlook (WEO) and the Global Financial Stability Report have a particularly dire prognosis for Europe and its currency. To quote the WEO, “The possibility that the euro area crisis will escalate remains a major downside risk to growth and financial sector stability”.
How can perceptions be so dramatically different? It’s perhaps a question of which macroeconomic variables one chooses to focus on. There are two things that are somewhat conspicuously absent from the European defence — a comprehensive discussion on the growth numbers from the region or a recognition that there is indeed a nexus between austerity (call it fiscal compression if you like) and deceleration. The Europeans seem hung up on the fact that a fiscal clean-up will improve long-term ‘structural’ growth progress but choose to remain silent on the fact that there is a short-term relationship between the ‘cyclical’ component of growth and fiscal policy.
Growth and fiscal compression are two (among others) issues that the IMF takes up in detail in its recent reports. As the agency’s forecasts show, the entire European region (with the exception of Ireland) is likely to be in recession in 2012. Recovery, if any, is likely to be tepid in 2013. Second, “fiscal multipliers” are strong, another way of saying austerity could hit growth hard. Finally, the “broad interconnections” between the economies in Europe means the spillovers of trouble in any one part of the region is much larger than in any other region.
Is it possible to reconcile the two views? One way is to just focus on the euro’s exchange rate. The fact that it is currently trading at around 1.28-1.29 to the US dollar (when just about six months back a number of analysts were predicting parity ) suggests the markets recognise both the improvement in the improvements and see the policy moves as credible and effective. However, the fact that the rally in the euro has petered out and the currency sells off on the faintest whiff of bad news suggests that much more needs to be done before any permanent stability returns to the region. The risk is that European policymakers get carried away by their current achievements and go slow on the next set of policy reforms. To quote the IMF’s WEO again, “The most immediate risk remains that insufficient or delayed policy action could lead to further escalation of the euro area crisis.”
The author is with HDFC Bank. These views are personal