Facing the Fallout of a Possible ‘Grexit’ and a Euro Break-up: Time for Preparation for Developing Countries

Dehan Jayamaha and Kaushalya Attygalle (Project Interns) with Anushka Wijesinha (Research Economist)

 

As the European crisis led by Greece and Spain has significantly worsened over the last few months, the future of Europe seems ever more uncertain. With the decreasing possibility of a favorable outcome coming out of Europe, the impact of this crisis on the United States, China and emerging Asia is steadily increasing. Countries outside of the region have begun to plan ahead for a possible breakup of the European Union and all eyes seem to be on the EU at the moment – waiting to see how the situation will eventually manifest.

 

 

With Greece unwilling and unable to pursue the spending cuts demanded by Germany, a “Grexit” increasingly seems to be a possibility. Even the less than required spending cuts implemented by Greece thus far have been met with violent protests and a significant jump in the suicide rate. The Greek suicide rate which increased by 40% year-on-year in the first five months of 2011 is likely to be even higher in 2012.[i] Thus, the possibility of further cuts as required by Germany and the European Central Bank (ECB) is increasingly unlikely, particularly with the Greek general election, scheduled for the 17th of June, just around the corner.

 

The Spanish predicament too seems to have deteriorated, with the process increasingly referred to as “Spanic”, as Spaniards are withdrawing billions of Euros and moving it to ‘safer’ locations, causing severe liquidity issues for banks. The Spanish government has struggled to inject sufficient liquidity into banks such as Bankia, Spain’s fourth largest bank[ii]. The high borrowing costs Spain is facing – over 6% yield on Spanish 10-year bonds – has forced the government to look to the ECB for cash at low interest or to inject liquidity directly into Spanish banks. However, Spain’s future looks somewhat better after the Eurozone finance ministers agreed on Saturday (9th June) to give Spain a credit line of up to 100 billion Euros to help bolster its banks.[iii]

 

 

With 2 trillion Euros of debt, an above 6% yield on 10-year bonds, and the third largest debt value relative to the size of the economy, Italy seems to be next in line to require a bailout.[iv] The rest of Europe too is in a vulnerable state with most nations facing large debt coupled with high unemployment and severe economic uncertainty. However, the impact of this crisis on Germany seems to be less unpleasant. As Germany experiences significant capital inflows for being the regional ‘safe haven’, the availability of credit in Germany has increased. This has raised Germany’s competitiveness while its European neighbors remain uncompetitive.[v] In terms of impacts across the Atlantic, if the European Union – the United States’ largest trading partner – was to enter into deep recession, American companies would be hit hard and unemployment would worsen. This is unfortunate given that the last couple of months had seen promising signs of a US recovery. In addition, as people consider the US Dollar to be a safer currency to hold their cash in comparison to the Euro, the Dollar would appreciate significantly and worsen prospects for American exports and growth.[vi]

 

 

Break-up or Different Make-up? – Possible Outcomes for the Eurozone

Compromise reached

One possible outcome is that of a compromise between the soon to be elected Greek government and the “troika” of the EU Commissions, ECB, and IMF such that fears of a “Grexit” disappear. However, given that this would require the ECB and Germany agreeing to pump significant amounts of further funds into Greece and depart from their insistence on immediate austerity, this scenario is unlikely.

 

 

Greek exit, contagion contained

A second more likely scenario is that Greece is unable or unwilling to meet the demands made by the ECB and Germany and subsequently exits the European Monetary Union (EMU). The impact of the “Grexit” is contained by extensive action taken by the ECB to improve the liquidity position and protect the remaining members of the EMU, possibly through the use of bailout funds, such that no other country follows Greece. As Greece does not represent a major export market to most emerging nations (including Sri Lanka) and as the remaining EMU members can pursue growth promoting policies, the impact on emerging economies is minimized.

 

 

Greek exit, contagion spreads

Alternatively, the Greek exit could lead to contagion spreading to Europe’s peripheral economies (Portugal, Italy, Ireland, and Spain). As the need for liquidity rapidly increases among these nations, the ECB may not be able to protect all its remaining members, forcing the peripheral nations to exit the EMU as well and re-introduce their national currencies. Depending on its severity, the spread of the contagion could see most of the present EMU members exiting the Euro, leaving only Germany and a handful of other nations with the common currency. As the exiting nations depreciate their national currencies to increase competitiveness, emerging economy growth could be damaged as exports to these exiting nations suffer.

 

A two-tier Eurozone

Since the European crisis began certain groups have been positing the creation of a two-tier system in the Eurozone. Although, such a structure might appear sensible at first glance, as it enables greater political and economic integration of similar countries, such a system would be neither beneficial nor easily implemented in terms of the Eurozone. In fact, German chancellor, Angela Merkel, French officials, and the EU have all rejected any ideas of creating a two-tier Eurozone which separates the stronger economies from the weaker ones.[vii] Under such a two-tier, the stronger tier of the German-led Eurozone would see a drastic appreciation of its currency adversely affecting its global competitiveness. With the most powerful and influential nations in the Eurozone effectively losing out as a result of the system, the implementation of the two-tier system seems extremely unlikely, at least in the foreseeable future.

 

 

Impact on the Rest of the World

 

Countries outside of the EU that depend on the EU for trade and finance are facing some setbacks that could be attributed to the events taking place in Europe. In May 2012, the Indian government reported that growth in the first three months of the year was the slowest in nine years[viii]. Although Europe may not be India’s biggest export destination right now, Kaushik Basu (Chief Economic Advisor to the Indian Prime Minister), stated this week that, “it will be a lie to say that we have the strength to weather [a Euro break-up]. It will hit us in the face”[ix]. Likewise, the obvious impact of the crisis on Chinese exports has added to the looming concerns about economic slowdown in China. In Taiwan, the manufacturers of electronic devices are facing setbacks due to a significant drop in orders from brands like Dell, Lenovo and Nokia[x]. It is also important to keep in mind that Southeast Asia in general is not as “well positioned” as they were three years ago when the global financial crisis began with higher sovereign debt burdens, budget deficits and inflation rates[xi]. However, with the impending Greek exit, countries with bigger domestics markets like India and China are expected to be less affected than countries like Singapore, Hong Kong and Malaysia which depend more heavily on exports. On the other hand, contesting views suggest that Asia will not be affected drastically if there is a Greek exit. While many feel that exiting the European Union is the only way out for Greece they also feel that a Greece exit alone will not have a drastic impact on the Asian economies[xii] as most of the Asian economies have the fiscal capability to “cushion some of the blows”[xiii]. A collapse of the European Union, however, will be a different story.

 

Planning Ahead – Emerging Markets Have Begun

 

Regardless of these contesting views and different scenarios, there are a few things countries outside of the European Union can and should do while they wait – build shock absorbers, increase international competitiveness and most importantly, have contingency mechanisms in place[xiv]. There are increasing reports on contingency plans set out by countries in the event that a “Grexit” does occur. While countries are very tight-lipped about the exact nature of their contingency plans there are reports that India, China and South Korea have started planning ahead. Kaushik Basu, stated that there are different “crisis management” groups within the government prepared to deal with the situation if there is a collapse of the European Union[xv] Other sources have also remarked that plans are in place to ensure the Finance Ministry and Central Bank are prepared to take monetary and fiscal policy measures if the contagion spreads. China is currently in the process of discussing contingency measures that would look into currency stabilization, increasing checks on cross-border capital flows, and additional policies to stabilize the domestic economy[xvi]. Similarly, the South Korean Finance Minister stated that Seoul must keep a close eye on the events taking place in Europe and its possible impact on South Korea – they must “prepare for every possible development that can arise”[xvii].

 

Planning Ahead – Sri Lanka Should Too

 

Although a Greek exit alone may not significantly affect Sri Lanka, if the crisis is not contained a Eurozone collapse could have severe negative effects on the country’s economy. The Sri Lankan manufacturing and tourism sectors are quite dependent on Europe and as a result could face a severe downturn. The apparel industry for instance depends on the European Union for 50% of its exports and over 42% of tourist arrivals in Sri Lanka are from Europe[xviii]. Given that apparels and tourism are two of Sri Lanka’s largest income earners (textiles and garments alone amounts to 39.7% of total exports[xix]) it is crucial that stakeholders in the Sri Lankan economy take a very close look at the effects of a possible Eurozone break up and ensure that robust plans are in place to mitigate the ripple effects of such an outcome. Clearly, other countries have begun to think ahead – Sri Lanka must do the same.

 

 


[i] Austerity drives up suicide rates in debt-ridden Greece, CNN online, April 6, 2012.

[ii] ‘Spanic,’ ‘Grexit’ and Europe’s flying money, CNN online, June 6, 2012.

[iii] Spanish PM: ‘Credibility of euro’ is saved, CNN online, June 10, 2012.

[iv] Italy in crisis crosshairs as Spain bailout rally fizzles, San Francisco Chronicle, SFGate online, June 11, 2012

[v] The Euro awaits its verdict, Project syndicate, May 22, 2012, Peter Boone and Simon Johnson.

[vi] Euro collapse and the American impact, Imogen Lloyd Webber, Huff Post Business, January 6, 2012

[vii] EU dismisses rumors of ‘two-tier eurozone’, euronews.com, Nov 10, 2011.

[viii] Asia strains under Euro Crisis, Wall Street Journal, May 31, 2012.

[ix] Eurozone breakup could hit us in face, warns Basu, The Hindu, June 10, 2012.

[x] ibid.

[xi] The Grexit’s threat to South Asia, Carnegie Endowment, June 6, 2012.

[xii] Mahathir says limited Asia threat if Greece Exits, Bloomsberg, May 28, 2012.

[xiii] Asian countries have enough leeway to deal with “Grexit”, Xinhuanet, June 6, 2012.

[xiv] The Grexit’s threat to South Asia, Carnegie Endowment, June 6, 2012.

[xv] India readies plan for Euro area meltdown, The Times of India, June 6, 2012.

[xvi] China Making Contingency Plans for a Greek Exit, CNBC, June4, 2012.

[xvii] South Korea contingency plan to deal with Greek crisis, Yonhap News Agency, May 21, 2012.

[xviii] Annual Report 2011, Central Bank of Sri Lanka.

[xix] ibid.


  • deshald

    when looking at implications for sl, it is also necessary to look beyond the impact on exports. we have seen an increased integration of sl’s financial market with the global financial system – both through gosl borrowing from international capital markets and increasingly commercial banks borrowing from abroad for tier II – a lot of this borrowing is tied to LIBOR. when lehmann crashed in 2008 there was a big increase in the LIBOR – and even last year when the euro situation looked bad LIBOR almost doubled and has remained at that level.

    if there is a major credit event in europe and it causes a sustained increase in risk perception for inter-bank borrowing causing LIBOR to spike, it could affect repayments on international borrowings that have been made when LIBOR was at very low levels. a dry up on inter-bank borrowings could also hurt trade finance which tends to have a short and sharp impact on global trade.