Tags: World | Contagion | Risks | Center Stage

Small World: Global Contagion Risks Take Center Stage

Sunday, 20 May 2012 03:08 PM EDT

World leaders are increasingly alarmed at the prospect of financial problems in Europe sending shockwaves through the global economy when advanced countries have very limited resources to fight back.

Yesterday's fear was Greece leaving the euro zone. Today it's morphed into a broader concern that bad loans piled up in Spanish banks are eroding confidence in Europe's financial system and could unravel the single currency.

What is unsettling them is new research from the International Monetary Fund, which has found that advanced and emerging economies have grown so deeply interlinked that a shock from one region could have effects worldwide that are even more profound than in 2008, when financial services firm Lehman Bros collapsed.

Global growth remains sluggish, debt levels in advanced economies high and their governments have very little if any fiscal or monetary policy room left to soften the blow should a fresh crisis erupt.

"The world is much, much more interconnected than at any time before," said Zhu Min, the IMF's deputy managing director, at a conference last week where he discussed the IMF study.

The global supply chain allows companies to source goods cheaply from a factory anywhere in the world. But it also means that a shock from one continent ricochets very rapidly into another, hundreds of thousands of miles away, through financial markets. Witness the Thai floods and Japan earthquake in 2011.

In 2003, this market linkage was 42 percent, but today the equity market linkage between the United States and Asia is 81 percent, Zhu said. Similarly, the impact of an external shock on industrial output has risen from 30 percent to 40 percent today, he said.

"Anything happening in one direction can be amplified in ways we never had before," Zhu said.

No wonder that the G8 leaders of the world's major economies meeting at Camp David in the C atoctin Mountains of Maryland this past weekend sought ways to boost growth and strengthen financial stability, particularly in Europe to prevent the euro zone crisis from spiralling out of control.

Within diplomatic circles, there is a deepening awareness that Spain matters, Greece is no island and that their economic collapse could have major consequences.

"This is a systemic crisis, there are systemic implications from the Greek crisis for their economies. That had not been fully appreciated in the debate so far," said Domenico Lombardi, a senior fellow at the Washington-based Brookings Institution and expert on international economic affairs.

European Union leaders will take an important step on Wednesday when they hold a dinner to discuss ways to stimulate economic growth in Europe, which stalled in the first quarter, while adhering to plans to lower their government debt loads.

If they were to embrace a bold growth plan - one that tears down rules and regulations in the service sector to boost competitiveness not only in Greece, Italy and Spain but also in France and Germany - it would mark a major breakthrough, Lombardi said. It would have a more lasting impact on growth and jobs, far beyond the infrastructure projects that they have discussed so far, he said.

"Right now we are heading toward a one-sided scenario where fiscal contraction leads to deflation and there is no room to be confident about any policy working in this scenario," he said.



A measure of the vulnerability of the world's major economies will come on Thursday when Markit, a London-based financial information services company, gives an early look at manufacturing and service sector growth in the Big Three economies.

China's manufacturing sector shrank in April, hurt by recession in its leading trade partner Europe. Weak bank lending figures and slowing industrial output are revealing the soft underside of Chinese growth, keeping investors edgy about its outlook.

Brown Brothers Harriman said the risks are tilted to the downside for China. "A fast rebound for China is unlikely in the context of sluggish U.S. growth, euro zone recession and a slowdown in the major emerging market economies," it said in a client note.

In the euro zone, analysts on average expect that Markit's flash Purchasing Managers Index for May will show that the contraction in manufacturing and services deepened slightly to 46.5 from 46.7 in April.

For the first time, Markit also will release a flash estimate for U.S. business activity. The ISM manufacturing index strengthened in April to 54.8 from 53.4 while services slowed to 54.6 from 58.9.

Nomura Securities economist Lewis Alexander said that so far U.S. economic data pointed to an economy that has remained resilient despite the pressures. "But rising concerns over Europe threaten the recovery through tighter financial conditions," he said.

In other words, interconnected economies and markets mean that we live in a very small world.

© 2024 Thomson/Reuters. All rights reserved.

Sunday, 20 May 2012 03:08 PM
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