The European Crisis and its Possible Impacts in
Latin America and the Caribbean

Demonstration in Madrid, Spain, 2010 Photo: Flickr, Olmovich

The fiscal difficulties in some European countries have cast a shadow over the recovery of the world economy. To address the effects of these imbalances, the European Union, the International Monetary Fund and the European Central Bank adopted joint measures to alleviate the pressure on these economies and mitigate the prevailing loss of confidence.

In addition to these financial efforts, these countries have announced the implementation of significant fiscal adjustment packages. Greece announced measures that would allow it to reduce its fiscal deficit from 13.6% of GDP to 2.6% in 2014. Spain is seeking to lower its deficit from 9.3% to 3% in 2013. Italy is announcing a 24 billion euro budget adjustment for 2011-2012, while Ireland hopes to reduce its fiscal deficit from 12% to 5% in 2015, and Portugal aims to lower it from 7% to 4.6% in 2011.

The measures include spending cuts, reducing employment and salaries in the public sector, raising the retirement age, increasing taxes and privatizing some public companies.

Other European countries have also adopted these measures as a way to meet the fiscal criteria established in the Maastricht Treaty (1992) and strengthen the stability of the euro. Germany, for example, hopes to save 80 billion euros in four years in order to reduce its deficit from the current 5% to 3% of GDP in 2013. France seeks to reduce its deficit from 8% to 3% during the same period by cutting spending by 100 billion euros. The United Kingdom has also announced plans that imply the greatest fiscal effort since the Second World War.

These packages have stirred controversy due to their effects on economic recovery. On the one hand, ECLAC, among others, has warned of the possible negative consequences of strong fiscal adjustments and an early withdrawal of economic reactivation stimuli.

On the other hand, some argue that these fiscal measures could have a positive effect by stabilizing international financial markets and thus improve medium and long-term expectations.

Despite the estimates of a moderate recovery, there are signs of an economic slow-down in Europe. Unemployment has risen considerably and in countries such as Spain, Greece and Ireland, it has reached the highest levels ever in recent history, forecasting what could be an “economic recovery without employment”.

Declining economic activity is also reflected in very low consumption in the euro zone, given the conditions of domestic demand. The external sector has also felt the blow, with trade deficits during the first quarter of 2010, fundamentally due to results in the United Kingdom, Spain, Greece and Italy, which register the highest deficits in Europe.

The economic difficulties in Europe can affect the economies of Latin America and the Caribbean through trade and finance. The scope and intensity of these effects will depend on the duration and breadth of the debt crisis in Europe.

Weak domestic demand in European countries caused by higher unemployment, the position of fiscal austerity and the depreciation of the euro is expected to reduce demand for exports from the region. The European Union continues to be an important trade partner for the region - the third destination for its exports after the United States and the regional market. In 2008, the European Union purchased 13% of Latin American and Caribbean exports. The United States buys nearly 40% of the region’s exports, and another 20% is sold within the region. The situation in Europe is even more sensitive to South America nations, whose share of exports to the European Union is the same as to the United States (18%).

If the European crisis deepens and eventually affects the performance of the global economy, the region’s exports could suffer an even greater decline with the drop in the price of its prime materials in addition to the effects already mentioned. So far this year, the average price of prime materials contracted 3.3%, notably the price of foods (6.5%) and metals (2.6%). The price of copper fell by 4.7%, while the price of oil has ranged from 75 to 85 dollars a barrel.

The greater precaution with which European consumers are making decisions in this context of higher uncertainty could also impact the region through tourism, given that several countries, especially in the Caribbean, are important vacation destinations for tourists from developed countries. A reduction in the flow of tourists could affect an important source of income for countries that are highly dependent on tourism.

The flow of remittances from Europe could slow down or even fall, impacting significantly countries such as Ecuador, Colombia and Paraguay, which receive a large share of their remittances from the European Union. This deceleration can be partly explained by the employment situation in one of the main destinations of Latin American immigrants, Spain, which is going through a severe unemployment crisis, with rates slightly below 20%, while average unemployment in the euro zone remains at 10%. (For more details on the possible impact of the European crisis, see Economic Survey of Latin America and the Caribbean 2009-2010, pages 42-46).

On the other hand, the devaluation of the euro and the higher risk in the euro zone could open the way to greater financial flows towards Latin America if investors opt for safer and more profitable destinations. This could add more pressure to the valuation of the region’s main currencies, deepening the dilemma of monetary officials, who would have difficulties in using interest rates as a tool for inflation control, given that if rates go up, it could encourage more financial inflows and cause an even greater currency valuation.

The new scenario arising from the European crisis undoubtedly finds the region with a tighter fiscal margin to address its potential impacts (a primary deficit and higher non-financial public debt), higher inflation and pressures on currencies, all of which make policy action and coordination more difficult.

Added to this potential source of instability in the future is the instability that could be caused by the significant presence of Spanish banks in the region, which strengthens its financial ties with Europe and at the same time leaves it more vulnerable to contagion. In countries such as Mexico, Chile, Paraguay and Peru the participation of Spanish banks in the local banking systems represents over 20% of total assets.

In terms of official development assistance, there is concern that fiscal austerity and the reallocation of resources to meet other needs may hamper prior commitments to deliver these resources. The poorest nations of Latin America and the Caribbean for which foreign assistance is essential will find themselves in a position of even greater vulnerability to address the challenges imposed by the international scenario in the short and medium-run while at the same time advance in attaining their goals of economic, social and environmental development.

*by the Development Studies Section