LMTSOM, Thapar University Patiala `

Global Business Enviornment1

2012

Impact Of European Crisis on International Business

Submitted to:

Submitted By:

Dr. Piyush Verma Asst Professor LMTSOM, Thapar University Patiala

1. Vikas Sharma 2. Sugandha Sharma 3. Rahul Kathuria

16/04/2012

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 Dated: April 16, 2012

Group Members: Vikas Sharma Sugandha Sharma Rahul Kathuria 501104027 501104026 501104019

(MBA IIIrd TRIMESTER)

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 zone and 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 their official 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 thereafter leading, Europe's finance ministers on 9 May 2010 to approve a rescue package worth 750 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.

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 of the 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 the deutschmark 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 grew very 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 was revealed to be unsustainable and their loss of competitiveness dimmed hopes of turning to

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 some countries. 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.

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 to realize (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 businesses further 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, vice versa, 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 vulnerable countries, and fragile European banks, which hold a large part of that debt. Monetary policy

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 expanded market 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 biggest boom 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 debts in their ability to devalue. As a consequence, they too suffer from the euro disease.

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, the crisis 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," said Deutsche 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

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 deep depression 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

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 fiveyear 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 percent of 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 sharper profit 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

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 threemonth 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 through financial 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 in developing 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 global financial crisis. This may impact developing countries in several ways. Fiscal consolidation

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 drastic 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 countries were 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), even though 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 countries and 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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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 also increase competition from Europe in sectors ranging from agriculture to garments and lowend 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 import from Europe at a lower cost.

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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-month high 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.

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 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 a reinforcement 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.

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