The Emerging Economies’ Eurozone Crisis

WASHINGTON, DC – Most of today’s economic institutions, from money to banking, evolved over many years – the unintended consequences of decisions by millions of individuals. By contrast, the eurozone stands out for being a deliberate creation. It is arguably the world’s second-largest, deliberately-planned economic structure, after Communism.

The eurozone is a remarkable experiment, a genuine vanguard of global progress. As 2012 comes to a close, it is in trouble, and every effort must be made to nurture and strengthen it.

By the second half of 2011, it was evident that emerging economies, which had weathered the financial crisis that began in 2008 moderately well, were taking on water as the eurozone crisis deepened. Growth slowed sharply in Brazil, India, China, and other countries.

Central banks acted as lenders of last resort, thereby averting a major crisis. In December 2011 and February 2012, the European Central Bank announced the long-term refinancing operation (LTRO), whereby European banks were lent around €1 trillion ($1.3 trillion) in two tranches. Then, in July, came ECB President Mario Draghi’s famous assurance to do “whatever it takes” to save the euro. The United States Federal Reserve injected liquidity, as did other advanced countries’ central banks.

There was a collective sigh of relief, financial markets stabilized, and industrial-production rebounded. The question on everyone’s mind now is whether this post-storm calm will last, allowing the global economy to pick up.

Nowhere does this question loom larger than in developing and emerging economies, which are outside the main theater of the crisis, but are more precariously positioned than the advanced countries. Many had only recently begun to grow rapidly, and, with vast reservoirs of poor people, economic growth has a moral urgency that it does not have in rich countries.

So, will the global economy stage a sustained recovery? Examining the past as carefully as I can, and aware of the risks of augury, my answer has to be no. Until 2015, the outlook is gloomy for Europe and, by extension, for the emerging and developing economies. The injection of liquidity that occurred over the last year was the right policy. But it only bought time; it did not solve the problem. And time is running out.

Unfortunately, most people have an instinctive propensity to look away from approaching problems until they are very close. America’s “fiscal cliff,” for example, was long in coming, but we are scrambling to avoid it only now. So we should take early stock of the fact that there is another problem coming our way, which may be called (to give it the resonance of a coming storm) Edward – the “European Debt Wall and Repayment Deadline.”

The LTRO money that banks received on such easy terms, we must recall, took the form of three-year loans, which implies a wall of debt repayment in December 2014 and February 2015. If Europe succeeds in making major fiscal and banking reforms and gets its economy in order, Edward will lose steam. If not, the crisis will persist, and Europe will be rocked as Edward makes landfall by the end of 2014.

Where does that leave developing countries? The US and Europe are the world’s two largest economic powerhouses. Their slowdown will have an adverse impact on all emerging economies. Moreover, the US and Europe have already used large doses of fiscal stimulus, which shares an uncanny similarity to antibiotics. Administered over a short duration, it can be a powerful antidote; but, used repeatedly over too long a period, the side effects can outstrip the benefits.

Consider the case of India. Since 2009, India has been expanding its deficit as a deliberate measure to counter its economic slowdown. Because fiscal expansion followed several years of restraint, it was very effective in spurring demand and output growth. But now the scope for further expansion is limited. Unlike advanced countries, most emerging economies are exhibiting inflationary pressures, which could be exacerbated by another round of stimulus spending. So the short-run situation remains precarious.

Nevertheless, for emerging economies, the medium- to long-term prospects are bright. Countries that are saving a substantial amount, investing in human capital, and providing a modicum of good governance should resume their previous rapid growth.

India, for example, is saving and investing well over 30% of its GDP, devoting a significant share of these resources to infrastructure. Its entrepreneurial capacity is expanding. In several recent years, India’s outward direct investment in Britain has exceeded inward direct investment from Britain. So, once the crisis is over, annual growth should rebound to its earlier rate of more than 8%.

Investors seem to be taking this view to heart. They have been tightfisted when it comes to short-term equity investments. But, when it comes to long-term direct investment, they committed a record-high $43.8 billion to India in 2011-2012. Beyond the current crisis, the prospect appears to be similar in other major emerging economies, including Brazil, China, and Indonesia.

Easing short-term jitters and paving the way for further developing-country growth will require a clear and credible program for returning high-income economies, especially those in Europe, to a sustainable fiscal path. It will be a bumpy road ahead, requiring careful navigation and bold policy implementation.