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Why Eurozone Woes are Creating Headwinds for Global Firms
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Published : April 25, 2012
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in Knowledge@Wharton

Why Eurozone Woes are Creating Headwinds for Global Firms



Europe is in crisis -- and that has major implications for multinational firms with significant operations in the region. In fact, while much is written about the race by corporations to penetrate emerging markets like China and Brazil, the reality is that the investment by multinationals in Europe dwarfs the assets they have in those fast-growing economies. And the sovereign debt crisis in Europe, along with weak economic growth, is sparking changes in how these firms operate -- altering everything from manufacturing strategies to marketing to financial maneuvers.








"In the same way that European firms can't do without the American market, Europe is a very important market for U.S. multinationals," says Mauro Guillen, a Wharton management professor. "But Europe is in recession, and American firms that have been there a long time are trying to become more efficient and rethinking [how they operate there]."





U.S. multinationals in particular have a tremendous amount at stake in Europe. According to a report published by the Center for Transatlantic Relations, over the last decade more than half of U.S. global foreign direct investment has gone to Europe. In the first nine months of 2011, U.S. investment in all the BRIC nations was 6.1% of the investment made in Europe. And U.S. direct investment in Ireland between 2000 and the third quarter of 2011 was more than 4.5 times greater than the investment in China during that period. Europe remains the most profitable region of the world for U.S. companies, with 2011 U.S. affiliate income from Europe hitting $213 billion -- nearly double earnings from South America and Asia combined. "It is a myth that all this money and capital leaving the U.S. is heading to low cost labor" in emerging markets, says Joseph Quinlan, managing director and chief market strategist at U.S. Trust-Bank of America Private Wealth Management. "U.S. companies are in Europe to sell products and to leverage highly skilled labor."




At the same time, the evolution of the U.S. economy has made Europe a preferred investment location for U.S. multinational firms, according to Heather Berry, a senior fellow at Wharton's Mack Center for Technological Innovation and a professor of international business at the George Washington University School of Business. "As the U.S. economy has shifted toward high technology services and financial industries, the foreign investment of U.S. firms has also focused on high tech, finance and service industries located in highly developed countries with advanced infrastructure and communications systems," she says.





"Europe is very crucial.... There are sophisticated customers and a lot of innovation there," notes Wharton management professor Felipe Monteiro. "American investments in Europe have deep roots. When we started to see multinational investment, it started among developed countries -- U.S. multinationals investing in Europe and Japan. We have a well established flow of trade and capital between the developed countries."




"The European Union is the largest economy in the world, representing more than 25% of the world's GDP and demand -- about twice as large as China," says INSEAD professor of European studies and economics Antonio Fatas. "You cannot ignore the largest economy in the world." Adds Quinlan: "People may think it is the old world and it doesn't matter. But in 2011, we woke up to the fact that Europe does matter."


.Fixing the Unfixable?


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The pain in Europe, of course, is not being experienced equally. "Germany is not growing quickly, but it has avoided a double-dip recession," says Guillen. "But in Ireland, for example, the economy has contracted by over 20%. And France -- while it's not a basket case, it's not Germany, either." Meanwhile, Italy and Spain have slid back into recession, and today the U.K. also announced it has returned to recession.





Berry notes that U.S. multinationals have the bulk of their investments in the stronger nations of Europe. "Of the European investment by U.S. multinationals, more than 70% has been invested in the Netherlands, the United Kingdom, Luxembourg, Switzerland and Germany," she says. "Those countries that have been hardest hit by the eurozone recession --including Greece, Italy, Portugal and Spain -- together represent less than 7% of the total FDI investment by U.S. multinationals."




Still, the problems of those weak countries are dampening growth elsewhere in Europe. Moreover, the push by the stronger nations for fiscal austerity in the weaker countries is likely to exacerbate the downturn. "What we need is some inflation," says Wharton management professor Olivier Chatain. "But politically, the response has been one of austerity, which, if it is implemented in the way it is now outlined, will be self defeating. In the case of Spain, they want to reduce the deficit as a percentage of GDP -- so they cut the budget. But when you do that, GDP goes down further." As a result, Chatain sees a protracted period of difficulty in Europe. "My gut feeling is that we will see five to 10 years of very slow growth with very gradual and painful institutional changes."



That outlook raises the prospect that the eurozone will not hold together. "There are more and more voices saying 'We are trying to fix a problem that maybe isn't easy to fix or that shouldn't be fixed,'" says Guillen. "You have a number of countries on the periphery that are having a lot of trouble. In the past, those countries would have devalued their [own] currencies to make themselves competitive. The problem is, how can you make a block of 27 countries with very different levels of competitiveness work?"



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Despite those issues, Guillen does not see a complete disintegration of the eurozone, but rather the emergence of a system that has a looser affiliation for some of those weaker nations. "I don't think the whole system of the euro will fall apart. But sooner or later, they will have some solution that results in a core group of countries remaining essentially a 'hard' and 'soft' eurozone. I don't see how you can remain within the same monetary area when you have such disparities in economic performance."




INSEAD's Fatas predicts the eurozone will emerge intact. "There is a small chance that some countries, Greece in particular, will abandon the euro area," he says. "But I cannot imagine at this point a large number of countries leaving the euro, and even less a disappearance of the euro as a currency. The main reason is that as much as the crisis is posing challenges to the euro countries, adding currencies will not solve those problems. To a large extent, what countries like Spain are going through is identical to what the U.S. economy has gone through: a large asset price bubble focused on real estate that has led to a deep financial crisis. Changes in the exchange rate are not a magical tool to deal with this situation."



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Protective Measures


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Regardless of whether the eurozone holds together completely, firms are looking to protect themselves from a breakdown. According to The Wall Street Journal, drugmaker GlaxoSmithKline (GSK) has been moving cash at the end of each business day from the eurozone to banks in the U.K. At the same time, GSK is trying to accelerate the collection of money owed to it by parties in the eurozone.




According to Wharton finance professor Franklin Allen, such steps are prudent. "[Companies] are worried that the eurozone will break down, even partially," he says. "If Spain decides to leave the eurozone -- a low probability right now -- deposits in Spanish banks will be translated into the new currency and will be worth much less than they were when they were denominated in euros. Firms could lose massive amounts of money. We saw this sort of thing play out in Argentina in 2000."




That risk has far reaching implications. "Companies have to look very carefully at the risks they take," Allen notes. "So how should they write contracts? Should they include clauses so that in the event a country leaves the eurozone, they are still paid in euros?"


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Just as daunting are the challenges of operating in the face of a recession and weak consumer confidence. Guillen notes that makers of durable goods -- autos in particular -- are among the hardest hit. "They are really suffering. People need to eat and buy clothes, but they can postpone buying an automobile." The Center for Automotive Research is projecting that car sales in Europe this year will contract 5%.




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The result is that automakers in Europe -- both domestic firms and the foreign affiliates of the Big Three auto manufacturers in the U.S. -- are facing significant overcapacity. At the Geneva Auto Show in March, there was much discussion about the likelihood of major restructuring and plant closings in Europe. Certainly, political issues make plant closings difficult in Europe, but auto executives have been warning they are inevitable. General Motors, for example, has said it is considering options to improve performance at its money-losing European Opel unit. The company has already trimmed its European work force by 5,800 and closed a plant in Belgium.




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U.S. automakers aren't the only ones looking to take costs out of European operations. In April, Japan's Mitsubishi Heavy Industries announced a restructuring of its forklift truck production in Europe, a step it attributed to "Europe's lackluster forklift market stemming from the deepening debt crisis in the eurozone and other factors." The economic weakness in Europe is also hurting consumer products firms. Procter & Gamble (P&G) took a $1.5 billion write down earlier this year on appliance and salon equipment businesses, in part due to weakness in the market in Western Europe, where 50% of the sales of those businesses are generated. And in February, P&G announced a $10 billion cost cutting program due to weak growth in developed markets such as Europe.



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But firms will need to do more than cut costs to make the European market more profitable. Take the case of Starbucks. The coffee marketer has seen disappointing performance in Europe compared to its dominance in the U.S. -- and austerity measures in some countries have amplified the problem. Now, Starbucks is looking to revitalize its European stores, in part by better tailoring its products to local tastes. Among the additions: a foie gras sandwich in France and stronger lattes in the U.K.
Regardless of sector, companies will continue to search for ways to maintain a foothold in the region.



"When you think about the contribution Europe makes for multinationals, it is not trivial," says Kannan Ramaswamy, management professor at Thunderbird School of Global Management. "Firms need to hold on to that mature, valuable existing market." Wharton's Monteiro agrees. "Companies won't close their [operations] there and leave," he says, echoing the notion that there is a "huge variance" in the level of crisis between countries in Europe. "When you are in a crisis like this, you have to be as efficient as you can. I think multinationals might look at the variance among different counties so that those [operations] that are less efficient are brought into line with the more efficient."

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Looking East



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While improving operations in Europe will be critical, the current crisis only ups the stakes when it comes to penetrating fast-growing markets, including China. "It goes without saying that Europe will become less important, relatively speaking," says Wharton's Guillen. "We are seeing a dramatic reconfiguration of consumer markets and economic activity around the world." Chatain agrees. "If you are specializing in something that is very high end, a luxury, there will be more growth in China and Brazil, where you have a whole layer of the population that is growing very rich."



P&G is one example: While the company is cutting costs overall, it is upping its investment in rapidly expanding consumer markets. The firm has outlined plans to open 20 new plants in countries like Brazil and China, including a massive new facility in Luogang, Guangzhou. All told, P&G is expected to invest as much as $1 billion in China by 2015.



But for many firms, making that transition will be difficult. "[Multinationals] have been talking a good game about shifting focus to emerging markets, but many have not followed through," says Ramaswamy. "They may not have enough on-the-ground expertise [in those markets]. Plus, they may suffer from a need for control -- so they want to implement their strategy in [a] market with little local input. That is the key reason they have been unsuccessful. I really doubt whether many ... multinationals will be able to make that switch to emerging markets quickly."


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Even if they are successful in building up share in emerging markets, multinationals will be far from insulated from the challenges facing Europe. Guillen co-authored a recent op-ed in which he noted that Europe's problems could clip the growth of even the fastest growing economies. "A European recession will affect the global economy as a whole," Guillen wrote. "The European Union represents some 25% of total global output and nearly 30% of consumption. Countries that export manufactured goods or natural resources will suffer slower demand and possibly falling prices." For multinationals, Guillen and other experts predict, the fallout from the European crisis is likely to be felt around the globe.



April 24, 2012 10:12 pm
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The high cost of disorderly deleveraging
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By John Plender


Markets in Europe have understandably been preoccupied with politics, but Monday’s weak eurozone purchasing managers’ indices suggest that more attention ought now to be paid to the dysfunctional relationship between eurozone banks and the real economy.



That point is reinforced by the latest Global Financial Stability Report from the International Monetary Fund, which ominously forecasts that the process of deleveraging in the European banking system is set to continue and broaden.

 

In the last quarter of 2011 alone, the 58 banks in the IMF’s sample reduced assets by almost $580bn. On current policies, the fund’s economists expect a $2.6tn decline in bank assets between end-September 2011 and the end of 2013, equivalent to a seven per cent decline in total balance sheet size. About a quarter of that fall in assets reflects a potential reduction in lending as opposed to asset sales.




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On a weaker policy scenario in which cyclical pressures are doing more to hold back the economy, which is where the PMI managers come in, the forecast is for assets to be cut by $3.8tn. This would amount to a 1.4 per cent knock to eurozone real gross domestic product.


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The report’s authors, though, are not entirely downbeat, pointing out that these simulated shocks to eurozone credit are well within the range of past episodes of deleveraging such as Japan in the 1990s or the US at the start of the financial crisis. It should also be said in passing that if the deleveraging process can be managed in an orderly way, any reduction in big bank balance sheets is good both from a systemic stability and competition policy point of view.



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That said, the aggregate figures say nothing about the extent of the pain in southern Europe, where any solution to the sovereign debt problem is inconceivable without economic growth. And this credit contraction coincides with a return to fiscal austerity across the eurozone; also with the end of the European Central Bank’s longer term refinancing operations and the imminent conclusion of the asset purchasing programmes of the Bank of England and the Federal Reserve. Indeed, the queasiness of markets probably reflects a tightening of global liquidity as all this stimulus ebbs away.



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The risk is of a vicious circle whereby eurozone economic conditions deteriorate, so depressing bank earnings and weakening asset quality, which in turn requires increased provisions. That erodes bank capital, creating more pressure for yet more deleveraging. A further risk is that deleveraging becomes disorderly if synchronised sales of bank assets cause a downward spiral in prices, which leads not only to capital shrinkage but funding shortages as interbank lending is cut back.



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The biggest victims will be the emerging market economies of eastern Europe, as eurozone banks seek to repatriate funds. The effects of the new parochialism will be felt further afield. Small and medium-sized enterprises, already penalised by the Basel capital regime, will also be badly hit. Where their credit lines have not been withdrawn, lending conditions have been tightened since early last year and borrowing costs could rise further.



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The SMEs are being doubly squeezed as big corporations seek to manage working capital more efficiently. GlaxoSmithKline last year increased the average number of days payable on outstanding trade credit in the UK from 50 to 61 days. That is going on all across the corporate sector of the developed world, helping knock the stuffing out of myriad potential employment creators.


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In the light of the weak policy response to this SME squeeze, it is easy to feel nostalgia for German-style banking, in which a more regionally based, politicised system operates on a non-profit-maximising basis and sees Mittelstand companies safely through the downturn. Yet the flaws in that model have been exposed by the crisis. Witness the state bailouts. Their undercapitalisation and over-dependence on wholesale funding has now made them doubly vulnerable.



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Compared with the US, and to a lesser extent the UK, the eurozone corporate sector remains overdependent on banks for funding. Even after the deleveraging predicted by the IMF, eurozone banks will still be relatively undercapitalised.


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If the eurozone economy is not now to be stricken by hypothermia, someone will have to offset the contractionary effect of bank deleveraging. As far as fiscal policy is concerned, the governments of northern Europe certainly will not, even if some of them can, while those of southern Europe cannot.


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So the mantle will fall once again on the central bankers. Yet the suspicion must be unconventional measures will have a dwindling impact. And of course they do little to address the underlying solvency problem. Plus ça change.



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The writer is an FT columnist


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Copyright The Financial Times Limited 2012

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Remittance corridors
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New rivers of gold
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Remittances from unlikely places are helping poor countries in the downturn
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Apr 28th 2012
TAPACHULA
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IN TAPACHULA, a furnace of a city in southern Mexico, people line up inside an air-conditioned branch of Banco Azteca to process their remittances. Last year Mexicans received an estimated $24 billion from friends and family working abroad, mainly in the United States, with which Mexico forms the world’s busiest remittance corridor (see map). But a closer look at the Tapachulan queue shows how the remittance business is changing. Many are not Mexicans receiving cash from America, but migrant workers sending it back home to Guatemala or Honduras. “Very similar to what happens at the other border,” observes Jorge Luis Valdivieso, the bank’s regional administrator, referring to Mexico’s better-known northern frontier.



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The value of remittances to poor countries is enormous. Since 1996 they have been worth more than all overseas-development aid, and for most of the past decade more than private debt and portfolio equity inflows. In 2011 remittances to poor countries totalled $372 billion, according to the World Bank (total remittances, including to the rich world, came to $501 billion). That is not far off the total amount of foreign direct investment that flowed to poor countries. Given that cash is ferried home stuffed into socks as well as by wire transfer, the real total could be 50% higher.


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Remittances are not just big, but growing—they have nearly quadrupled since the turn of the millennium—and resilient. In 2009, when economies around the world crashed, remittances to poor countries fell by a modest 5%, and by 2010 had bounced back to record levels. By contrast, foreign direct investment in poor countries fell by a third during the crisis, and portfolio inflows fell by more than half. “The most remarkable thing about remittances today is their continued growth, year after year, despite the global economic crisis,” says Dilip Ratha, head of migration and remittances at the World Bank.




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One reason for this apparent boom is simply that the data are better. Money senders such as Western Union and MoneyGram have improved their reporting to central banks. Oversight has tightened since September 11th 2001. This has led to big jumps in some numbers: Nigeria posted a near-doubling of remittance receipts in 2007. Where governments are sensitive about providing information, economists have used other methods. India, for instance, subjects remittances to Bangladesh to stringent tests. But by examining migration data, the World Bank reckons that some $3.8 billion probably crosses the border every year.



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Partly thanks to these techniques, it is now known that remittances come from a wider variety of countries than was previously thought. This might in turn explain how they have avoided being affected by Wall Street’s hiccups. In 1970 46% of recorded remittances were reckoned to originate in America. By 2010 America’s share was just 17%. One big new player is the Gulf, which has sucked in migrant workers since the oil boom. Saudi Arabia is now the world’s biggest sender of remittances after America, posting $27 billion in 2010, mostly to the families of South Asians and Africans who toil on its building sites and clean its homes. More than half of all remittances to South Asia come from the Gulf; worldwide, the region sends almost as many remittances to poor countries as western Europe does.




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Expensive oil has made Russia a big destination for immigrants, too. In 2000 it was only the 17th-biggest remitter in the world—indeed, it was a net receiver. But by 2010 it was the fourth-largest sender, dispatching nearly $19 billion, mostly to Central Asia. Remittances from Russia are worth more than a fifth of Tajikistan’s economy (see chart).

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Though they are less volatile than many types of income, remittances are not immune to fluctuations. Cash flows to Mexico last year were still 12% lower than their pre-crash peak, partly because many Mexican migrants worked in the American construction sector, which is still reeling. The “Arab spring” of 2011 made a dent in remittance receipts in the Middle East and Africa, as migrant workers from the region fled countries such as Libya. An exception was Egypt, where receipts shot up by 14%. One reason may be that exiled Egyptians returned home with their savings; another is that a fall in property prices encouraged émigrés to snap up bargains.



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Currency fluctuations can also skew remittance patterns. American greenbacks and euros are no longer sought after in those African countries where currencies have appreciated sharply in real terms thanks to demand for the commodities they export. “When you send dollars back to a family in Angola, they don’t feel as rich as before,” says Marcelo Giugale of the World Bank. Working in Europe for five years no longer buys a house back home.

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The question is whether migrants will react by spending longer in far-flung destinations, or by staying closer to home. Many already go for the second option: one-tenth of remittances to Africa come from within the continent. South Africa sends most of its $1.4 billion in remittances to its neighbours, for example.



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In the rich world, many countries have closed their borders to protect home-grown workers. America has made its southern frontier harder to cross, which partly explains the slowdown in immigration from Mexico.

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Emigration has risen, too, since the economy stalled. But perhaps because they know it will be harder to come back, migrants are staying longer. According to the Pew Hispanic Centre, 27% of Mexicans deported from America in 2010 had been in the country for at least a year, up from 6% in 2005. That may help explain why remittances from America fell by only 5% in 2009, whereas in Britain, which has open borders with some of its biggest senders of immigrants, they fell by 27% (exchange rates played a part, too). Stricter border controls keep migrants in as well as out, and the remittances flowing.



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Regional Economic Outlook
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Latin America Needs to Rebuild Resilience and Flexibility

April 25, 2012 .


  • Latin America's growth expected to moderate in 2012, but tailwinds remain

  • Risks remain from renewed tensions in Europe and oil prices

  • Countries should strive to rebuild fiscal buffers, with flexible monetary policies


Economic growth in Latin America and the Caribbean is expected to moderate in 2012, but will remain solid, the IMF said in its latest assessment of the region.



The IMF’s Regional Economic Outlook for the Western Hemisphere, released on April 25, projects growth in Latin America at 3¾ percent in 2012, before returning to about 4 percent in 2013.



According to the report, growth continues to be led by commodity exporters, where favorable external conditions—in the form of high commodity prices and cheap and abundant external financingcontinue to push domestic demand and credit.



Meanwhile, growth has held up reasonably well in Mexico and Central America, in part as a result of the steady, yet still tepid, recovery in the United States.



The Caribbean region finally turned the corner in 2011 after a long recession, although high debt levels and tourism dependence continue to constrain the outlook.



In its latest forecast, the IMF projects that global growth will ease from close to 4 percent in 2011 to about 3½ percent this year, returning to over 4 percent next year. For the United States, the IMF raised its projection to an average of 2¼ percent during 2012–13, compared with roughly percent in 2011.



Risks to the outlook


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The report says that Latin America continues to face potential problems, given the still fragile global recovery. It highlights three main risks to the outlook:


• Tensions in Europe. Renewed bouts of financial stress in the euro area could accelerate bank deleveraging, disrupt markets, and hit activity, both in Europe and beyond. However, the subsidiary model of European banks operating in Latin America, and their reliance on local funding, are likely to mitigate the risk of deleveraging.



• Oil-price shock. Geopolitical tensions in the Middle East could drive up oil prices, dampening global demand as well as nonoil commodity prices. Countries highly dependent on oil imports (Central America and Caribbean) and nonoil exports (for example, Chile, Paraguay, Peru) would be particularly affected.



• Medium-term risks. Looking beyond the near term, persistent fiscal imbalances in the United States and Japan could unsettle financial markets if unaddressed, while a hard landing in China could hit global growth and commodity prices.



That said, upside risks cannot be discarded for the region, particularly if the planned policy normalization does not materialize or proves insufficient.



Need to rebuild fiscal buffers



Despite downside risks, the report said that external conditions are expected to remain favorable, with easy external finance and strong terms of trade supporting growth in many of the larger countries. In this environment, the challenge for many countries in the region is to take advantage of favorable conditions to rebuild fiscal space, while giving monetary policy the needed flexibility to fine tune the economic cycle.



This challenge is especially crucial for South America: countries there stand to benefit the most from continued favorable external environment, but with output near or above potential, they also need to guard against overheating, the report cautioned. Special care also needs to be given to ensuring liquidity conditions are not disrupted should global volatility bouts recur.



Mexico and Central America, which are more dependent on the U.S. economy than their southern neighbors, also need to continue rebuilding fiscal buffers, especially in Central America where output is near potential and public debt remains above pre-crisis levels.



Weak balance sheets and strong tourism dependence will continue to restrain growth in the Caribbean, where fiscal consolidation needs to continue despite the sluggish growth environment, the report said.