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The euro zone crisis and developing countries

Isabella Massa, Jodie Keane and Jane Kennan Working Paper 345, May 2012 ISBN 978-1-907288-66-1 Working Paper (Print) ISSN 1759 2909 ODI Working Papers (Online) ISSN 1759 2917

Isabella Massa, Jodie Keane and Jane Kennan Working Paper 345, May 2012 ISBN 978-1-907288-66-1 Working Paper (Print) ISSN 1759 2909 ODI Working Papers (Online) ISSN 1759 2917

This paper analyses the vulnerability of developing countries to the euro zone crisis, looking at differences across countries and groups of countries. In addition to this, it simulates the potential effects of trade shocks due to the crisis on lower-income economies, and establishes a set of stylised facts on the actual impacts of the European debt crisis on poor countries. Policy responses at the country and international level are also discussed.

From the analysis it emerges that the developing countries likely to be more at risk from the euro zone crisis are those which : • direct a significant share of their exports to European crisis-affected countries • export products with high income elasticities • are heavily dependent on remittances, foreign direct investment, cross-border bank lending and aid flows from European countries • have limited policy room to counter the effects of the crisis.

Significant differences in the degree of vulnerability to the euro zone crisis exist among countries as well as across developing regions and groups of countries. The European debt crisis is likely to hit poor countries hard through the trade channel. Our simulation results show that a drop of 1% in export growth could reduce growth rates in low- and lower-middleincome countries by an average of 0.4% and 0.5% respectively.

The impact of the crisis on developing countries is already visible in the form of reductions in exports, declining portfolio flows, cancelled or postponed investment plans, and falling remittances and aid flows. In Mozambique Portuguese public investments have been reduced ; in Nigeria remittances have declined ; in Kenya the stock exchange has suffered heavy sell-offs ; and in Rwanda foreign investments have been delayed. Nevertheless, the effects of the euro zone crisis so far (at least from a trade and finance perspective) seem to be less severe than those of the 2008–9 global financial crisis. The slowdown in China’s growth may, however, increase the risks for developing countries, thus leaving them overly exposed to the trade- and finance-related adverse impacts of the euro zone crisis.

In order to weather the crisis, developing countries should, whilst maintaining fiscal soundness and macroeconomic stability as long-term targets, spur aggregate domestic demand, promote export diversification in both markets and products, improve financial regulation, endorse long-term growth policies, and strengthen social safety nets. For their part, multilateral institutions should ensure that adequate funds and shock facilities are put in place in a coordinated way to provide effective and timely assistance to crisis-affected countries.

  • 08/06/2012

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