International contagion

Markets have rejoiced at a Greek referendum reprieve and a welcome rate cut from the European Central Bank. But the euro zone crisis has already harmed growth. The big question will be whether the United States and Asia hold up, or follow Europe down.

Recessionary forces already look strong in Europe. IHS Global Insight expects to downgrade its current forecast of just 0.3 per cent euro zone growth in 2012. There are two problems. First, fiscal austerity has become essential through most of the euro zone. Even France promises to make an effort. In the short term, government spending cuts and tax increases are hurting growth. Second, confidence has plunged. Businesses won’t invest and hire when the euro zone’s future is under question. Banks can see the write downs on the wall. Threatened by defaults, orderly or otherwise, they will trim balance sheets rather than lend more. And, who other than distressed governments, wants to borrow more now?

The further danger is that European slowdown spreads. Recession in Europe means less demand for Asia’s exporters. Commodity demand – and prices – could weaken. And though financial markets are rejoicing on Friday, the next leg of the euro zone drama is very likely to cause renewed panic, making euro zone-induced volatility a global problem.

The overriding question will be whether the United States and China can take the strain. America’s relatively closed economy helps. Exports account for less than 13 per cent of GDP. And , US recovery is helped in one respect by global fear: the exiguous yields on US treasuries are making mortgages cheap and helping to stabilise the housing sector.

But capital flows pose a special risk for Asia and emerging economies in general. Investors will retreat again from emerging market assets when euro fears heighten. Such flights for safety cause emerging market currency weakness and financing difficulties and could lead to stagflationary pressures, already evident in Turkey. Europe’s crisis has the world rightly worried and calls for a global response, but policymakers have to be careful. A third round of US quantitative easing would risk adding to the inflation that has already forced tighter policy in most emerging economies. But the G20 would be right to push China to allow the yuan to rise faster. That would help rebalance world trade and China and curb Chinese inflation – rather than pumping Chinese exports at a crisis-afflicted world. Overall, the picture is worrying. A world still struggling to recover from one recession can ill afford another one in Europe. The danger to global growth is real.