Three scenarios for euro zone

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Three scenarios for euro zone

Like the 2008 global credit crunch, the sovereign debt crisis in the euro zone is having an outsized impact on Korea’s financial markets. The country’s export-dependent economy makes its financial markets extremely vulnerable to external developments as evidenced by the recent levels of volatility. For example, from Sept. 9 to Oct. 10, the won depreciated 8 percent against the U.S. dollar, marking the third-highest rate among 20 major currencies.

The overriding danger is that a Greek default may lead to contagion, causing a domino effect beyond the euro zone. Considering Korea’s heavy dependence on external factors, Europe’s fate will largely dictate how the domestic economy fares in the short- to mid-term.

As the situation develops, any of three scenarios could play out.

In the best-case scenario, the euro zone crisis does not get any worse. Greece accepts another dose of painful austerity measures to close its budget gap and the euro zone facilitates an orderly default or restructuring of Greece’s debt. An orderly restructuring is most probable as it is considered best for both the euro zone and Greece. Although uncertainties in financial markets would likely continue, a severe credit crunch could be avoided as European banks that stand to suffer losses from Greek government bonds would be given financial support. The probability of this happening is about 70 percent.

In scenario No. 2 - which is about 25 percent likely to happen - Greece defaults in a disorderly manner and leaves the European Monetary Union system. Europe could see a run on its banks and some may collapse, magnifying financial uncertainties. But euro zone members and the international community will realize the gravity of the situation and tighten coordination, therefore saving Spain, Italy and the rest of Europe from a similar fate.

In the third possible eventuality, which has a low probability of around 5 percent, euro zone countries fail to take proper action to prevent a disorderly default by Greece. This creates a much-feared domino effect that puts Spain and Italy under pressure to seek bailout funds. Talk of a euro zone break-up would also escalate. In such an event, major European banks could collapse, sparking a global credit crunch and foreign currency crises in emerging economies. The eventual outcome could be another global financial crisis.

But this is unlikely to occur as the orderly restructuring of Greek debt remains a very viable option at this point, meaning that Korea should not face another situation similar to the one in 2008.

The soundness of the nation’s foreign-exchange situation has been improved by measures such as increased foreign currency reserves. Its banks are in better shape financially, and controls on foreign capital movements have been tightened. But slowing economic growth is almost inevitable as advanced economies will likely impose belt-tightening measures, while emerging economies suffer from sluggish exports.

Accordingly, the Korean economy is expected to see growth slow to 3.6 percent next year from 4 percent this year. If the Greek fiscal crisis spreads across Europe, advanced economies could fall into a double-dip recession. In that case, Korea’s financial markets would likely experience a massive flight of foreign capital, especially European capital, followed by a credit crunch and a sharp contraction in the real economy.

In the short term, the country should try to secure sufficient foreign-exchange liquidity to calm fears of another currency crisis. Financial authorities should reach foreign currency swaps with the U.S. and European Central Bank, while private financial institutions should diversify their sources of foreign currency funding from the U.S. and Europe to the Middle East and Asia.

In the mid- to long-term, the government should stem sudden inflows and outflows of foreign capital and try to build a global financial safety net.

*The writer is a research fellow at the macroeconomics department at the Samsung Economic Research Institute. For more SERI reports, please visit www.seriworld.org.


By Jeong young-sik

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