The inconclusive Italian general election has brought to an end the uneasy calm that was prevailing in the global economy, snug in the belief that with the immediate tail risk being taken care of, the global economy would likely to do better this year than last.
In fact, the election result (potential second round of election looming large as Italy is being deemed ungovernable in certain quarters) reverberated throughout the world with its diverse impact on various assets classes. The Stoxx Europe 600 index and Italy’s FTSE MIB index dropped post the announcement of the results. Italian markets were further rattled by a weak government debt sale. The Treasury sold 8.75 billion euros ($11.5 billion) of six-month bills at higher borrowing costs (produced an average yield of 1.24% versus 0.73% in a late-January sale) and lower demand than at the late-January sale. According to Market Watch, post the announcement of the result, Italian government bonds sold off sharply in the secondary market, with the yield on Italy's 10-year bond rising by 0.28 percentage point at 4.73%. Elsewhere, the VIX (a measure of volatility and fear) rose sharply. Even the US stock market had its worst day since November while the Japanese stock market tanked. So did the Indian stock market. Clearly the mood of the global investors turned for the worse against risky assets.
On the other hand, the safe haven phenomenon was again back to the fore. Swiss Frank rose, as did Japanese Yen. In fact the Japanese stock market, which was gaining of late as investors banked on a weaker Yen pushing up Japanese exports, started to slide as Yen moved up.
The result of the Italian election is a clear indication that austerity fatigue has set in in Europe. The European voters have started to reject the policy that Germany and the ECB are trying to impose on the weak Eurozone countries. This is not just happening in Italy but other countries may well follow suit.
However it’s important to understand why things came to pass in the first place. The Italian economy has, for long, been facing structural constraints, the most debilitating of which is falling productivity and high labour cost. Prior to being part of the Euro Zone, Italy preferred to play the depreciation game with regard to their currency (i.e. Lira) to keep their competitiveness going rather than taking steps to correct the anomaly. Post their joining Euro (which resulted in them losing their monetary independence), they lost the most potent weapon and gradually fell by wayside. With high incidence of corruption resulting in humungous loss of revenue, the country kept on piling up the debt to keep their social spending going till water went over their head, that is. Hence, austerity and even potential bailout.
Sounds familiar? Think of India. Sure India is not there yet. India has a much better demography than Italy. India’s debt to GDP ratio is manageable. India is still growing ok and likely to grow better. But let’s not lose our sight from the potential danger. Politics driven social sector spending has created havoc with government finances. Although the pinch is not yet being felt, India is already courting trouble. Inept policy making continues to create structural impediments. Unlike some of its Asian peers, India does not have any further fiscal space left to stimulate the flagging economy. The structural impediments have resulted in persistently high inflation that has also ensured that India lacks monetary space. Now, we are getting into a situation of fiscal drag, or austerity measure if you please. With climbing deficit threatening to throw government finances out of gear, the finance minister (after having resorted to dubious means of accounting jugglery) was left with no other option but to cut expenses (after non-payment of oil subsidies failed to dent the burgeoning deficit). The austerity measure will impact India’s growth in the short-term.
What is even more worrying is that, as politics continue to rule the roost, the finance minister, in his effort to trim the expenses, is actually cutting down on the muscles (read capital expenditure) more than the flab (read wasteful social sector spending). Thus, not only will the growth be affected in the short-term, even the long-term growth potential will be hampered.
This desperate measure of resorting to austerity clearly shows India’s lack of foresight. India never bothered to right the wrongs when the going was good (read recording real growth rate of 9% plus) and hence forced to take restraining actions when the going became bad. This incapable policy making does not augur well for India. As mentioned earlier, India is not in as dire a strait as Italy and will possibly not be there for some more years to come, but unless they come out of this ineptitude and think of the economy (and the people) for a change, the potential dark days may not be very far ahead. But again given India’s penchant for reacting only during a crisis, do not bank too much on better sense to prevail, though short spurts of sensible decision-making would still be visible.