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Prospects Weekly: Euro Area woes have worsened on growing concerns about banking-sector exposures

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Euro Area woes have worsened on growing concerns about banking-sector exposures to sovereign obligations and skepticism about the medium-term solvency of several high-spread member countries. A crisis of confidence has taken hold, partly prompted by the apparent inability of politicians to get in front of the crisis. Unlike previous episodes of volatility, contagion to core Euro Area countries and abroad—including developing countries—has taken hold. The cost of insuring against sovereign default has risen globally, and a shift into safe-haven assets has led to a sharp decline in global equities and in foreign capital inflows to developing countries. Although real-side consequences are uncertain, they could be severe and potentially put an end to the post-Tohoku recovery in industrial production that was taking shape in June and July. Global purchasing managers’ surveys for manufacturing and services for August point to stagnation.


The sovereign debt crisis in the Euro Area has intensified, leading to a rise in the cost of insuring against default worldwide. Significant Euro Area banking-sector exposures to countries with sharply elevated, and deteriorating, sovereign-debt obligations are a key concern, along with ongoing Euro Area political discord and slowing growth. Credit default swap rates have risen for many countries, notably those of Greece, Portugal, and Italy. In contrast to past episodes of market volatility, sovereign spreads in developing countries and several core European countries (including Germany) have also increased—arguably an indication that the world is already experiencing the kind of contagion that earlier analyses used as the basis for downside growth scenarios.
Reflecting spreading market jitters, international gross capital inflows to developing countries tumbled in August to $22.8 billion, half the average recorded in the first half of 2011, and the lowest level since July 2010. Developing-country equity markets were also affected, declining 17.9% year-to-date versus 15.3% in mature markets. Investor redemptions from emerging market equity funds surged, and registered an estimated $15 billion in August—a withdrawal of funds not seen since 2008. World stock market capitalization has fallen by an estimated $5.3 trillion since the end of July (or 8.7% of 2010 global GDP). Despite lower bond issuance, developing country bond yields have remained broadly stable since the beginning of August.
While there was a pronounced and rapid slump in global industrial production in the second quarter, growth was reviving in June and July as the strong negative drag emanating from the Tohoku-disaster and rising oil prices was beginning to abate. Led by a 7.9% rebound in high-income countries—global industrial production grew 5.3% (2m/2m, saar) in June (latest available) after contracting in the previous two months. This positive trend appears to have continued into July, when German industrial production surged 4.6% (m/m, sa). However, August market volatility is generating strong headwinds, with both the global manufacturing and services PMI surveys falling in the month. Worryingly, new orders and export orders sub-components of these indexes signal contraction—suggesting a continued weakness through September. Employment PMIs have also declined, contributing to a negative feedback loop with consumer demand.


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