Mc Donalds.. Project

7/31/2019 Mc Donalds.. Project

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2012

16/04/2012

Impact Of European Crisis on

International Business

Submitted By:

1. Vikas Sharma2. Sugandha Sharma3. Rahul Kathuria

Global Business

Enviornment1

Submitted to:

Dr. Piyush Verma

Asst Professor

LMTSOM, Thapar University

Patiala

LMTSOM, Thapar University

Patiala


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Acknowledgement

With deep sense of gratitude, we acknowledge the encouragement we have received from Dr.

Piyush Verma and for giving us the help to do this useful assignment. We would also thank

him for his guidance and suggestions throughout our dissertation work, which has been of

immense value in successful completion of our work.

Finally we will like to thank all individuals including our friends and family members who

has co-operated and helped us for completing the project work in time and provide

confidence and timely motivation.

Place: Patiala Group Members:

Dated: April 16, 2012 Vikas Sharma 501104027

Sugandha Sharma 501104026

Rahul Kathuria 501104019

(MBA IIIrd TRIMESTER)


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The Euro zone officially called the Euro area, is an economic and monetary union (EMU) of

17 European Union (EU) member states that have adopted the euro () as their common

currency and sole legal tender.

The Euro zone currently consists of:

Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy,

Luxembourg, Malta, Netherlands, Portugal, Slovenia, and Spain. Most other EU states are

obliged to join once they meet the criteria to do so. No state has left and there are no

provisions to do so or to be expelled.

Monetary policy of the zone is the responsibility of the European Central Bank (ECB) which

is governed by a president and a board of the heads of national central banks. The principal

task of the ECB is to keep inflation under control. Though there is no common

representation, governance or fiscal policy for the currency union, some co-operation does

take place through the Euro Group, which makes political decisions regarding the euro zoneand the euro. The Euro Group is composed of the finance ministers of euro zone states,

however in emergency; national leaders also form the Euro Group.

Since the late-2000s financial crisis, the euro zone has established and used provisions for

granting emergency loans to member states in return for the enactment of economic reforms.

The euro zone has also enacted some limited fiscal integration, for example in peer review of

each other's national budgets. The issue is highly political and in a state of flux as of 2011 in

terms of what further provisions will be agreed for euro zone reform.

On occasion the euro zone is taken to include non-EU members who use the euro as theirofficial currency. Some of these countries, like San Marino have concluded formal

agreements with the EU to use the currency and mint their own coins. Others, like Kosovo

and Montenegro have adopted the euro unilaterally. However, these countries do not formally

form part of the euro zone and do not have representation in the ECB or the Euro Group

EUROZONE CRISIS:

From late 2009, fears of a sovereign debt crisis developed among investors as a result of the

rising government debt levels around the world together with a wave of downgrading of

government debt in some European states. Concerns intensified in early 2010 and thereafterleading, Europe's finance ministers on 9 May 2010 to approve a rescue package

worth750 billion aimed at ensuring financial stability across Europe by creating

the European Financial Stability Facility (EFSF). In October 2011 and February 2012,

the euro zone leaders agreed on more measures designed to prevent the collapse of member

economies. This included an agreement whereby banks would accept a 53.5% write-off

of Greek debt owed to private creditors increasing the EFSF to about 1 trillion, and

requiring European banks to achieve 9% capitalisation To restore confidence in Europe, EU

leaders also agreed to create a common fiscal union including the commitment of each

participating country to introduce a balanced budget amendment.
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While sovereign debt has risen substantially in only a few Euro zone countries, it has become

a perceived problem for the area as a whole. Nevertheless, the European currency has

remained stable. As of mid-November 2011, the Euro was even trading slightly higher

against the bloc's major trading partners than at the beginning of the crisis. The three

countries most affected, Greece, Ireland and Portugal, collectively account for six percent ofthe Euro zones gross domestic product.

The Making of a Crisis: Reasons

1. Confidence in the prospects for growth and stability of the economies of Greece, Ireland,

Italy, Portugal, and Spain (GIIPS) surged when the euro was introduced, causing their interest

rates to decline to those of Europes more stable members.

2. Improved confidence and lower interest rates drove up domestic demand in the GIIPS and

investors and consumers were emboldened to increase spending and run up debts, often owed

abroad as foreign capital flowed in.

3. Growth accelerated and the prices of domestic activities (i.e., those least exposed to

international competition, such as housing) rose relative to the price of exportable or

importable products, attracting investment into the less productive non-tradable sectors and

away from exports and industries competing with imports.

4. Meanwhile, exports rose sharply as a share of GDP in Germany, the Netherlands, and

other historically stable countries in the European core. Growing demand in the GIIPS

enabled these core countries to increase exports. The adoption of a common currency, whose

value was based on broader European competitiveness trends that made it lower than thedeutschmark or guilder might have been, made their exported goods more affordable.

5. The domestic demand boom in the GIIPS induced rapid wage growth that outpaced

productivity, increasing unit labor costs and eroding external competitiveness further. This

trend was reinforced by especially rigid labor markets in most of the GIIPS. The emergence

of China, as well as currency depreciation and rapid labor productivity growth in the export

sectors of the United States and Japan, added to the competitiveness problems of the GIIPS.

6. The single European monetary policy was too loose for the rapidly growing GIIPS (Spain,

Greece, and Ireland) and too tight for Germany, whose domestic demand and wages grewvery slowly compared to the European average. This reinforced the loss of competitiveness in

the GIIPS.

7. Lower borrowing costs and the expansion of domestic demand boosted tax revenues in

the GIIPS. Instead of recognizing this as temporary revenue and saving the windfall gains for

when growth slowed, GIIPS governments significantly increased spending. Blatant fiscal

mismanagement added to the problems in Greece.

8. The financial crisis in 2008 brought an abrupt end to the post-euro growth model in the

GIIPS. As they plunged into recession and tax revenues collapsed, government spending wasrevealed to be unsustainable and their loss of competitiveness dimmed hopes of turning to


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foreign demand for recovery. The GIIPS are left with high public and private debts and weak

long-term growth prospects, unless they make difficult adjustments to cut deficits and restore

competitiveness.

EURO CRISIS IMPACT ON THE REST OF THE WORLD:

Euro crisis is not just a problem of the Euro Zone. In any of the forthcoming days when you

wake up in the morning you may find that it had hit the global economy. However, this is

going to be the beginning of another global recession at a time that the world has not yet fully

recovered from the recession in 2008-2009 triggered by the US financial crisis.

What is the matter this time? It is again excessive debt financing of aggregate demand

including excessive government spending. But, there are new dimensions this time. First, it is

in an economic union of countries which agreed to be together but did not. Second, the

adverse effects of the US financial crisis were also carried forward in contributing to the Euro

zones excessive debt financing.Let us cut short a long story and make it simple. There cannot be an Economic and Monetary

Union or, as it is simply known as a single currency union unless the member countries

agreed upon macro policy coordination and maintaining common macro-economic

fundamentals. When the member countries in the Euro Zone which now consists of 17

European countries launch a single currency Euro in 1999, they also agreed upon

maintaining such macroeconomic fundamentals related to budget deficits, debt ratios,

inflation rates, and interest rates.

Crossing the boundary lines

Although the member countries in the Euro Zone obliged to maintain a budget deficit at less

than 3% of GDP and, public debt ratio less that 60% of GDP, particularly during the last few

years after the US financial crisis, these indicators were seen as going out of control. The

governments increased spending leading to huge budget deficits, which, as a result became

highly indebted countries. The most-indebted countries in the Euro Zone - Greece and Italy

reached public debt over 150% and 120% of GDP, while that of Belgium, Ireland and

Portugal was around 100% of GDP. France and Germany also had experienced a rising debt

ratio over 80% of GDP. One important problem of the Euro Zone policy coordination was the

lack of any effective mechanism to deal with the violation of the agreement by the member

states. The issue is not only economic, but also political as tensions mounted in somecountries.

The problem was not just the high debt, but its accompanied economic progress and the

speculation about the ability of the country to repay the loans. Along with high budget

deficits and high debt ratios, GDP growth was slower and unemployment was high around

10% and, well above that in Greece, Ireland and Portugal. That is exactly why the high

budget deficits and accumulating debts of Greece, Italy, Ireland, Spain and Portugal became

major problematic countries since the beginning in 2009. Not only their debt problem got

worsened, but it spread across the region. The latest country coming under pressure is France,

while the only country in the Euro Zone which was least affected has so far been Germany.


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The problem:

Origin and transmission

What is the problem, then and, where do you feel the heat? The problem is in the financial

market. When the investors who have bought bonds by lending to these countries begin torealize (or rather speculate) that these countries are unable to repay the loans, they become

nervous and start selling off bonds. This panic in the financial markets would raise the

interest rates. Rising interest rates of the 10-year bonds is a sign of the financial market

becoming heated and coming under pressure. The long-term interest rates of the Euro Zone

were rising during the past few years and rising fast during the past few months of 2011.

During a period of 12 months from mid-2010 to mid-2011, the long-term interest rate

doubled reaching 18% in Greece and 12% in Ireland and Portugal. The European Central

Bank (ECB) can intervene in cooling the heat by buying bonds, and the ECB actually

continued to do so. But it could be only temporary as the speculations deepen and interest

rates increased.

Let us look at the global picture of the Euro crisis and the differences in crisis impact. If you

are holding Euro-denominated bonds, you are nervous because your financial investment is

likely to lose its value. If you are holding Greece bonds you are more nervous than another

who is holding German bonds, because the bonds issued by Greece is likely to lose more than

those issued by German. Depending on the banks exposure to Euro bonds issued by different

governments in the Euro Zone, the financial crisis deepens. In fact, the European banks are

holding part of the stock of Euro bonds so that they are in a vulnerable position which affects

their current lending businessesfurther pressure on interest rates.

USA and Euro Zone (which are quite similar in size of the economy and size of the

population) are big lenders to each other borrowers from each other. As USA holds Euro

bonds, the Euro crisis would hit the USA financial sector as the USA investors lose their

assets values. And, it is worthwhile noting that historically USA is a debt-financing country

as it continued with massive trade deficits, but managed to import what it wants by borrowing

from abroad. Therefore, both USA and Euro Zone, which have the biggest consumers in the

world and must reduce their expenditure, would be faced with a slump in aggregate demand

simultaneously. The two are also the major trading partners of each other as they import from

each other and export to each other. If the USA has to buy less from Euro Zone and, viceversa, they both have to face a contraction in international trade too. This is another channel

of the spread of crisis impact contributing to the decline in aggregate demand. The eventual

outcome is a fall in incomes and a loss of employment, once again.

The damage took three main forms, each of which poses a major risk to the stability of the

global economy today: high and rising public debts, fragile banks, and a huge liquidity

overhang that will need to be eventually withdrawn.

The Euro crisis, which strikes at the heart of the worlds largest trading block, contains only

two of the three fateful elementsproblematic sovereign debt in Greece and other vulnerablecountries, and fragile European banks, which hold a large part of that debt. Monetary policy


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in the Euro area and in industrialized countries more generally, remains expansionary and, if

anything, the crisis pushes back the time when tightening can occur safely. As a result of the

problems in Europe, the world economy has become even more exposed to the three mega

vulnerabilities.

While ballooning public debt may be the clearest manifestation of the Euro crisis, its roots go

much deeperto the secular loss of competitiveness that has been associated with euro

adoption in countries including Greece, Ireland, Italy, Portugal, and Spain (GIIPS).

The sequence of events that led to the secular loss of competitiveness is depressingly similar

among the GIIPS countries:

The adoption of the euro was accompanied by a large fall in interest rates and a surge in

confidence as institutions and incomes expected to converge to those of Europes northern

core economies.

Domestic demand surged, bidding up the price of non-tradable relative to tradable and of

wages relative to productivity.

Growth accelerated, driven by domestic services, construction, and an expanding

government, while exports stagnated as a share of GDP, and imports and the current account

deficit soared amid abundant foreign capital.

The result was that indebtednesspublic, private, or bothsurged. Meanwhile, following

reunification, Germany was undergoing a historic transformation to become the worlds

largest exporter, and all of Europes northern economies reaped the benefits of the expandedmarket and decreased competition offered by the GIIPS. But the growth model in the GIIPS

was inherently flawed: eventually, the domestic demand bubble burst. Now, governments

must shrink, and high costs pre-empt any efforts to resort to export markets for growth.

Countries are stuck in low growth equilibriumand potential domestic battles over the

limited resources will only accelerate the onset of crisis.

This basic story fits the Euro area periphery, but the details vary within each country. For

example, Italy and Portugal saw growth peak very early on, while Greece, Ireland, and Spain

enjoyed decade-long booms followed by busts during URI DADUSH 3the global crisis. The

single monetary policy of the euro was too loose for the countries who enjoyed the biggestboom and accentuated their inflation and competitiveness loss, while it was too tight for

larger economies like Germany, depressing domestic demand there and widening its unit

labor cost advantage vis--vis the GIIPS.

Effects on Other Countries

A similar and even more virulent strain of the euro disease has already hit countries that are

not part of the Euro area but that pegged their currencies to the euro many years ago,

beginning with Latvia, Estonia, and Lithuania. Other recent EU joiners, such as Hungary and

Romania, retain flexible exchange rates, but are constrained by large foreign currency debtsin their ability to devalue. As a consequence, they too suffer from the euro disease.


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The rest of the world will feel the effects of the Euro crisis via six important channels: first,

the crisis will lower growth in Europe, a market toward which about a quarter of world

exports are destined. Second, it will lead to further euro depreciation, sharply reducing profits

from exports to Europe while also increasing competition from the continent. Third, by

keeping policy rates low in Europe and potentially other industrialized countries as well, thecrisis may encourage capital surges into emerging markets. Fourth, the crisis will add greatly

to the volatility of financial markets and will lead to bouts of risk-aversion. Fifth, and

potentially most important, the crisis could deal a mortal blow to many fragile financial

institutions. Sixth, a failure to contain the crisis will raise the alarm on sovereign debt in other

industrial countries and, inevitably, in any exposed emerging market.

Following are possible scenarios of how the sovereign debt crisis in the euro zone could

affect the U.S. economy:

MILD EURO-ZONE RECESSION:

Euro zone economy contracts by about 1 percentage point in late 2011/early 2012 and then

posts very slow growth, which already is built into many forecasts.

IMPACT: Lowers U.S. GDP by 0.1 to 0.2 percentage point in first half of 2012.

Trade is the primary channel through which the U.S. economy is hit. The euro zone is the

United States' third largest export destination, accounting for 15 percent of total U.S. exports.

But the U.S. economy is relatively closed and euro zone exports accounted for only 2.1

percent of total U.S. economic activity in the second quarter, according to the latest available

figures from the U.S. Commerce Department.

As the U.S. recovery has gathered momentum, it has grown less dependent upon trade.

International trade has contributed 1.1 percentage points to total GDP growth since the

recession ended in 2009, almost triple the post-war average, Deutsche Bank said. But export

growth has slipped to 5.8 percent in the third quarter of 2011, year over year, from a peak of

13.5 percent in the second quarter of last year. Deutsche forecasts it will slip further to 3.9

percent by end of this year.

"If household consumption and business investment spending continue to pick up, as we

project, then exports will play a less critical role over the next several quarters," saidDeutsche economist Carl Riccadonna said.

PROTRACTED EURO-ZONE RECESSION:

A deeper and longer recession in the euro zone would spill over to other U.S. trading

partners, marginally weakening the U.S. growth picture. But as long as domestic demand

continues to gradually improve in the United States, the impact should be limited since

international trade is not the primary engine of U.S. growth.

A serious slowdown throughout the European Union would lessen its import appetite, hurting

China. The European Union is China's largest export market, so a euro-zone recession would
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cause a slowdown in China, dragging down other Asian countries which increasingly feed

China's manufacturing machine, and thus would drive a global economic slowdown.

Wells Fargo estimated that a slowing Europe would dampen demand for commodities, hitting

coal mining in West Virginia and precious metals in Utah.

Auto and aircraft parts manufacturing in Kentucky, Connecticut, Washington, South Caroline

and Alabama would be affected. Key service sectors also are likely to be affected --

tourism, finance, entertainment, software and engineering. This would hit New York,

California Florida, Texas and the Carolinas.

Mark Vitner, Wells Fargo senior economist, predicts a rolling euro-zone crisis that affects the

U.S. economy like a low-grade fever, not bad enough to fell it.

"We are really going to be bumping along from crisis to crisis," he said. "I can't see European

leaders allowing it to fall apart, and I can't see them fixing it either."

FINANCIAL MELTDOWN:

A disorderly sovereign default that causes a 40 percent decline in world equity prices, a

widening of credit spreads by 350 basis points in some euro-zone countries, plunging

business and consumer confidence, and a global downturn.

IMPACT: U.S. GDP growth lowered by 2.05 percentage points in 2012 and by 2.77 points

in 2013, accompanied by deflation or disinflationary pressures. Unemployment, currently at 9

percent, would rise by at least two percentage points in 2013. Developed country GDP would

be 5 percent lower by 2013.

The OECD is the first agency to provide a detailed forecast of the possible impact of the

euro-zone crisis spiralling out of control. The picture could turn even uglier, depending upon

the policy response. If euro area countries stuck to their fiscal tightening, a further 2.5

percentage points would be robbed from U.S. GDP in 2013; and if one or several countries

were seen at risk of leaving the euro zone, higher interest rates on debt and bank runs would

add to instability. Exit would cause political, economic and market upheaval.

"Such turbulence in Europe, with the massive wealth destruction, bankruptcies and a collapse

in confidence in European integration and cooperation, would most likely result in a deepdepression in both the exiting and remaining euro area countries, as well as in the world

economy," the OECD said on Monday.

The U.S. Federal Reserve provided a similar taste of how severe an impact a Lehman-style

event could have when it asked U.S. banks last week to test their resiliency against an 8

percent contraction in U.S. GDP and unemployment climbing to 13 percent. That was the

size of hits the U.S. economy suffered after Lehman collapsed.

However, economists point out there is some factors to offset the worst-case scenario.

Households and businesses have deleveraged significantly, putting their balance sheets in a
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stronger position to withstand a downturn than three years ago, and the economy is less

dependent on the housing sector.

Businesses also are sitting on large piles of cash, which they could use as a buffer to support

employment and investment if they expected only a short-lived hit, the OECD said. U.S.

inventories are lean, and most banks have rebuilt their capital, limiting the contractionery

impact.

As a result, the U.S. economy has proven itself able to withstand a worsening of financial

market conditions in recent months. The S&P 500 stocks index has tumbled 12 percent over

the past six months as the euro-zone crisis deepened and the cost of insuring unsecured five-

year U.S. bank debt against default has doubled since July on spill over concerns, yet U.S.

growth has gathered pace.

The trade and investment links between the United States and the European Union (EU) are

significant. Europe consumes twenty percent of U.S. exports and holds more than 50 percentof U.S. overseas assets, while the United States holds close to 40 percent of Europes foreign

assets. Lower growth and higher volatility in Europe could therefore have serious

consequences for the United States, hindering export growth and endangering assets. Europe

has already shown itself to be the laggard in the global recoveryin the first quarter,

European GDP was up only 0.3 percent (y/y), compared to 2.5 percent in the United States

and 11.9 percent in Chinaand the situation may well get worse before it gets better.

The crisis will likely lead the euro to depreciate further in the coming months. The euro has

already fallen more than 20 percent against the dollar since late Novembertwo months

before Obama unveiled his goal of doubling exports in the next five yearsand it may fall to

parity. In sectors where U.S. and European exports overlap (e.g., aircraft, machinery,

professional services), a lower euro will hinder the competitiveness of U.S. goods on the

global market. The depreciation will also reduce the purchasing power of European tourists

travelling to the United States and make European goods relatively cheaper in U.S. markets at

a time when policy makers are hoping to avoid a return to high current account deficits. With

imports likely to rise and exports likely to fall, the U.S. bilateral trade balance with Europe

will likely deteriorate. By definition, the profitability of U.S. companies operating in Europe

will be affected by the Euro crisis when profits and assets on the balance sheets are expressed

in dollars. U.S. companies selling in Europe and sourcing in dollars will see even sharperprofit declines, though U.S. companies selling into the dollar area and sourcing in Europe

will benefit.

Despite the negative effects a weaker euro would have on U.S. job creation, the most

important consequences of the Euro crisis in the United States will operate through financial

and, more specifically, banking channels. Though the exposure of U.S. banks to the most

vulnerable countries in Europe is limited to $176 billion, or 5 percent of their total foreign

exposures, their indirect linkages to these countries, which operate through all of the

international banks, are much larger. Not surprisingly, European banks hold large amounts of

their own countries bonds and, according to a recent World Bank report, these holdings


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exceed reserves in some instances. A string of bank failures in Europe could well trigger

another global credit crunch.

The crisis has already significantly increased stock market volatility; the VIX volatility index

more than doubled in the last two months. The confidence that banks have in doing business

with each other has also plummeted, with the TED spread, the difference between the three-

month inter-bank lending rate and the yield on Treasury bills, reaching a nine-month high of

35 basis points in May, up from 10.6 basis points in March

Developing countries in the eye of the storm Transmission mechanisms:

The euro zone sovereign debt crisis is likely to affect developing countries through three

main transmission channels: financial contagion, Europes fiscal consolidation effects, and

exchange rate effects.

First, financial contagion to developing countries may occur in the form of spill over throughfinancial intermediaries and stock markets, as well as shifts in investor market sentiment and

changes in investor perception of risks.

European banks hold a big share of Greek sovereign debt, with Germany, France and the UK

holding $22.6 billion, $15 billion and $3.4 billion respectively. If Greece defaults, European

banks may experience significant losses and, as a result, they may need to cut their credit

lines in developing countries to restore their capital adequacy ratios. Recent estimates show

that in the event of an 80% write-off of Greek debt, euro-area banks would lose over 63

billion. This amount might be even bigger if Greek default extends to other European

economies such as Spain and Italy.

Growing uncertainty on the full extent of European default may further limit bank liquidity,

thereby increasing difficulties for developing countries in securing lines of credit on

international markets.

The euro zone crisis is also causing continuous turmoil in global stock markets. Global

markets plunged 6.8% in August 2011, with European markets the worst performers:

Germany fell 18.7%, Italy 14.9%, France 10.9% and Spain 8.8% (Brandt, 2011). Stock

market volatility may have adverse consequences for developing countries. Prolonged sell-off

in European equity markets, for example, could lead to fast withdrawals of money indeveloping countries, generating important adjustment problems. In addition to this, the

European sovereign debt crisis and fears of a new global recession have led to a collapse of

investor appetite for risk, as seen in the Credit Suisses Global Risk Appetite Indicator, which

hit panic levels with a 30-year low (JP Morgan, 2011). Such changes in market sentiment

may prompt delayed or cancelled investments and reduced portfolio flows in developing

countries. Nevertheless, the European debt crisis may also lead investors to reallocate their

portfolios from advanced country bonds into more attractive developing country bonds.

Second, austerity packages in several European economies have led to a considerable rise in

unemployment and weakened growth that was still recovering from the previous globalfinancial crisis. This may impact developing countries in several ways. Fiscal consolidation


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plans, for example, have forced European governments to slash spending. The UK has

announced the biggest cuts in state spending since World War II (83 billion by 2014-15); in

France there are plans to cut spending by 45 billion; and Germany has unveiled drasti c

public spending cuts totalling more than 80 billion. These cuts might lead to declines in aid

to developing countries, adding to concerns in a context where several European countrieswere already struggling to meet aid targets after the global financial crisis. Slower European

growth may also have a severe impact on developing countries by reducing EU demand for

commodities, manufactured goods and services. These effects will further undermine already

weak EU imports, which have yet to reach pre-global financial crisis levels. Unemployment

in European economies is also on the rise. The euro area unemployment rate reached 10% in

August 2011, with Spain leading the way with an astonishing 21%, followed by Ireland

(14.6%), Slovak Republic (13.4%) and Portugal (12.3%). The US is also suffering, with an

unemployment rate of 9.1%. This will certainly translate into fewer remittances to the

developing world as immigrants struggle to maintain or find new jobs

Third, exchange rate movements may also pose new challenges (and opportunities) for the

developing world. Euro depreciation against the dollar (Figure 1) may affect trade flows in

developing economies in two opposing directions. On the one hand, those countries with

currencies pegged to the euro may actually benefit from a weaker euro that makes their

exports more competitive in world markets. This might be the case for crude oil, cocoa,

coffee and groundnut exports from the CFA zone countries in West Africa although these

also hold their reserves in Euros, which could depreciate in real terms, in terms of months of

import cover (Kang et al., 2010). On the other hand, countries with dollar-based exports will

suffer from an appreciation of the dollar against the euro.

Trade in services may also be affected by a weaker euro as European tourists travelling to

developing economies will have diminished purchasing power.


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A weaker euro is also likely to reduce the value of remittances originating in Europe and

flowing to developing countries. Vulnerability to the euro zone crisis .The impact of the

European sovereign debt turmoil on developing countries will depend on a number of

structural and process factors.

Structural factors refer to exposure and resilience characteristics of developing economies.

Poor economies are likely to be exposed to shock waves of the euro zone crisis for a number

of reasons.

First, developing countries still have strong trade linkages with Europe (Table 1), eventhough the importance of the EU as an import and export partner was slightly lower in 2010

than it was in 2007, before the global financial crisis. Increased trade linkages with

China has seen this country supplant the EU as the main partner for both imports and exports

from Least Developed Countries (LDCs), with a 4.6 percentage point increase since 2007 in

its share of LDC imports, and a 7.2 percentage point increase in its share of exports. This may

cushion impacts from the euro zone crisis. If China also slows down, however, LDCs will be

overly exposed. Over the same period the US has increased its share of LDC imports very

slightly but has lost ground as an export market.

Second, developing countries also have strong financial linkages with European countries.

Europe is a big investor in the world economy (including LICs), with EU Foreign Direct

Investment (FDI) outflows an accounting for a 31% share of global FDI in 2010.

In addition, the number of European banks in LICs has increased significantly during the past

decade. Over the period 2000-06, 56% of foreign-owned banks in sub-Saharan Africa were

European (mainly from the UK, France and Portugal; World Bank, 2008). This figure was

even higher in Latin America, where 62% of foreign-owned banks in developing countries

were European (with Spain leading the way with a 40% share). Cross-border bank lending

from European banks to developing countries also increased between 2000 and 2010, despite


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a slowdown during the global financial crisis in 2008 (Figure 2). In March 2011 it amounted

to more than 18% of total claims from European banks.


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Third, Europe remains a key source of migrant remittances for the developing world. On

average, remittances account for about 8% of LICs GDP, with notable peaks in countries

such as Tajikistan (39%), Nepal (22%), and Gambia (14%).

Finally, developing economies are still heavily dependent on development assistance from

Europe. In particular, LDCs receive roughly half of their aid from Europe. On the other hand,

developing countries are likely to be less resilient to the effects of the ongoing debt crisis

compared to the previous crisis, as their fiscal policy room is now much more limited. The

data in Figure 3 (overleaf) reveal that several LICs have experienced a severe worsening of

their fiscal balance as a share of GDP following the global financial crisis.

Looking at selected exposure and resilience indicators, Table 2 highlights the LICs that are

relatively more vulnerable to the possible financial and real shocks of the euro zone crisis.

Mozambique appears to be among the most vulnerable countries given its high dependence

on euro zone trade flows between 2007 and 2010 it experienced a dramatic increase in

exports destined to the EU27 or euro zone countriesand on cross-border bank lending from

European banks. It is also highly dependent on aid and has a significant fiscal deficit that has

worsened since the global financial crisis. Kenya is also highly vulnerable because of its

strong trade and financial linkages with European countries. On the other hand, Burkina Faso,

Mali and Niger are likely to feel the effects of the euro zone crisis mainly through

depreciation of the euro and lack of adequate fiscal policy space.

In addition to these structural factors, the extent of transmission of the euro zone crisis to

developing countries will also depend on process factors, such as the ability of EU countries

to coordinate and respond quickly to the crisis and the policy solutions implemented. So far,no agreement has been reached on how to respond to the crisis but three possible solutions

are under discussion among euro zone leaders:

An orderly default with a 50% write-off of Greek debt

A strengthening of European banks that could be affected by potential government defaults

within the euro area

Enhancement of the European Financial Stability Facility (EFSF) from 440 billion to

around 2 trillion.

Table 2 summarises the transmission mechanisms and possible effects of the euro zone crisis

on developing countries, as well as possible euro zone solutions.


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14

Impact of the Crisis on Developing Countries

Exports: The Euro crisis is likely to deduct at least 1 percent of growth, and potentially much

more, from Europea market that consumes more than 27 percent of developing countries

exports, In addition, the euro has already devalued more than 20 percent against the dollar

since November 2009 and the two could reach parity before the crisis is over. A lower euro

will sharply reduce the profitability of exporting to the European market and will alsoincrease competition from Europe in sectors ranging from agriculture to garments and low-

end automobiles.

Tourism and Remittances:

A lower euro will reduce the purchasing power of European tourists travelling to developing

countries, and the value of remittances originating from Europe.

Domestic Competition:

At the same time, a lower euro may provide opportunities for consumers and firms to importfrom Europe at a lower cost.


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15

Capital Flows:

The Euro crisis will force the European Central Bank to maintain a very low policy interest

rate for the foreseeable future. Similarly low rates in Japan and the United States, combined

with low growth in Europe, may lead even more capital to flow to the fastest-growing

emerging markets. This will lead to inflation and currency appreciation pressures, as well as

increase the risk of asset bubbles and, eventually, of sudden capital stops in emerging

markets.

Market Volatility:

The Euro crisis will add greatly to the volatility of financial markets and will lead to sharp

bouts of risk-aversion. The VIX index, which measures the cost of hedging against the

volatility of stocks, has more than doubled in the last two months. This, in turn, has increased

the level and volatility of spreads on emerging market bondswhich have risen by more than

130 basis points since Apriland will make currencies more volatile across the globe.

Credit Availability:

The Euro crisis may constrain trade and other bank credit available to developing countries as

it raises questions about the viability of European banksespecially those based in

vulnerable countries whose assets likely include large amounts of their own governments

bonds. But all international banks will be viewed as having either direct or indirect (through

other banks) exposure to the vulnerable countries. The confidence that banks have in lending

to each other has already fallen; the TED spread (the difference between the three-month

inter-bank lending rate and the yield on three-month Treasury bills) reached a nine-monthhigh of 35 basis points in May, up from this years low of 10.6 basis points in March.

Contagious Crises:

A failure to contain the crisis in Greece and its spread to Spain or other vulnerable countries

will raise the alarm on sovereign debt in other industrial countriesfor example, Japan,

whose debt-to-GDP ratio is projected to be nearly twice that of Greece in 2015and

inevitably in any exposed emerging market. If more countries are hit, the pressures on trade,

global credit, and capital flows to emerging markets will only increase.

Policy Implications:

Though there are no one-size-fits-all prescriptions for developing countries given their very

different starting points, some general policy conclusions emerge:

Developing countries will need to rely less on exports to the industrial countries and more

on their own domestic demand and South-South trade.

In some cases, greater caution may be called for in reversing stimulus policies. In other

cases, even greater prudence may be called for in containing fiscal deficits and moderating

the accumulation of public debt.


18/18

Given the sharp rise in exchange rate uncertainty, matching the currencies of foreign

liabilities with those of export proceeds and reserve holdings will become even more

important.

The Euro crisis also calls for great caution in the way surging capital inflow is managed. In

some countries, regulations to moderate the inflow of portfolio capital and to instead

encourage the more stable form of foreign direct investment may be warranted.

Countries with large external surpluses and that receive large capital inflows may allow

their currencies to appreciate, as this may help both stimulate domestic demand and moderate

inflationary pressures.

Close monitoring and tight regulation of the operation of foreign banks and of their links

with domestic banks may be prudent in the current circumstances.

Two other important policy lessons flow from the Euro crisis experience to date: one is areinforcement of the message that strictly pegged exchange rates together with open capital

accounts and the ability to borrow abroad in foreign currencies are often a dangerous

combination. Just as a tight peg to the U.S. dollar led to significant GDP contraction in

Argentina (18.4 percent from 1998 to 2002), countries that are not part of the Euro area but

had pegged their currencies to the euro many years ago have seen their GDP decline sharply.

GDP in Latvia, Estonia, and Lithuania, for instance, will have contracted by 24.8 percent,

16.5 percent, and 14.1 percent, respectively, from 2007 levels by the end of 2010. Countries

with flexible exchange rates, such as Poland or Brazil, and those with pegged exchange rates

but tight capital controls appear to have dealt with the dislocation caused by the crisis more

successfully.

Last but not least, the crisis has exposed the limitations of regional mechanisms in dealing

with financial crisiseven among countries with deep pocketsand underscored instead the

vital role that a global lender of last resort, in the form of the IMF, can play. Not only can the

institution bring more resources and broader expertise than would plausibly be available to a

regional institution, but its distance from potentially divisive regional politics can also be a

big asset.

As European banks reduce international lending, it's hurting importers and exporters in Asia,

Africa and Latin America, and raising fears of a trade-crippling global credit crunch.
http://content.usatoday.com/topics/topic/Places,+Geography/Regions/Latin+Americahttp://content.usatoday.com/topics/topic/Places,+Geography/Regions/Latin+America

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