The Finance Minister, Mr Pranab Mukherjee's recent remarks at the World Bank Development Committee meeting would seem to echo the sentiments of emerging economies, particularly India. It may not be right to say, as expressed by analysts and experts, that the crisis in Europe will have next to no impact on the Indian economy. Though the Emerging Markets (EMs) such as China and India managed well after the collapse of Lehman Brothers, with the right policy stimulants to boost domestic demand, the expected double dip due to European mess-up would be much more difficult to handle. Unlike the global financial crisis of 2008, the situation looks more worrisome for the world economy due to problems in several countries.

China's overheating and signs of slowdown, India's trade-off with growth to fight inflation, weak US markets due to downgrading of sovereign debt and efforts to cut government spending, and Japan's negative growth scenario due to the impact of the tsunami, have resulted in an overall fall in investors' and consumers' confidence across countries.

WHY THE PRESENT CRISIS

Sustained budget deficits and high government debt without structural reforms to improve productivity growth in peripheral European countries led by Greece, Ireland, Portugal and also Spain, is a major reason for the current crisis. The other, more significant, reason is investors deserting these troubled European countries during the 2008 crisis. After the Euro was introduced as a common currency in 1999, investors in rich and core European countries found it very attractive to buy assets in these countries. The huge capital inflows created high current account deficit, adding to already high fiscal deficits. The simultaneous twin deficits were manageable so long as there were huge capital inflows, but sudden stop of capital inflows and investors' decision to dump government bonds created the present sovereign debt crisis.

In fact, three of the Eurozone's bonds have been downgraded to junk status and this contagion effect on European banks might just take world economy to another crisis.

The Euro was created to unify market in Europe and create better investment opportunities. But somewhere, the European Union failed to stamp its authority on these countries to follow structural reforms and adhere to tight fiscal discipline. Thus, the present danger to the Euro is the Euro itself.

INFUSION OF FUNDS

Coordinated efforts led by rich European countries such as Germany, the Netherlands along with G-20 countries are urgently required to rescue Greece, Ireland, Portugal and help investors get back their confidence, thereby averting a banking collapse in Europe. It's a matter of saving the euro as an international currency and also the world economy from going into a recession.. In this context, G-20 countries including EMs assuring help to international financial institutions is a welcome step. During a crisis, many stressed economies need funds to stabilise domestic demand and financial markets, though this will put added pressure on bank funds.

Though in the near future, multilateral financial institutions and developed countries along with EMs may rescue and bail out the eurozone countries, the long-term plan should be to bring these economies into a growth path led by structural reforms and liberalisation. Labour market inefficiencies and lack of competitiveness have been prominent features for long of many of these European countries.

EFFECT ON INDIA

In the event of a collapse of European banks, the supply of foreign credit to EMs will dry up. That will add to the pressure on investment spending in EMs, already struggling with high capital costs due to a tight monetary policy.

Therefore, it is imperative that the EMs including India look inward and boost domestic demand to compensate for the shrinking world market.

Europe is one of the largest trading blocs for India. The austerity measures by European countries and falling consumer expenditures may affect exports, more so services exports from India. Though China is India's largest trading partner, it mostly imports raw materials for finished products for the rest of the world, which is down and staring at a recession, be it Europe, US or Japan.

If European banks become insolvent, capital will fly back, leading to a sharp depreciation of the rupee which is already weak. Given the higher intra-industry trade today than before and the high import intensity of Indian exports, a falling rupee would hurt industries and their profit margins both within and outside the country.

But every crisis is an opportunity in disguise. Policymakers in India need to maintain domestic demand and work towards gaining investors' confidence. Governments must explore and focus on export markets such as Africa and the Asean and continue to reduce its dependence on Europe and the United States. The government may consider giving special tax incentives to exporters to Europe and US to help them retain their competitiveness and share in these markets.

Some of the pending reforms, whether it is FDI in retail, labour reforms, financial and insurance sector reforms, need to be pushed to keep the growth and investment momentum going. It's time to show that India is a safe haven for investment, and for that we need bold reforms, which will improve overall competitiveness.

(The author is an Associate Professor and visiting researcher at the Institute of Economic Growth and East West Centre University, respectively.)

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