A study on FDI in India and impact of Euro Crisis on it

Abstract

This report is a study on the European Sovereign Debt crisis which seemed to have started in late 2009 and is running till date. The fears of this debt crisis developed because of rising amount of borrowings by governments around the world and this was further escalated by the downgrading some European government bonds. The report begins with a survey of the major financial crisis in the world and an attempt to find a unifying theme acting as cause for all these these crises. These included the German Hyperinflation, The Great Depression, Japanese Asset Price Bubble, Dot Com bubble, Asian Financial Crisis, Russian Financial Crisis and the Argentinian Economic Crisis. Although the visible elements of the Euro zone crisis started stirring up in late 2009, there were multiple events in the timeline of history which built the crisis brick by brick. The section on timeline describes various critical events in chronological order such as Formation of the European Union and the Euro zone, declarations by Greece on misrepresentations of earlier announced economic positions and the downgrade of credit ratings. There were also other important events which were an attempt to provide relief to the current situation such as announcement of bailout packages by various institutions, establishment of European Financial Stability Facility, support pledged by countries such as Germany and France, and the suggestion of ‘Haircut’ plan. The complexity of the Eurozone crisis and the ineffectiveness of multiple attempts to find a solution lie in the multiple causes behind this problem. The Government and household debts and Trade imbalance levels are much higher than the threshold values set by Eurozone committee. The high level of interest rate and low GDP growth rate make it extremely hard to bring down these levels within the acceptable limit. Then there is the problem of Structural imbalances – Eurozone countries have a unified monetary policy but independent Fiscal policy which brings in implementation issues. In event of economic downturn, the Eurozone countries have only Fiscal policy tool at their disposal. Thus, without monetary flexibility they have to resort to making tough trade-offs between interest rate, output and trade balance. Again, the unified monetary policy brings introduces moral hazard issues by weaker economies which have improper utilization of funds and the responsibility to guarantee against default had to be borne by stronger economies such as Germany and France. There is also the problem of loss of confidence among investors which has escalated the risk premium. The European crisis will have far reaching effects across the world owing to the strongly intertwined nature of economies. Outside of Europe, the economy of United States would be hit most severely owning to its trade dependence with Europe, close integration of Capital markets and exposure of American banks to European Debts. However the effect on BRIC economies is moderate. Initially the stock markets of these countries grew because of movement of investors here but the trend flattened towards 2011. The European crisis compared to US Subprime crisis, which happened a couple of years before it, shows considerable similarities and difference between the two. Both the crises were initially believed to be liquidity issues and both of them were highly contagious because of the inter-linkages between global economies. In both cases, the credit rating agencies gave fake AAA ratings to the junk debts and financial products and there was distress selling when the actual situation was realized. However, the origin of both situations was quite different. In case of sub-prime crisis it was the households who resorted to excessive borrowings whereas in the Eurozone case it was Governments which did over expenditure. The sub-prime crisis required only financial bailouts whereas the Eurozone crisis needs revival of investor confidence along with bailout packages. Owing to the complex nature of the Crisis involving multiple intertwined economies, there would not be an easy and holistic solution to the problem. The solutions suggested by economists and politicians fall into two categories – those involving break-up of Euro zone and those without the break-up. The first category consists of suggested solutions like strong countries exiting from Euro zone and creating their own currency allowing weaker countries to devaluate their currency. Another solution suggests only Greece to exit and devalue its currency sharply. The solutions involving Eurozone to stay intact involve steps such as differential inflation target by ECB, sever austerity measures, renewal of investor by purchase of Spanish & Italian bonds, establishment of ‘Lender of Last Resort’, establishment of Central supervisory authorities etc.