beyondbrics

It is D-Day for the eurozone, time for Europe’s leaders to conjure up a solution to the single currency’s problems. What will be the implications for the emerging markets more generally and Latin America and Brazil, in particular?

That depends largely on what solution the eurozone comes up with or, indeed, whether it is able to come up with one at all. But there are three major channels by which a crisis could be transmitted from Europe to the global emerging markets, according to London`s Capital Economics.

1. Weaker export demand: The economies of Eastern Europe (notably Hungary and the Czech Republic) are most vulnerable to a slump in the eurozone, while Mexico is highly exposed to a slowing US economy.

2. A decline in capital flows. Turkey is the major emerging economy most reliant on foreign financing – its current account deficit is on track to hit 10 per cent of GDP this year. But domestic demand in Latin America would also weaken if capital inflows were to slow.

3. The banking sector. Banks in Eastern Europe are particularly dependent on financing from Western European parents.

In the case of Brazil, Goldman Sachs research has argued that the strongest channel of any likely contagion will be through the financial system because net capital inflows to Brazil are large and the share of Europe in Brazil’s external financial flows is high. In the last two years, about two-thirds of foreign direct investment flows into Brazil came from or were registered in Europe. And during the same period, about two-thirds of the remittances of profits and dividends in Brazil went to Europe.

Another channel of contagion would be the tightening of financial conditions for European banks operating in Brazil. But foreign banks are not big enough in Brazil to pose a systemic threat, Goldman argues.

The other major impact of a eurozone meltdown for Brazil would come from trade. Europe accounts for nearly 20 per cent of Brazil`s exports and imports – more than any other country or trading block. A meltdown in Europe would also hurt Brazil’s terms of trade in the form of lower commodity prices.

But Brazil seems relatively well positioned to meet these challenges.

Brazil’s foreign reserves – At $352bn – are 71 per cent higher than they were in September 2008. The government is already aggressively cutting interest rates and will continue to do so if the economy weakens. If capital inflows disappear and the exchange rate comes under pressure, the government could also reduce a financial transaction tax on foreign investments in local markets and reduce other capital controls.

Brazil could also cut its reserve requirements in the banks and take other measures to resolve any liquidity crunch. Brazil’s financial system has a healthy buffer in terms of capital adequacy ratios.

The president could also turn to the Brazilian consumer again, reducing sales tax for consumer durables or other measures. But one difference this time is that the government would have less room to spend its way out of any crisis, having already splurged during 2009 and 2010.

In all, Brazil and many other emerging markets look well-placed to weather any shock from Europe. But the nature of shocks is that they contain an element of the unexpected. Brazil can afford to be confident but not complacent.

Related reading:
Emerging markets: decoupling decoupled, Lex
Swift exit from emerging market currencies, FT
Investors pull back from emerging market funds, FT
Emerging markets fundamentals stay firm despite sell-off, FT