If Europe sneezes, India could catch a cold

Both capital flows and GDP growth face risks if the European crisis escalates

The ‘risk-on’ party is over. After a dream run, equity markets are back to staring at a renewed crisis in Europe. At the start of the calendar year, a semblance of normalcy returned to the euro zone after the member states signed a pact on fiscal discipline. This was followed by the European Central Bank infusing $1 trillion through a Long-Term Refinancing Option (LTRO) into the banking system, at one per cent for three years. Two rounds of LTRO temporarily averted a liquidity crunch and helped support sovereign bond yields. With the infusion of new funds, world markets returned to a “risk-on” mode.

 

But data released since then have been far from encouraging. According to a note by Religare Macquarie Private Wealth, “None of this addresses the underlying solvency concerns. As the initial euphoria faded, investors started focusing on the uncertain outlook for many euro area countries.” Unemployment is at a record high and the composite purchasing manager’s index for manufacturing and services fell to 46.7 in April from 49.1 in March. The austerity moves are not going down well with the people. Given that the spectre of a European crisis is looming large again, should India worry?

If there is a meltdown in Europe, India will face the heat in more ways than one. Analysts say the return of risk aversion would see a reversal in capital flows. India is largely dependent on capital flows to fund its current account deficit and a reversal in flows could aggravate the fragile external situation. From Rs 40,000 crore in the first three months of 2012, foreign institutional investments have become a trickle in April (negative Rs 568 crore) and May so far (Rs 451 crore). India’s General Anti-Avoidance Rule proposal has not helped either.

A sensitivity analysis of India’s vulnerability to such shocks suggests the transmission of European shocks to India would be multifaceted. Dhananjay Sinha, economist and strategist at Emkay Global, says: “Given the synchronous economic cycles during the 2000 decade, the vulnerability of Indian growth is expected to be high. Based on the sensitivity analysis, India will continue to show positive gross domestic product (GDP) growth, unless European GDP contracts by over five per cent. A zero-growth scenario for Europe will imply that Indian GDP could decline by 140 basis points.”

Market estimates say growth in Europe could be flat, implying India’s GDP growth will also feel the heat. The current composition of the export basket also suggests India is far more vulnerable to a slowdown in Europe than the US, explains Sinha.