July 2010

EconomyView

European Sovereign Debt Crisis:

What Does It Mean For India?
Analytical Contact :

Vidya Mahambare

vmahamare@crisil.com

Introduction
As the global economic crisis intensified after October 2008,
governments across the world began to resort to expansionary
fiscal policy to boost fading domestic demand. As government
expenditures rose in most of the countries and taxes were cut,
fiscal deficits began to rise rapidly. In turn, the financial markets
started to factor in the possibility of the sovereign debt crisis and
by October 2009, the risk premium for sovereign debt for some
European countries had shot up sharply suggesting that financial
markets had ceased to believe that these countries could repay their
short term debt obligations.
For now, the crisis has been contained within Europe. However, the
risk remains that significant deterioration of the crisis would result
in a loss of confidence, and once again cripple financial markets

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Table1: Vulnerability Indicators for sovereign

as well as the real economy thereby posing a serious threat to a

fragile global recovery. A double-dip recession in Europe would
have severe adverse implications for the rest of the world with a
little room for further monetary and fiscal stimulus.
This article reviews the underlying causes of the European sovereign
debt crisis and analyses the implications of intensification of the
European crisis for the Indian economy.

Greece
Portugal
Ireland
Italy
Spain
UK
US

The crisis in the making: The background

In October 2009 Greece revised the projected fiscal deficit for 2009
from the initial estimate of around 5per cent to 12.5per cent of
GDP which was subsequently revised to 13.6per cent in April 2010
(fig 1). Such drastic and frequent upward revisions of the deficit
of the GDP ratio were rare for any other country even during the
times of crisis. Greeces poor track record of (not) maintaining the
fiscal deficit within the stipulated limits as per the European Union
(EU) rules as well as a history of making upward revisions made
the situation worse. With the loss of credibility, the cost of Greek
government borrowing began to rise sharply, precipitating the crisis
which has been in the making since Greece joined EU.

Budget
deficit
2010 (per
cent GDP)
-12.2
-8.0
-14.7
-5.3
-10.1
-12.9
-12.5

Debtto-GDP,
2010
124.9
84.6
82.6
116.7
66.3
80.3
93.6

External Short-term Current

Debt (per debt (per account
cent debt) cent GDP) 2010 (per
cent GDP)
77.5
20.8
-10.0
73.8
22.6
-9.9
57.2
47.3
-1.7
49.0
5.7
-2.5
37.0
5.8
-6.0
22.1
3.3
-2.0
26.4
8.3
-2.6

Source: OECD, 2010

In addition to a large fiscal deficit, Greece has also been running
a high current account deficit (table 1) as a result of high import
growth and relatively sluggish exports growth. Countries running
twin deficits with low domestic savings rate were hit hard during
the crisis as foreign capital dried up, thereby making the funding
of their deficits vulnerable.

After joining the EU in 2000, even then by

falsifying the fiscal deficit numbers to meet the
criteria of EU membership, Greeces economic
growth rose due to access to lower interest rates.
The government deficit appeared to have stabilized,
but even then financing of the deficit was a problem due to the low
level of domestic savings. Since 1990s, the national savings rate
has averaged just 11per cent while that for Portugal and Spain was
around 20per cent. The reliance on external debt to finance public
deficit therefore, rose sharply (table 1) and over three-fourth of it
is held by European banks, mainly German and French.
Crisis of
liquidity,
solvency and
credibility

In April 2010, Greeces credit rating was downgraded, worsening

investors confidence on the economy. This raised fears that Greeces
problem will infect other Euro zone economies, especially the weaker
members like Portugal, Ireland and Spain. As a result, the 16 nations
sharing the euro currency came up with an emergency rescue plan
of US$1 trillion on May 9, 2010 to prevent the crisis from spreading
through the region and to keep the euro currency from imploding.
The package included loans, guarantees, bond purchases and US$ 318
billion of assistance from the International Monetary Fund (IMF).

Impact on India

Fig 1: Fiscal deficit/GDP (per cent debt)

There are five principal channels through which

Significant trade
the developments in Europe can percolate to the
and financial
linkages between Indian economy (figure 2). Those channels are:
India
and Europe

trade
currency
investment
banking
commodity price

Some of these channels are interlinked and work simultaneously

to compound the impact of individual channels. For example, both
the trade and banking channels could interact due to the interaction
between international trade activity and trade credit as well as
commercial borrowing.

Source: OECD, 2010

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Fig 2: The transmission of European crisis to the Indian economy
Trade Channel

Merchandise exports

IT/ITES exports

Currency Channel

Export
competitiveness

Profit margins

Investment Channel

Capital inflow

M&A

Banking Channel

International exposure

Borrowing cost

Commodity Price
Channel

Crude oil prices

Metals and other raw

material

Among the major sectors (graph 3), the European share in

the exports of readymade garments, machinery and chemicals
are significant. Among the commercial services, around 25per
cent exports of IT/ITES services are to European countries,
but the exposure to the worst affected countries is relatively
less. The UK followed by Germany account
Readymade
for a significant part of the total demand for
garments and
IT/ITES could software exports and a sharp contraction in
witness an
these economies would have an adverse impact
adverse impact
on demand for software exports.
Graph 3: Sector-wise exports to Europe

Source: CRISIL
1) Trade channel - The trade channel is expected to work through
the impact of the European crisis on exports and imports of
merchandise goods and commercial services. India exports to EU,
especially to the countries worst affected by the crisis is expected
to slow down in the near term. As European countries cut back
deficits to meet the 3 per cent limit under the EU regulations,
Europes export demand could take a hit until private demand
picks up sufficiently. Around one-fifth of Indias merchandise
exports and around 10 per cent of Indias commercial services
exports are to EU 27 countries. However, the share of the countries
worst affected by the crisis Greece, Ireland, Portugal, and Spain
is relatively low (table 1). Most Indian exports to Europe go to
larger European economies such as Germany, France and the
UK and thus, the crisis in the smaller countries would not be felt
much by the Indian exporters. However, if European crisis spreads
across the continent, then trade with other European partners is
also likely to be affected.

Source: Ministry of Commerce

2) Currency channel Apart from its adverse impact on
export demand, the intensifi cation of crisis in Europe is
expected to lead to further depreciation of Euro against
the major world currencies including the Rupee (graph 4).
In such a scenario the profi t margins of India exporters
would be negatively impacted in the coming months. In
contrast, imports would be relatively cheaper and Indian
importers, especially of machinery and equipment from the
European countries would benefit. The appreciation of the
Rupee could also undermine Indias export competitiveness.
However, its negative impact is likely to be muted since
currencies of other major emerging markets which compete
with India in the similar export markets are also likely to
witness appreciation.

Table 1
Vulnerability ranking
Greece
Portugal
Spain
Ireland
Italy
France
UK
Germany
Source: Euro stat

International trade with Europe

Exports
Imports
2008-2009 % Share 2008-2009 % Share
878
0.47
69
0.02
440
0.24
57
0.02
2538
1.37
1024
0.34
450
0.24
239
0.08
3825
2.06
4428
1.46
3021
1.63
4632
1.53
6650
3.59
5872
1.93
6389
3.45
12006
3.95

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Graph 4: Currency movements - Rs per unit of foreign currency

Graph 5: Portfolio capital movements

Source: RBI

Source: RBI
forward, the volatility of the stock market would also increase.
The number of initial public offerings (IPOs) in the private sector
as well as the disinvestment programme of public sector units
could witness a slowdown. Similarly, resources mobilised through
ADRs/GDR and the private placements market which has been
major alternative sources of funding for Indian corporates in the
recent years should remain muted until the uncertainty about the
European crisis continues.

Investment channel The on-going crisis in

Europe should benefit foreign capital flows in
emerging markets in the medium term. The crisis
has altered perceptions on risk and return in
developed countries relative to emerging markets.
The favorable performance of the emerging
market assets relative to mature market assets has prompted growing
interest by global investors in raising their asset allocations to
emerging markets and other advanced economies. Portfolio capital
inflows in emerging markets including India, should increase in
the medium term.
Portfolio inflow
and thereby
currency &
equity market to
remain volatile

Apart from its impact on portfolio capital inflow, the European

debt crisis could also affect the European involvement in the Indian
corporate sectors mergers and acquisitions (M&A) activity. During
the last few years, European companies have emerged as significant
partners for Indias in-bound and out-bound M&A (graph 6 and
7). With European economies remaining sluggish, the appetite of
European companies for M&A in emerging markets including India
is expected to decline. However, for the Indian corporates, this
crisis could present an opportunity to acquire European companies
at lower valuations.

While the trend of appreciation of the Rupee should continue in

the medium run, with increased risk aversion the Forex market is
expected to witness increased volatility in the immediate future.
As uncertainty remains about the sovereign debt crisis engulfing
the Eurozone, portfolio capital would remain volatile due to
capital flight into safe havens like US treasury securities. In fact,
portfolio capital recorded net outflow of US$ 1.5 billion in May
2010 before recovering to net inflow of US$ 2.4 billion in June
2010 (graph 5).

European
participation in
M&A activity to
slow down

With the volatile foreign investment, the volatility in exchange

rate, measured in terms of the difference between high and low
would remain elevated in the coming months. Similarly, going

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During the recent global economic crisis it has

been observed that the investment channel has
assumed a more dominant role in transmitting
the effects of global developments in the Indian
economy during recent periods.

July 2010
Graph 6: Per cent share in-bound acquisitions in India, 2000-07

Graph 7: Per cent share out-bound acquisitions of India, 2000-07

Source: UNESCAP, 2010

corporate sector might increase if the alternative sources
of funds such as external commercial borrowings become
difficult in the months ahead (graph 9). The international
banks may once again get guarded on their lending activities
and companies may find it difficult to raise capital in
the European fi nancial markets. Also, the increased risk
averseness of the lenders would raise the base lending rate of
London Interbank offered rate (LIBOR) as well the premium
leading to higher borrowing costs for the corporate sector.
The lack of alternat ive resources for funding investment
of the corporate sector may raise deamnd for and the price
of bank credit in the domestic banking system.

3) Banking channel The banking sector in India, as in

most of the emerging market economies (EMEs), displayed
resilience during the global financial meltdown which began
in the late 2007. The Indian banks remain relatively wellcapitalised with greater exposure to domestic conventional
assets. Even with the on-going European crisis, the direct
effects on the Indian banking and financial system should
remain negligible as the direct exposure of Indian banks to
Europe, excluding the United Kingdom is relatively low
(graph 8).
Although the Indian banking system would not come under
the direct stress, the lending requirement of the Indian

Graph 8: Exposure of Indian banks to Europe end-Dec 2009

Source: BIS

Graph 9: International borrowings of Indian corporate sector, Dec 2009

Source: BIS

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Summary

4) The commodity Price channel Global commodity

prices affect price of imports and cost of
Low direct
production. Before the global economic
exposure of
crisis the prices of commodities such as
Indian banks to
crude oil and primary commodities surged
Europe
significantly due to soaring demand and
supply-side constraint. Apart from straining the balance of
payments situation, sustained high commodity prices generate
inflationary pressures through elevated import prices. In India,
oil imports, which constitute a large part of total imports,
are critical input for real activities. Oil imports in India are
relatively price inelastic and, hence, are highly correlated with
their prices. The crude oil prices of the Indian basket peaked at
US$ 147 per barrel in July 2008. The global crisis, however,
drastically reduced the demand for these commodities globally
and their prices fell sharply. In the current episode, the troubles
in Europe initially resulted in the drop in the price of oil and
going forward, the oil price is not expected to rise sharply until
the uncertainty about the European crisis persists which should
result in savings for Indias oil import bill

Despite the likely adverse impact of the European troubles on

the Indian economy, Indias recovery from the 2008 financial
crisis is unlikely to be derailed by the European debt crisis,
albeit it may be temporarily slow in certain sectors. However,
if European crisis to spreads to the other parts of developed
world, especially the US, it would threaten the global economic
recovery currently underway. In such a scenario, the economies
of emerging markets including India would come under stress
once again.
But what are the lessons from the European crisis? Excessive
debt build-up without a credible solution comes with a heavy
penalty in the future. Although it is encouraging to see that
despite the fact that Indias fiscal economic is nowhere near that
of the troubled European economies, the Indian government has
already ventured on the path of fiscal consolidation before things
become difficult. Apart from cutting public expenditure and to
introduce measures to increase the efficiency in tax collection,
the emerging countries such as India must find ways to minimize
the big subsidy bill that is incurred every year. The most recent
policy change in the terms of deregulation of retail fuel prices
is a step in the right direction.

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