Europe confronts a complex set of political and economic challenges. Recent weakness in asset markets in Asia shows that investors now believe Europe’s woes will put these regions at risk of a severe deterioration in economic and financial conditions.
Exploring two possible scenarios in Europe can help us understand if this fear is justified: (1) a complete eurozone breakup, and (2) a painful and long deleveraging which pushes the European economy close to or into a recession.
Those who strongly believe in the first scenario have reason to be worried. A eurozone break-up involving any of the major economies would have disastrous global consequences. We would see a domino effect on sovereign debt defaults; the collapse of the European financial sector with global shockwaves; and foreign exchange markets plunged into chaos by the sudden disappearance of the world’s second most important reserve currency. The overall impact on the global economy would likely be far worse than the impact after Lehman’s collapse.
But how likely is this scenario? Very unlikely. Recent moves towards establishing a stronger fiscal union in Europe, unprecedented and massive provisioning of liquidity through both the European Central Bank (ECB) and national central banks, the massive additional balance sheet capacity of the ECB, fiscal and structural reforms in Italy, and the prohibitive costs of an exit from the euro for any major member of the European Monetary Union, including Germany, should ensure that this first scenario does not materialize.
However, the second scenario of a painful deleveraging in many European banks and anemically weak European growth is very possible. This outcome would be bad for Europe, but not bad enough to undermine the outlook for stronger parts of the global economy, especially emerging Asia. Here’s why.
Europe was not the main engine of the global economy to start off with, and it remains a relatively closed economy. A European recession, especially if deeper and more protracted, would dampen world trade, including Asian exports; but nothing on the scale seen in 2008.
But trade only provides part of the linkage. The more important linkages come via the capital markets. The European Banking Authority’s requirement for banks to reach a tier 1 capital ratio of 9 percent by June of this year will require broad based deleveraging. As raising fresh capital is extremely difficult, one other avenue could be to shed assets, including assets abroad. Asia and other emerging markets, however, should not suffer unduly.
Most foreign banks are present in Asia via wholly-owned subsidiaries, which cannot simply siphon capital back to their parent companies. Many of these subsidiaries are some of the most profitable parts of their businesses, and growing profits provides one important way to recapitalize. Shutting down all business lines in emerging markets would leave these banks without this important source of profits and force an even greater reliance on a weak domestic banking market in Europe.
Furthermore, a plan to temporarily exit and reenter may not be possible, as a foreign company that leaves town during hard times would not be quickly welcomed or permitted back.
Lastly, should there be no other choice for a European bank but to sell and exit, there are other domestic and foreign banks that would gladly step in; as demonstrated recently where European banks have sold parts of their Latin American business to local institutions. Indeed, even at the height of the post-Lehman financial crisis Asia did not see a wholesale pulling out of assets.
But this deleveraging by many European banks is only part of the capital flow story. Meanwhile, the ECB has launched its version of quantitative easing which now augments the extraordinarily loose monetary policy of the US, Japan and UK. We now see the most aggressive printing of money in modern times. While this aims to address domestic conditions, most notably to ease the deleveraging of domestic banks, capital cannot be contained within national borders.
Given open capital markets, abundant global liquidity will continue to flow into Asian markets blessed with strong macro fundamentals — particularly as the region’s currencies still appear largely undervalued. Short term volatility excluded, monetary policy in these four major economies will ultimately facilitate net capital inflows into Asia and many other asset markets and thus avoid the risk of a recession-induced credit crunch in Asia.
Also, strong economic and political fundamentals support Asia. Many emerging Asian economies have built ample liquidity cushions through significant accumulation of international reserves. Unlike Europe or the US, Asia has built up plenty of room to provide fiscal stimulus and to lower interest rates in response to a worsening external environment as debt levels remain low and interest rates were preemptively hiked at the end of the recession.
For example, Korean government debt levels have been slashed over the last decade and international reserves now well exceed levels seen before the global financial crisis. And the largest countries like China, India and Indonesia can count on a robust and resilient domestic demand to counter external demand weakness. Also, consumers and corporations in Asia have broadly maintained strong balance sheets.
Eurozone disintegration would be as calamitous as it is unlikely. It would be a global disaster. On the other hand, the far more probable scenario of painful deleveraging by European banks and weak European growth, while a serious setback for Europe, will likely have far more modest and manageable global spillovers than the current markets are assuming.
Disappointing European growth is nothing new. The current round of structural reforms will hopefully change this, but the world economy is used to powering ahead without much help from European demand. It will do so this time as well. Asian markets, with their current strong market fundamentals and unparalleled future growth prospects, will continue to lead the charge.