Greek crisis? China slowdown? How global macro affects you

By Arjun Parthasarathy

The US, China, Greece, Italy, Portugal and other eurozone countries are all contributing to market sentiments at present. Domestic investors in equities have already been impacted by domestic issues such as the spectrum allocation scam, inflation and rising interest rates; now they have to contend with global issues as well. Domestic and global headwinds are increasing nervousness amongst investors.

In order to overcome market fears, investors have to understand the causes and effects of global macro developments on Indian markets. It is true that global macro drives market sentiment in India, due to the large foreign institutional investor (FII) presence.[caption id=“attachment_40107” align=“alignleft” width=“380” caption=“A deepening crisis. Getty Images”] [/caption]

The FIIs have cumulatively invested around Rs 4,40,000 crore in the Indian equity market, which constitutes around 20% of the free float market capitalisation of the equity market. Hence, reading into and deciphering global macro issues becomes important.

The current global macro issues are: a) Chinese inflation and Chinese local government debt; b) Over-indebtedness in a few eurozone countries; and c) US unemployment and US debt issues. Let’s take each issue by turn.

Chinese inflation and local government debt: China raised its benchmark interest rates for the third time this year. The People’s Bank of China raised one-year deposit rates from 3.25% to 3.5% on 6 July. China raised rates to counteract inflation, which came in at 6.4% for June 2011 against 5.5% for May 2011. Inflation is running at a three-year high and the government is worried about the effects of inflation on its large population.

The rate hike comes at a time when there are concerns over Chinese banks’ exposure to local government debt. China’s local government debt was placed at US$ 1.7 trillion, while Moody’s estimates that it is a third higher by US$ 540 billion.

Defaults by local governments on their debt will place China’s banks in trouble. Worries on local government debt will bring down investment activity in China, leading to slower investment-led growth. Investment spending contributes to almost 50% of China’s GDP.

Why we should worry: China’s growth slowdown is both a positive and a negative for the Indian economy. On the one hand, if China slows down commodity prices will fall, as China is the largest buyer of commodities in the world. On the other hand, global growth suffers, as China is the largest trading partner of many countries, including Japan.

A Chinese slowdown means China can also flood the global market with cheap goods due to the excess capacity it has. Indian manufacturing will have more severe competition. Inflation will come off due to a slowdown in China’s growth and this is good for the economy.

Indebtedness in eurozone countries: A few eurozone countries such as Greece, Portugal, Ireland, Spain, Italy and Belgium are all running large debt-to-GDP ratios. The gross debt to GDP ratio ranges from 140% for Greece to 92% for Italy. All these countries belong to the euro currency area and the debt is denominated in euros. The holders of these countries’ debt are predominantly European banks, pension and trust funds.

Given that these countries run large sovereign debts, and these countries are facing a sharp drop in economic growth due to the inability of governments to spend, there is a serious issue of default by the countries on their debt. Since the debt is denominated in euros, governments cannot print money to pay back debt holders. Debt defaults will force European banks to make provisions on their investments, leading to a sharp fall in the valuations of these banks.

India is relatively safe from eurozone debt issues as a) India’s debt is denominated in Indian rupees and the government can print money to pay back debt holders; b) India’s debt-to-GDP (centre plus states) ratio is around 73% (2010-11) and the country is growing at a nominal rate (real GDP growth plus inflation) of around 14% and servicing the debt is currently not an issue.

But why we should still worry: Indian banks do not have exposure to European government debt and banks are safe from defaults. Indian will not be directly affected by debt defaults by eurozone countries but sentiments and global investor risk appetite will affect Indian markets.

**US unemployment and debt issues:**The US unemployment rate came in at 9.2% for June 2011, the high for this calendar year. The rate has actually fallen from close to 10% levels seen 15 months ago, but is still considered negative by policymakers in the US. High unemployment and sluggish jobs growth (18,000 jobs added in June, the slowest in eight months) portends an economy that will grow at a slow pace.

The US has reached it maximum level of debt at US$ 14.3 trillion, and has to increase the ceiling to pay back debt maturing in August. The debate on increasing the debt ceiling is going on.If the US increases the debt ceiling with committed increases in revenues though spending cuts and tax hikes, it is not good for the US economy as the economy will face a slowdown given its high unemployment levels.

Why we should worry: Slow growth in the US economy will prompt the US Federal Reserve (Fed) to support the economy through ultra accommodative monetary policy. The Fed will embark on a third round of government bond purchases, which will infuse liquidity into the markets. An accommodative monetary policy by the Fed will benefit India as liquidity will flow into the country due to its higher growth rates. It also helps our exporters and software companies earn more from North America. However, it can also be inflationary in nature.

Global macro is both positive and negative for India. If the domestic issues on scams, inflation and rate hikes are resolved sooner than later, Indian market can do well despite global issues.

The author is editor www.investorsareidiots.com, a financial web site for investors.