- We see significant downside risks to the European growth outlook, primarily linked to the conflict in Ukraine and related dislocation in energy markets.
- Emerging market (EM) economies in Europe are most tied to the fortunes of advanced European economies, but a downturn in the eurozone and the U.K. also poses a threat to EMs in other regions through trade and financial linkages.
- For now, emerging economies are benefiting from a strong European pent-up demand for travel, but ongoing pressure on European households' real income, as well as supply-side disruptions to air travel, may start negatively affecting tourism flows to EMs from Europe later this year.
- Diminishing current account surpluses in the eurozone and rising interest rates in Europe point to a weakening of the prospects for capital flows from advanced Europe to EMs.
Emerging market (EM) economies have shown some resilience to a set of negative domestic and international shocks, but risks to their economic outlooks are mounting amid worsening geopolitical and financial conditions (see "Economic Outlook Emerging Markets Q3 2022: Testing Times Ahead For Emerging Market Resilience," published June 27, 2022). As EMs navigate the fallout from the longer-than-expected Russia-Ukraine conflict, inflationary pressures, higher global interest rates, and economic damage from lockdowns in China, they also now face the prospect of weaker growth in advanced economies. In this report, we assess EM vulnerability to a sharper-than-expected slowdown in activity in developed European economies (the eurozone and the U.K.).
Europe's Growth Outlook Has Significant Downside Risks
In our latest macroeconomic update in June, we forecast eurozone GDP growth of 2.6% this year and 1.9% in 2023. This is 0.7 percentage points lower than in our March forecast for both years. At the same time, we estimate that the probability of a full-fledged recession is now 30%-43% (see "A Eurozone Slowdown Is For Sure; Recession Is Less Certain," published July 19, 2022). We have also revised down our GDP growth projections for the U.K. to 3.2% for this year and 1% next (in March, we expected 3.5% in 2022 and 2.3% in 2023). In both cases, this year's forecast reflects a statistical carryover to the end of a solid first quarter, while we expect anemic growth for the rest of the year and a technical recession in the U.K.
We see significant downside risks to the European growth outlook. These are primarily linked to the conflict in Ukraine and related dislocation in energy markets. Gas shortages could become more pronounced this year, which would be another blow for European consumers and may--in the most extreme case--also result in a halt of production altogether for some firms, if substitute sources of energy are only partially available. Another risk is an unwarranted tightening of financing conditions, especially for the eurozone periphery, which could turn into a drag on growth. And while the COVID-19 pandemic has lost most of its grip on the economy, some countries in Europe are reporting a resurgence in incidences that could become widespread (see "Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce," published June 27, 2022, and "Economic Outlook U.K. Q3 2022: The Great Inflation Squeeze," published June 27, 2022).
The nature of the headwinds that the European economy is facing is fundamentally different from those that triggered the last eurozone recession in 2011-2012. Today, the fallout from the Russian-Ukraine conflict dominates the risks. While European banks are exposed to a shock to economic growth in the eurozone, this is not comparable with a negative feedback loop between sovereigns and banks, and direct parallels with the 2011-2012 eurozone sovereign debt crisis are therefore not applicable. The withdrawal of European bank funding was a prominent channel of transmission of the 2011-2012 European debt crisis (as well as 2008-2009 global financial crisis) to Central and Eastern Europe (CEE), which we do not anticipate seeing today.
Things are different from 2011-2012 in other aspects, as well. The eurozone's labor market today is in much better shape than on the eve of the sovereign debt crisis, with unemployment at historically low levels. Coupled with savings buffers accumulated during the pandemic, this should support domestic consumer spending. And while public investment in the eurozone fell sharply during 2010-2012, today EU governments have committed a large part of their budget to investing in the green transition and digitalization. This, in turn, can support emerging markets exports to the region. Still, in a downside scenario, trade between emerging markets and developed Europe will suffer.
A Downturn In Europe Poses Risks To EM Exports
Trade linkages between advanced European economies and emerging markets have evolved since the global financial crisis of 2008-2009. Trade integration with EMs in Europe has deepened (see table 1). At the same time, the importance of developed Europe as an exports destination for emerging Asian economies has diminished, reflecting strong growth in intraregional trade in Asia. For Latin America, exports to Europe fluctuate with commodity prices, but they have generally also declined since the late 2000s, due to growing trade with China.
Exposure to advanced European economies' exports is highest in European emerging markets, particularly in CEE economies. Poland's combined exports to the eurozone, its major trade partner, and the U.K. account for 30% of GDP. For Turkey, this figure stands at above 10% of GDP.
|Merchandise Exports To The Eurozone And The U.K. By Type|
|(% of GDP)||Raw materials||Intermediate goods||Consumer goods||Capital goods||Total goods exports 2021||Total goods exports (2006-2008 average)|
|Note: For Argentina, Colombia, Indonesia, Thailand, and South Africa data are for 2020. For Indonesia, data prior to 2010 are unavailable, and the last column reflects the 2010 figure. For the Philippines, data prior to 2007 are unavailable, and the last column reflects the 2007-2008 average. Sources: WITS, Haver Analytics, S&P Global Ratings.|
Advanced European countries also represent a significant export market for South Africa (above 5% of GDP). Among emerging Asian economies, Malaysia has the greatest exports exposure, at 6.5% of GDP. Latin America is relatively less exposed, with exports to developed European markets representing 3.3% for Brazil and even less for all other major economies in the region.
Deeper trade integration allows CEE economies to reap benefits from the upswing in their advanced European neighbors, but also increases their vulnerabity to a downturn in these economies.
Developed European markets have gained importance as a destination for Polish exports since 2004, after Poland joined the European Union (see chart 1a). Notably, the share of Poland's goods exports to the eurozone and the U.K. is 7-10 percentage points of GDP higher now than it was on the eve of the European sovereign debt crisis. During that crisis, Poland's goods exports slowed significantly. Given stronger trade links with developed European economies now, this suggests that risks to Polish exports from a downturn in Europe are even higher.
What's more, the Polish manufacturing sector has become closely integrated with European supply chains. It is therefore vulnerable to supply chain disruptions or interruption of energy supply due to the Russia-Ukraine conflict that would affect the Germany-based industrial complex.
Turkey's trade links with advanced European economies have also strengthened, with the exports share rising by around 3 percentage points of GDP from the late 2000s (see chart 1b). That said, Turkey is a less open economy than Poland and other CEE economies. Past experience shows that Turkey's agile businesses adapt quickly to changing economic circumstances in the country's trading partners by reorienting exports to the regions with more favorable growth outlooks. During the eurozone sovereign debt crisis, for example, Turkey successfully diversified exports to the Gulf markets that were enjoying windfall gains from high hydrocarbon prices. In the current environment, Turkey may again reorient some export flows to the Gulf in the event of faltering demand from Europe.
By contrast, for emerging Asian economies, the share of exports going to Europe has declined considerably over the last 15 years (see table 1). The increasing importance of China has been a key factor, as it has risen from being a small trade partner to the largest single trade partner for several economies. In addition, there has been generally wider intra-regional trade as well.
Rising Commodity Prices Benefit Some Emerging Market Economies
Commodity-exporting EMs have benefited from rising commodity prices triggered by the Russia-Ukraine conflict, and in our view several EMs may see an additional upside linked to sanctions on Russia.
Following the start of the conflict, the EU and the U.K. introduced a number of sanctions including bans and in some cases high tariffs on imports of a wide range of commodities from Russia. Notably, they banned imports of coal and oil from Russia, expected to be applied gradually, with a phaseout of oil imports towards end-2022. The EU and the U.K. have also banned imports of wood and most products derived from steel and iron ore, and the U.K. has introduced a 35% tariff on most iron ore and steel products. In addition to already-sanctioned commodities, the situation in European gas markets remains tense following recent disruption of Russian gas supplies.
These developments provide some EMs with the opportunity to replace Russia as a source of several commodities for European countries, with an added benefit of elevated commodity prices. Prior to the conflict, Russia was a key exporter of various commodities to the EU. As of 2021, Russia provided the eurozone with 15%-20% of its oil and coal imports, as well as around 4%-5% of wood and iron ore or steel.
Among key EMs, exports of relevant commodities are important for several economies (see table 2). Colombia and Indonesia are major exporters of coal, and at the same time South Africa, Turkey, Brazil, and Indonesia are major steel exporters.
|Sanctioned Commodities Are Key Export Components For Some EMs|
|(% of total goods exports)||Coal||Oil||Wood||Iron and steel|
|Note: Data for Thailand and South Africa correspond to 2020. Sources: WITS, Haver Analytics, S&P Global Ratings.|
Some of the key EMs are already exporting a significant share of these commodities to Europe, in particular Brazil, Colombia, Turkey, and India (see chart 2), and ongoing developments provide these economies with opportunities to increase these exports even more. Commodity exporters would also likely conitnue to benefit from elevated commodity prices. Coal prices have approximately doubled since the start of the conflict, while prices for oil have grown by around 50%. Prices for wood and iron ore have decreased, however, since demand for these commodities has softened due to a dip in the number of new construction projects in Europe and China.
While there is the potential to raise commodity exports to the EU, some EMs may face constraints on production capacities, as is currently the case with iron ore production in South Africa and Brazil.
Greater Exposure To Tourism From Europe Is An Upside For EM Economies, For Now
The lifting of travel restrictions in the EU and U.K. and the sizeable pent-up demand for tourism has led to a surge in international arrivals to EMs from Europe this year. There remains a gap with pre-pandemic numbers of foreign visitors among most EM economies, however, epsecially in Asia, pointing to more catch-up potential.
Three EM economies stand out as strong beneficiaries of surging travel demand from the eurozone and the U.K.: Turkey, Poland and Thailand. In Turkey, tourism contributes meaningfully to growth, employment, and foreign currency revenues, while 45% of foreign tourists come from the EU and advanced European non-EU members (see chart 3). In Poland, the share of revenues from travel exports in GDP is half that in Turkey, but 65% of the arrivals are from the EU and the U.K. Thailand is the most dependent on tourism among key EMs, with travel exports accounting for more than 10% of GDP pre-pandemic. European travellers made up a meaningful share foreign arrivals, at 17%, second to China (see chart 5). While China's borders remain closed, European tourist arrivals can provide a welcome boost to the Thai economy.
We expect demand for travel to hold up well during next few months, even if the European economy slows more than we currently forecast. This is because many bookings have already been made, while strong pent-up demand for travel means that consumers are likely to prioritize tourism over other spending. However, ongoing pressure on households' real income, as well as supply-side disruptions to air travel, may start negatively affecting tourism flows to EMs from Europe later this year. Potential resurgence of the pandemic is a lingering risk to international travel.
Financial Flows From Europe To EMs Could Be At Risk
Europe is an important source of cross-border capital flows to emerging markets, providing financing in the form of foreign direct investment (FDI), portfolio investment, and bank lending. Weakening of these flows would tighten financing conditions and weigh on growth in EMs.
Diminishing current account surpluses in the eurozone and rising interest rates in Europe point to a weakening of the prospects for capital flows from advanced Europe to EMs, in our view. The eurozone has been running large current account surpluses of 2%-3% of GDP since 2013, led by Germany, which recorded external surpluses of 6%-8% of GDP. As a result, the single currency area has been an exporter of capital to the rest of the world, including EMs. We expect the eurozone's trade and current account surplus to narrow significantly this year due to a large adverse terms-of-trade shock. Indeed, Germany recorded its first monthly trade deficit since 1991 in May. This means less capital to export to the rest of the world. Meanwhile, current account deficits in several major other advanced economies including the U.S. and the U.K. have widened, increasing their financing needs.
What's more, yields in advanced European economies are rising, making riskier EM assets relatively less attractive. Monetary policy normalization proceeds at a faster pace than expected some months ago on the back of persistently high inflation. We expect the European Central Bank to lift the policy rate to 1.5% by the end of next year, and the Bank of England to hike rates to 2% before pausing. That said, as consumer price inflation and GDP growth are forecast to slow down in the years to come, we do not expect long-term yields to rise much beyond the levels they reached in early June.
Zooming in on portfolio flows, which are the most volatile component of overall capital flows, Europe-based investors hold a significant share of outstanding portfolio investment in many key EMs (see chart 4).
The eurozone and U.K. make up 60% of total portfolio flows in Poland, above 40% in Saudi Arabia, Turkey, and Columbia, and around 20%-30% in other emerging economies excluding China. There are notable differences between emerging economies in terms of the level of accumulated stock of portfolio investment in GDP. South Africa stands out as having the highest level, at close to 50% of GDP (see chart 5). On the other end of the spectrum, the level of outstanding portfolio investment as a share of GDP is relatively low in China, Saudi Arabia, Argentina, and Turkey. In the cases of China and Saudi Arabia, the share has been rising gradually from low levels, while for Argentina and Turkey, the share has dropped over the last years, as many cross-border portfolio investors have exited from these countries.
Looking at exposure to Europe-based portfolio investors and the level of outstanding investment, South Africa stands out as most vulnerable to the risk of a withdrawal of European funding, as the level of accumulated liabilities from the eurozone and the U.K. exceeds 20% of GDP (see chart 5). Mitigating the risk, South Africa's recent stream of current account surpluses means that it is less exposed to a drying up of foreign capital flow. In Chile, Colombia, and Malaysia, the share of the eurozone and the U.K. holdings in total portfolio investment exceeds 10% of GDP. In Poland, the share is just above 10% of GDP, reflecting a combination of the significant role of the eurozone as a source of portfolio flows, but relatively low levels of overall portfolio investment.
The eurozone and the U.K. are also key providers of FDI for EMs (see chart 6), which are mostly concentrated in the services sector, although investment in manufacturing is significant in some cases, for example in Mexico's automotive sector. FDI from developed European neighbours are particularly important in CEE, with eurozone holdings representing more than 80% of outstanding FDI in Poland. Europe is also a major source of FDI for other key emerging economies in EMEA and Latin America. In the case of emerging Asian markts, however, FDI inflows are currently dominated by China, Singapore, and Japan. FDI flows from developed markets to EMs have been mostly increasing over the past years with some exceptions, such as Malaysia, Turkey, and Argentina. Nevertheless, FDI levels (as a share of GDP) of many EMs are still below the peaks prior to the global financial crisis.
A Hard Downside Scenario Would Negatively Affect All EMs
Our analysis points to emerging European economies as being most tied to advanced Europe's fortunes, while several emerging markets in other regions have a meaningful exposure to Europe via trade, tourism, and financial channels. These economies are therefore most vulnerable to a sharper-than-expected slowing in economic activity in developed European markets. Our analysis only looks at direct channels of transmission of a downturn in Europe to the rest of EMs. As highlighted in our previous publications, a hard downside scenario that would involve a trade rupture between Russia and Europe centered on oil and gas, plus a host of industrial commodities used as inputs in the German industrial complex, would materially disrupt production and employment in key sectors of the European economy. This would hit markets in ways that would reverberate well beyond Europe (see "Global Macro Update: Growth Forecasts Lowered On Longer Russia-Ukraine Conflict And Rising Inflation," May 17, 2022). While emerging European economies are particularly vulnerable, such a scenario would negatively affect all emerging markets.
- A Eurozone Slowdown Is For Sure; Recession Is Less Certain, July 19, 2022
- Economic Outlook Emerging Markets Q3 2022: Testing Times Ahead For Emerging Market Resilience, June 27, 2022
- Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce, June 27, 2022
- Economic Outlook U.K. Q3 2022: The Great Inflation Squeeze, June 27, 2022
This report does not constitute a rating action.
|Lead Economist:||Tatiana Lysenko, Paris + 33 14 420 6748;|
|Economist:||Valerijs Rezvijs, London (44) 79-2965-1386;|
|Research Contributor:||Prarthana Verma, CRISIL Global Analytical Center, an S&P affiliate, Mumbai|
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