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Prospects Weekly: Renewed Euro Area tensions cut into capital flows to developing countries in May and June

Renewed Euro Area tensions cut into capital flows to developing countries in May and June, and prompted a sharp downturn in business sentiment worldwide. Together these developments point to slower growth in 2012Q2 and Q3, unless recent improvements in financial markets and policy steps cause business sentiment to strengthen. Falling industrial commodity prices, notably oil prices, may mitigate impacts for importing countries, but will exacerbate strains on government revenues in commodity exporting nations.

Capital flows to developing countries picked up slightly in June after falling sharply in May due to renewed Euro Area tensions. The resurgence of Euro Area turmoil in May caused gross capital flows to developing countries to fall by a revised 45% in May (solid line in figure). The bulk of the decline was in bond and equity issuance, as borrowers may have voluntarily delayed going to market given heightened uncertainty. In June, total gross capital inflows picked up somewhat. Perhaps surprisingly, in the most recent period syndicated bank lending has held up (despite European banking-sector deleveraging). Overall, inflows in May-June are down 36% from the levels observed in the first four months of the year. Should capital flows remain depressed they could contribute to weaker investment and growth in developing countries in the second half of the year.

 

The financial turmoil in the Euro Area has cut into business sentiment worldwide. Purchasing manager indexes (PMIs) published by national sources and Markit deteriorated further in June. The global indicator descended into sub-50 territory, suggesting that global output shrank in June, with all economic regions weakening (except China whose official PMI improved slightly). A similar decline in PMIs occurred in the second half of 2011, when Euro Area tensions rose in July of that year. Perhaps, reflecting lessons learned from that earlier episode, the deterioration has been quicker and more marked this time around. The decline in sentiment is consistent with a scenario where firms and consumers are holding back on expenditures because of increased uncertainty. Economic outturns for the second and third quarters of 2012 will depend critically on whether confidence remains weak or begins to strengthen in response to recent policy steps.

 

Euro Area tensions and global growth concerns have accentuated downward pressure on industrial commodity prices, notably oil prices. International prices of crude oil and other industrial commodities have been on a downward trend in recent months, reflecting strong supply growth and weak demand. The initial easing in prices occurred even as global economic activity was firming, but has accentuated with financial market tensions and expectations of weaker growth. As of July 3rd, international crude oil prices were $25 lower than their first quarter highs, and copper and aluminum prices were down 10 percent and 16 percent respectively. Internationally traded wheat prices have strengthened in recent weeks amid concerns that high temperatures may reduce global supplies, especially from key exporters including the United States and Russia. Compared with a year ago, wheat prices are up 15 percent and maize prices are up 14 percent. While lower oil prices will help to cushion the real-income effects of weaker GDP growth in most developing countries – lower oil and metal prices can be expected to cut into incomes and government revenues in exporting countries, exacerbating the downturn in those economies.

 

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