Dynamic Macro Interdependencies in the World Economy: How Will Emerging Economies Be Affected by the Eurozone Crisis?

Is Europe going to drag the world down into depression? The financial markets seem to believe it. The rush to safety is widespread and the safe havens are few.

For the two-years after the brisk but flimsy recovery due to the 2009 stimulating plans, the Eurozone has headed downward to the Japanese disease, while the US has managed to stay on modest growth still disappointing policy makers. However, the Eurozone crisis is turning viral, infecting the world economy. How will emerging economies be affected from this crisis?

To probe into this highly complex question, we will use the results of a recent research paper (Erten, 2012) that analyzes the robustness of emerging economies growth performance to a number of external demand shocks using a Bayesian vector autoregressive (BVAR) model with informative priors on the steady state. Conditional forecasts of different scenarios indicate that a deepening of the Eurozone recession would create a significant contraction for the emerging market economies in Asia and Latin America, depending on the response of the U.S. growth to this shock.

Before displaying the results of the econometric estimations and scenario simulations of this study, let us outline briefly most recent characteristics of the deteriorating outlook in the US and the largest economies of Asia and Latin America

Deteriorating Outlook in the United States, India, China and Brazil

The United States

The U.S. economic outlook is haunted by politics: the November election and the socalled “fiscal cliff”. It is the third time since 2010 that a surge of growth in early months of the year has petered out in late spring. The fiscal cliff implies automatic tax increase and spending cut that will arise on December 31 with the end of Bush fiscal ease. The political bickering aside, a key question is whether growth is far under potential or the trend of potential growth is permanently lower than before the crisis. Those believing in the first assumption are waiting for a brisk recovery. The alternative view is that the economy is not much below its potential. Potential growth was around 3% before the crisis; it might have slowed to about 2%. The reason lies in the lasting damage inflicted by the financial crisis.


Amongst the BRICs, India is most affected. Growth slowed down to 5.3% in May 2012, decelerating steadily from 9.2% in the first quarter 2011 and almost 10% in 2004-2007. The reasons lie in the macroeconomic disequilibria: the twin deficits in public finance (- 5.9% estimated for fiscal year April 2011-March 2012) and current account (-3.5% * University Paris Nanterre and CEPII, and Post-doctoral Fellow of the Committee on Global Thought at Columbia University, respectively. 2 GDP), as well as the stubbornly high inflation (7.2%). The current account balance is very sensitive to acceleration of domestic growth. Therefore the impact of the slowdown in world growth is unlikely to be compensated by bolder economic policies.


The marked slowdown of growth in the first quarter of this year, prolonged by worries in April, has triggered a speedy response of the State Council in sharp contrast with the political paralysis in the US and Europe. A calibrated countercyclical policy was decided in early June. The present proactive policy is a combination of some fiscal stimulus compatible with the direction of the 5-year plan and looser monetary policy with room to respond to further downside shocks.


In Brazil investment is far too low to sustain a growth rate of GDP consistently higher than 5%, a minimum for the catching up of an emerging market economy. Since mid of 2011 the central bank succeeded in lowering the leading interest rate to 9%. Applying a more restrictive fiscal policy, the government hopes that the basic real rate will decline to 2% in 2013 from an average of 4% over 2000-07. Absent a further big shock from Europe, growth could reaccelerate with the reduction in interest rates and reach 3.3% in 2012 against 2.7% in 2011.

Transmission of shocks from developed to emerging market economies

The purpose of our research is to identify channels of transmission and to measure macro spillovers between world regions. The resilience of big emerging market countries in the last ten years shows substantial contrast with the two former decades (1982-2002). The large devaluations in 1997-2002, due to the string of financial crises from Asia to Argentina, have fostered export-led growth in Latin America and Asia. It has entailed a substantial accumulation of foreign exchange reserves and a systematic reduction of foreign indebtedness. The financial safety thus acquired and the much better counter cyclical macro policies make these countries better equipped to weather headwinds from Europe.

Structural reasons have reinforced the partial decoupling:

  • Regional integration in Asia has been polarized by Chinese growth and has linked Asian economies tighter as the intra-Asian trade increased faster than trade with Western countries after 2008.
  • The trend decline in relative prices of commodities has reversed its course since 2005. It has supported the strong recovery in Latin America and intensified trade and financial links with China.
  • The growth regime has begun to change in China since 2010 with the transformation of the labor market and the strategic focus on energy efficiency to avoid the middle-income growth trap.
  • Competitive policies in Asia are designed to mobilize domestic saving towards investment in traded goods sectors via undervalued real exchange rates.

Nonetheless Europe is still an important partner to Asia. To capture the growth spillover between regions of the world, the model distinguishes two developed economies (US and Eurozone) and three groups of emerging economies (China, rest of emerging Asia and Latin America). It describes macro interdependencies focusing on GDP growth rates, global liquidity, and global financial risk.

Table 1. Output Elasticities of External Demand Shocks in China, Emerging Asia and Emerging Latin America following 1% GDP shock in the different zones after 1 and 3 quarters

Source: Author’s calculations from impulse response functions.

Note: The elasticities represent the percentage point response of growth rates for each emerging economy to a one-percentage-point shock in external demand. Data cover 1993 Q2 – 2011 Q4.

One can observe that a 1% shock on US growth has an instant impact (1Q) nearly twice in emerging Asia and more than twice in Latin America than in China. The impact is dampened after 3 quarters in China, where the working of counter cyclical policy is blatant. It is augmented in the other two emerging regions. A Eurozone shock works differently with a smaller impact in China in the short run than a downside shock from the US. After 3 quarters it is persistent because Europe is the first customer. In the end its magnitude is about the same as a US shock but the profile is different. In the other two regions the contrast is more pronounced. The most striking result is the muted impact of a European shock on Latin America because of the weight of Mexico, which is entirely under US influence. A calibrated shock from Europe has an impact of 5 to 6 times less than a shock from the US. In emerging Asia the profile is much more contrasted. In the short run there is almost no impact. After 3 quarters it increases markedly in a more roundabout way, via China. One can see that China impinges strongly on both emerging Asia and Latin America.

Stress scenarios in the world economy

The main systemic risk is a partial or full breakup of the Eurozone, depending on the response to contagion in financial markets. The intensity of the recessive dynamics depends on what might happen in the US. Either the US has the capacity to undertake aggressive counter cyclical policy, or the political paralysis cannot be overcome and the US falls off the fiscal cliff.

We define the scenario by calibrating -3% annual recession starting from mid-year 2012 that goes on at the same speed in 2013. The variants depend on the US response. The US can either coordinate monetary and fiscal policy or fall from the fiscal cliff. In the first case they keep 1.5% growth. In the second they lose about 2% and their growth rate falls to 0%.

When the US counter cyclical policy is effective, our model predicts that Chinese growth slows down to 7.8% after 3 quarters and a little bit more thereafter, stabilizing at 7.4%. The magnitude of the spillover is therefore limited to 1% the first year and 1.4% after 3 4 years. The Chinese economy does not recover the previous growth trend. However, the long-run slowdown is compatible with the planned transition to sustainable growth.

Average growth in emerging Asia but China loses 2% after 2 quarters, slipping from 3.5 to 1.4%. However growth rebounds at 3% after 4 quarters then turns down again to converge to 2.2%. As we have shown, Latin America is much less linked directly to Europe. If the US keeps its momentum, it shelters the rest of the continent from permanent adverse effects. Growth diminishes from 2.8 to 2.0% in 2 quarters. However, it bounces back to 3.3% after one year.

If US growth chokes off to standstill, consequences are much direr. China’s growth loses 1.4% in 2 quarters to 7.0%. However there is a recovery to 8.2%. The reason lies in the fall in the price of primary commodities due to the high impact of US stagnation compounded with China’s sharp slowdown on the demand for primary resources. Because China is the largest importer of commodities, the fall in the price is tantamount to a positive supply shock in China’s manufacturing industry and a positive domestic demand shock fed by the increase in household real income. It largely offsets the negative foreign demand shock due to the Eurozone crisis. The other emerging regions suffer more, albeit keeping the same time profile. Emerging Asia and Latin America plummet from 3.2 and 2.8% growth to quasi-stagnation (0.4%) in two quarters. The subsequent recovery is weaker in Latin America to 2.9%.

What about a derailment of the Chinese transition leading to substantial diminution of Chinese growth? Let us suppose that China’s growth slumps from 8.5 to 6.0%. Emerging Asia would undergo a loss of growth from 3.5 to 1.7%, then turns up again to 2.9% on reorienting their foreign trade. On the contrary Latin America suffers much more. In the short run growth follows the same slowdown as in the Eurozone crisis from 2.8 to 2.0%. Then it goes on decelerating to 1.3% instead of reaccelerating. The reason lies in the structure of foreign trade. Emerging Asia and Latin America have very different links to China. Emerging Asia trades competitive industrial goods. Overtime the firms can diversify their customers and diffuse the shock in a scenario where China’s problems in restructuring its economy are specific, thus not linked to Europe’s crisis. On the contrary, Latin America exports primary commodities to China. The trade is complementary instead of substitute. A severe and pervasive shock on China’s growth would affect Latin America’s exports and income through a sharp contraction in the price of primary commodities.


Aglietta, Michel (2012), “Europe and the World Economy at the Tipping Point”, International Economics, forthcoming.

Erten Bilge (2012), “Macroeconomic Transmission of Eurozone Shocks to Emerging Economies,” CEPII Working Papers, No: 2012-12.

International Monetary Fund (2012), “China Economic Outlook”, February 6.