www.AfricaEconomicAnalysis.org

The Euro: Implications for 3rd world countries

By Enase Okonedo

 

FOR developing countries especially those in Asia, Africa and Latin America described as third world - the key economic challenge is to develop and implement policies which successfully meet the challenges of grinding domestic poverty and a very competitive international economic environment.

Many of these developing countries have not participated in the decade-long growth in world trade driven by steady growth in America and many parts of Europe. While economies of Europe and the USA have witnessed higher levels of economic activity and income, the experience of developing countries has been one of economic instability.

From Asia through Latin America to Africa, the economic story in the recent past has not given much cause for applause. With the exception of China, the horizon of most developing countries has been characterized by crisis, which have adversely affected economic performance.

In 1997 the ‘tigers’ - the popular description of the fast growing East Asian countries - collectively ran into a financial crisis. Currency devaluation, domestic financial sector difficulties, declining output and growing unemployment that followed the financial whirlwind are consequences which most of these countries are still trying to recover.

In Latin America, the economic problems - resulting from financial market reactions - are a recurring decimal. The recent example of Brazil is instructive.

For Africa, the situation is even less encouraging. Wars, declining commodity market prices, deficiency of economic infrastructure and inept leadership have combined to produce a continent increasingly irrelevant in global economic calculations.

For these countries, developments in the world economy pose new challenges, which must be adequately responded to. The alternative to adequate response does not bear thinking about. Phenomenal advances in technology have brought about a globalization of the world economy. No longer can small individual countries hope to successfully go it alone.

Previously, economic policy meant monitoring trade balances, balance of payments and foreign exchange and interest rates and governments received constant feedback on these key indicators affecting national economic performance. They could therefore react accordingly. Now, most of these will disappear at the national level and will now be at the Euro level. So while monetary policies will now be determined by the European Central Bank (ECB), at the Euro level, other tools of macroeconomic management/fiscal policy still remain in the hands of national authorities. This is likely to create conflicts between governments and the ECB especially when economic conditions diverge within Euroland.

One of the constraints on the fiscal policies of government however is the excessive deficit procedure that is included in the Masstricht treaty, which states the sanctions applicable to a country whose annual budget deficit is greater than 3% of its GDP. But there is a proviso that this can be suspended when a country is undergoing severe economic downturn or negative annual growth of 0.75%.

The thinking behind the excessive deficits procedure is that excessive public borrowing worsens a currency and that once a country is in, it may be tempted to borrow and spent more, at every one else’s expense which could worsen interest rates for all. However, there is little evidence that budget deficits or high debts per se undermine currencies. In the ‘80’s, budget deficits helped fuel the dollar and in the ‘90’s, it helped the deutsche mark. In a global market, it is unlikely that one country’s borrowing will have an impact on interest rates.

Another key expectation is that the single currency would lead to further progress in reforming Labour markets and addressing other structural problems, and consequently, to medium-term output gains. It will not solve Europe’s structural unemployment problems but to the extent that it is expected to spur economic growth, it will indirectly stimulate job creation.

It is also likely to speed deregulation as seen in the airline and telecom industries in Europe. Governments will be more willing to sell state owned corporations. The increasing wave of deregulation across countries in the region is transforming Europe into a freer, more efficient market. It is expected that more new jobs will be created and prices will reduce due to competition, especially in areas such as telecommunications, which is growing at an annual rate of 8%; and electricity where it is expected that 50% of national markets will be opened up by the end of the century.

There will be a massive expansion of European equity markets, currently only one-fourth the size of the US market. With the creation of an enlarged financial market, it is likely that more investors both within and outside Europe will be attracted to the zone. The Euro will lower the cost of money and thereby create more resources for corporate innovation and individual wealth.

In addition, it is expected that the Euro will bring monetary stability to businesses in countries like Spain and Italy where previously, their fluctuating currencies have increased the risk, and therefore the cost, of foreign investment. The predictability of the Euro will now make it easier for local businesses to embark on bigger investment projects than previously.

It is also believed that with low interest rates in the zone and low inflation, growth will follow. But we see from the case of Japan, that low interest rates alone are not sufficient to stimulate the economy and create growth. We should be looking at the real interest rate in order to find out what the effect on the economy will be and this is determined more by prices than by the level of economic activity.

As the new millennium approaches, it is obvious from the above that the Europe and US will become twin anchors of prosperity and stability. What will be effect of these on other nations, particularly third world countries?

The European Monetary Union (EMU) and the development of a single, more powerful economic market will have an impact not only on the other economies of Western Europe, but also on other countries with established trade and financial links to Europe. These will include countries that link their currencies to the Euro such as the eight countries in West Africa whose currency, the CFA franc, has been pegged to the Euro via the French franc as from January 1st, 1999.

The greatest impact of the single market is likely to be in trade and financial linkages. Increased activity and high import demand in the Euro zone will lead to increased exports from developing and transition economies. In the same way, exchange rate arrangements, financial market developments and capital flows will have implications for these economies and their policies. For instance, where there is a single trade regime for the EU and a different one for member countries, the EU regime supercedes. One of the benefits of this is in lower tariffs on items. Average weighted industrial tariffs for individual countries are currently higher than the 3.6% average for the EU and so countries importing into the EU zone will enjoy reduced tariff at this rate.

Increases in the cyclical strength of the Euro zone will lead directly to enhanced exports for Europe’s trading partners. Trade with the zone is currently between 40% to 50% of total goods trade for Africa, with countries in North Africa and the CFA franc zone at the higher end of this range.

It is also expected that emerging market countries with close ties to Europe whose currencies are linked to the Deutsche Mark or the French franc will shift these links to the Euro, as has been done by the Central Bank of West African states (BCEAO) on January 1st, 1999. Changing values between the dollar or yen could affect such countries’ external competitiveness when the currency or currency basket of the exchange rate target deviates from the trade-based effective exchange rate. Also, countries with dollar or yen denominated debt would be affected. An increase in the value of the Euro would benefit those countries that peg their currencies to the Euro, as it would decrease the domestic currency cost of servicing such debt. Conversely, any depreciation of the Euro would increase the cost of such debt service.

To offset these effects, countries may decide to adjust their exchange rate regimes to better reflect the composition of their trade and financial links, or to change their debt-management policies. Adjustments to debt management will be facilitated as the Euro becomes more widely used in trade and financial markets and accounts for a larger share of debt securities. Countries that peg to the Euro will be able to lower their dollar exposure and reduce the fluctuations in their dollar-denominated debt payments.

The Euro will bring the continents even closer because by the consolidation of eleven different markets, it will create a more liquid market with a source of capital far bigger than the sum of its parts. Capital markets in the zone will come to represent a fresh source of funds for European and US companies. In essence, such companies will no longer need to look to the developing world for growth. Increasingly, Western companies are getting more capital, while flows of net credit into emerging countries are declining. It is obvious that investors in both zones are moving towards low but less volatile returns from each others capital markets rather than looking for short-term high returns from emerging countries especially in the light of the Asian crises which almost completely eroded confidence in emerging markets. Strong demand by advanced countries for exports from the Euro zone as well as depreciation of the currencies of countries in the zone in the last three years has stimulated recovery in these areas and helped to offset the effects of the Asian crises.

Also, for this reason, the IMF as well as the World Bank have now shifted ground from their traditional positions and now agree that developing nations now imbibe financial controls since floating currencies and free inflows of ‘hot money’ may actually hurt countries with primitive financial systems. It is now agreed that European and US financial systems, where capital inflows account for only 2% of economic output, are big and sophisticated enough to absorb hot money shocks as opposed to these developing nations. One way by which developing countries can help themselves in this regard is by greater transparency in its banking system to decrease the notion that they are inherently unstable. Since its 1994 crash, Mexico has tried to put this in place and so far, this has helped it escape the worst of the panic.

There is a danger in this trend of increased capital flows into the West however because as the economies of Europe and the US proper while those of emerging countries become less relevant to this prosperity, many developing countries face many more future years of trauma.

Another effect of the EMU will be felt in the export of goods from emerging countries. Developing countries who are primarily exporters of commodities are getting less for the commodities they produce. Since a lot of their currencies value has declined, purchasing power especially for things such as machinery and raw materials, which would improve production, has declined. They are therefore unable to increase their exports. Without inflow of funds from the developed or Western world, many developing nations are now clearly more disadvantaged than they were previously. Unlike in the early 90’s when there was massive capital inflows into emerging markets from the western world, now these economies are left alone to struggle out of the recession with minimal, if any, western investment. We also see that direct investment by companies have also declined. The effect of this is that emerging countries now face years of slower growth, as the cost of capital has become astronomical. These countries have lost the ability they had in those years of increasing global growth. With this situation, it is likely that new Foreign Direct Investment (FDI) will be concentrated in a few countries such as China, Korea, Mexico or Poland, for strategic reasons.

There might however still be some investment by private institutions such as insurance companies and pension funds in the Euro zone that will shift some of their portfolios into emerging market investments. Because investments outside their home countries but within the Euro zone will be reclassified as domestic currency investments, investors may find that EMU effectively eases constraints imposed by currency exposure requirements. Emerging market economies could also benefit from direct and portfolio capital inflows if converging asset returns in Europe lead global investors to increase their emerging market holdings in order to diversify across countries.

There are however some financial risks that emerging market countries will now be exposed to: a successful EMU that raises productivity and growth could make Europe more attractive to investors (as earlier described) and increase the cost of capital for emerging market economies. Furthermore, increased competitiveness of European financial institutions and the greater depth of financial markets in the Euro zone could lead companies in developing and transition countries to raise capital in Euro rather than in their domestic currencies, thus challenging local capital markets. This could however, provide an incentive for such countries to strengthen their financial intermediation and build sound banking systems.

The Euro and the environment it will create bring with it many opportunities. At the same time there are many threats for the unprepared economies and countries. The Nigerian government and businesses have to come to grips with the fact that the introduction of the Euro is a global phenomenon with global consequences and must be prepared to take advantage of the opportunities and to mitigate the threats the Euro poses.

Rather than calculating the gains to the Euro zone and the disadvantages to countries outside the zone - especially developing countries - the challenge is for us to take actions and launch initiatives to make us more competitive, as well as spur growth in our region.

Mrs Enase Okonedo is a member of Faculty, Lagos Business School.

 

Date Uploaded 1/23/2008
Copyright Africa Economic Analysis 2005