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eurasia group
Defining the Business of Politics.
™
Eurozone Risks Loom Large
for the US and Japan
eurasia group
Defining the Business of Politics.
™
Eurozone Risks Loom Large
for the US and Japan
Contents
Eurozone risks loom large for the US and Japan. .
Political implications of a eurozone failure. .
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Foreign exchange . .
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Trade . .
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Banking sector exposure . .
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Foreign direct investment . .
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Report issued 13 January 2012
Prepared for PricewaterhouseCoopers Co., Ltd.
This confidential report is intended solely for the internal use of PricewaterhouseCoopers Co., Ltd. and is based on the opinions of Eurasia Group analysts and
various in-country specialists. Eurasia Group is a private research and consulting firm that maintains no affiliations with governments or political parties.
© 2012 Eurasia Group, 475 Fifth Avenue, 14th Floor, New York, New York 10017
eurasia group
Defining the Business of Politics.
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Eurozone risks loom large for the US and Japan
The economic troubles underlying the eurozone’s sovereign debt crisis will continue to plague the
region in 2012, and will worsen if an increasingly likely recession occurs. Several governments
will struggle to implement the economic restructuring necessary to correct their economies’ fiscal
and trade imbalances, including already agreed upon but politically difficult budget cutting and
productivity-enhancing measures. Even optimists likely realize that Europe is headed for another
year of muddling through, while pessimists will note that the possibility of a sovereign default
remains, with severe economic implications reaching well beyond the EU.
Despite the recently increased ability of the European Central Bank (ECB) to smooth shortterm crises via the European Stability Mechanism, national parliaments will struggle to ratify
associated agreements in 2012 and the euro’s future will remain in question.
Europe faces two potential ugly scenarios. In the first, a eurozone member nation defaults on its
sovereign debt and abandons the common currency. In the second, the pressures on the euro become
insurmountable forcing the dissolution of the eurozone as presently structured. Both scenarios are
unlikely, although discussions over the fragmentation of the eurozone have gained more traction. An
exit from the euro, whether by a core or a peripheral state, would be extremely costly, piling political
costs atop economic ones, as Europe’s soft power would decline and the idea of a unified Europe would
falter. These are outcomes that member states are unlikely to risk.
Regardless of whether Europe continues to muddle through or a more severe dislocation
occurs, Japanese and US exposure to the eurozone will be affected by a sustained appreciation
of their currencies against the euro. The shock to exchange rates, in turn, presents risks to those
exposed to the EU in terms of trade, FDI, or even financial market counterparty risk. Japan and
the US are very exposed to a eurozone calamity.
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
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Political implications of a eurozone failure
Domestic political calculations will influence how Japan and the US respond to efforts to stabilize
the European currency union.
Japan
US
Failure of the eurozone would sap EU
demand, becoming a drag on Japan’s struggling economy. The decline in the value of
the euro (or post-euro national currencies)
would severely affect trade with Japan, even
though banking sector and FDI exposure
are relatively limited. Tokyo would certainly
participate in any external efforts to stabilize
EU financial markets, but it would likely
only do so as part of a coordinated plan in
which losses were essentially insured at face
value by the ECB or a more credit-worthy
eurozone member (Germany).
A eurozone crisis would be disastrous for
US financial stability and economic activity.
It also represents a large threat to President
Barack Obama’s reelection campaign, given the
impact it would have on the US economy. The
Obama administration has tried to inoculate
itself by admonishing Europe for not solving
its problems, while preparing for any contagion
that a European sovereign default might cause
for US financial institutions. Still, domestic
political gridlock and economic interdependence leaves little room for the US to mitigate
or remedy the impact of a euro collapse.
Such efforts would be constrained,
however, by the domestic realities Prime
Minister Yoshihiko Noda’s government faces.
These constraints include a daunting array
of fiscal hurdles and structural rigidities in
the economy, which are all reinforced by
a degree of legislative gridlock that will be
difficult to manage. Japan looks set for another year of divided government, with the
opposition obstructing the legislative process
and looking for an opportunity to force an
early general election. In that context, an
EU banking crisis and subsequent economic
Such a crisis would put pressure on the US
fiscal deficit by reducing demand in the largest
market for US exports. Political stalemate
precludes responding with a large-scale stimulus, implying slower US economic growth,
which would reduce tax revenues and increase
borrowing to fund automatic countercyclical
spending. Both dynamics would exacerbate
Washington’s budget deficit, and possibly set in
motion additional credit ratings downgrades.
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
Moreover, a crisis could thrust financial
regulation back onto the legislative agenda.
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downturn would likely imperil both Noda’s
policy agenda and his government. This
would play out in two ways. First, the EU
remains the global economy’s largest source
of consumption, so a crisis there would
undercut demand for Japanese exports.
Second, a crisis would make EU exports
relatively cheaper as the value of the euro
declines, squeezing Japanese competitors.
Domestic political turmoil
may constrain Japanese
efforts to stabilize EU
financial markets
Japan’s economic prospects in 2012 are
likely to improve after the disasters of 2011.
Earthquake and tsunami reconstruction
spending will stimulate the economy regardless of an EU crisis. But current spending
plans, an already high debt load, and
political gridlock practically eliminate the
possibility of new spending in the event of
an EU meltdown, while a decline in export
revenue driven by declining EU demand
would further hurt government finances.
One place where an EU crisis could fuel
economic activity is in M&A efforts. Cashflush Japanese firms with relatively little direct
exposure to EU losses will be looking for EU
acquisitions, stimulating the M&A market.
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
In the US, the Dodd-Frank Act constrains
the government from bailing out any
financial institution without congressional
approval and has created a process for the
resolution of failing financial institutions
that is untried and unwieldy. Such a
method could prove treacherous if multiple
systemic institutions fail simultaneously,
a situation that a European crisis could
produce. In Europe, the cross-border
nature of large financial firms would make
resolution incredibly complex, and weak
government finances raise serious questions
about some governments’ ability to bailout
failing financial institutions. Moreover, to
the extent that a eurozone crisis were to
require bank bailouts, popular and political
responses would likely push for a much
more stringent regulatory response, potentially making Dodd-Frank look moderate
by comparison.
A eurozone crisis
would threaten Obama’s
re-election chances
Finally, a eurozone crisis would dramatically alter the US political environment by
decreasing Obama’s electoral prospects. The
basecase—absent crisis—is that Obama is a
slight favorite for reelection, and that he has
the potential to regain control of the House of
Representatives, although retaining control of
the Senate is likely out of reach given the large
number of Democratic incumbents up for
reelection. As a result, a eurozone crisis could
deliver unified Republican control of government, which is otherwise unlikely. Policy
volatility as a result of government alternation
would then be an indirect effect of the crisis.
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Foreign exchange
Both the US and Japan would suffer from declining demand and currency appreciation against
the euro if the eurozone debt crisis explodes.
Japan
US
In the years prior to the eurozone sovereign
debt mess, the yen fell steadily against the
euro. But since the onset of the eurozone’s
debt troubles, the yen has appreciated
sharply as EU growth slowed in fiscal year
2007–2008. Unsurprisingly, the yen’s value,
particularly compared to the dollar and euro,
is watched closely in Tokyo, where politically
powerful exporters have significant influence.
But a stronger yen could create opportunities
as well, with Japanese firms looking to use a
strong yen to snap up relatively cheap assets,
particularly in the EU.
In the decade leading up to the financial
crisis, the US dollar depreciated steadily
against the euro and most other currencies.
While concerns about economic recovery
have led the EU and US central banks
to hold rates at historically low levels,
dampening demand for their currencies,
eurozone instability has spurred a flight
to safety in US debt, pushing the dollar’s
value up. To the extent that Europe’s crisis
worsens, this would lead to further euro
depreciation and dollar appreciation.
Exchange rates
1.2
0.010
0.008
0.006
0.6
0.004
0.3
0.002
Yearly price
Yearly price
0.9
Left axis
USD/EUR
Right axis
JPY/EUR
0.000
0.0
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
10
20
Note: Rising lines indicate appreciation against the euro
Source: Bloomberg
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
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Trade
Though the US exports far more to the EU than Japan does in gross terms, a eurozone
meltdown would hit both economies similarly given the scale of their European exports relative
to the size of their economies.
Japan
US
Japan is the EU’s third-largest trading partner,
with total Japan-EU imports and exports
representing approximately 2% of Japan’s
2010 GDP. Japan has historically maintained
a strong trade surplus with the EU, but
the yen appreciated sharply as EU growth
slowed in fiscal year 2007–2008, resulting in
a substantial drop in Japanese exports to the
EU. Even though the yen then fell against the
euro, starting in late 2008 and continuing
into 2009, Japan’s 2009 trade surplus with
the EU fell dramatically; the EU’s economic
contraction reduced imports from Japan
by approximately 31%. In 2010, Japanese
exports to the EU bounced back, but as EU
governments have cut budgets and yen appreciation has resumed, demand for Japanese
exports has remained below normal levels.
Through the crisis, the US and the EU have
remained each other’s largest trading partners. But the relationship has faced tremendous volatility. While trade between the two
fell in fiscal year 2008–2009, it rebounded
sharply in fiscal year 2009–2010, returning
to pre-crisis levels as the initial recovery took
hold. While the US continues to import
more from the EU than it exports, the
dollar’s steady depreciation against the euro
resulted in rising US exports between 2006
and 2008 and a shrinking trade deficit. Since
the 2009 global recession, US imports from
the EU have continued to decline, while US
exports have nearly recovered to pre-crisis
levels. Another hit could have brutal political
implications for incumbents facing election
in 2012, however, particularly Obama.
Exports (percent of GDP)
Exports (million euros)
2006
2006
2007
2007
2008
2008
2009
2009
2010
2010
2.0
1.6
1.2
0.8
0.4
0
50,000
100,000
150,000
Japan to EU
US to EU
200,000
Source: European Commission, World Bank, Bloomberg
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
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Banking sector exposure
Direct exposure to potential sovereign debt losses is similar, given the relative sizes of the US
and Japanese economies, but US financial firms face much higher indirect risks.
Japan
US
The direct exposure of the Japanese banking
sector to the eurozone is much higher than
its indirect exposure, but even that is mild
compared to the exposure of the US. This
factor likely explains demand for the yen
and its appreciation, despite Tokyo’s high
government debt levels and the economy’s
weak performance. Moreover, Japan’s direct
exposure to EU debt is about half that of
the US, and is concentrated in Germany
and France (54%), likely further reducing the risks to Japan’s financial sector.
Japan’s financial system does not have the
significant credit default swaps and derivative exposure that the US has to eurozone
sovereign defaults. Instead, most indirect
exposure is in the form of credit commitments, which is unlikely to cause concern.
The US banking sector’s overall exposure to
the eurozone crisis is significant. Indirect
exposure is considerably higher than direct
exposure ($1.92 trillion versus $882 billion), and consists mainly of credit default
swaps, followed by other derivatives, and
credit commitments. Banking sector exposure would be the principal mechanism by
which the eurozone crisis could harm the
US economy. As European debt sours, US
financial institutions will suffer significant
losses, undermining reserve capital positions and causing them to tighten credit.
This would contribute to already weak
private spending and investment in the US,
relative to typical post-recession experiences, which could seriously undermine the
US recovery.
US and Japanese banking sector exposure to the eurozone
Direct exposure
Indirect exposure
Japan−$472 billion
US−$882 billion
Japan−$62 billion
US−$1,915 billion
Source: Bank for International Settlements, Eurasia Group
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
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Foreign direct investment
A crisis-driven fall in FDI flows would hit the US harder than Japan, but would create opportunities
for firms in both countries to pick up relatively cheap assets as their currencies strengthen.
Japan
US
Japan has traditionally been an important
investor in Europe, though at much lower
absolute levels than the US. Japan has a
relatively inhospitable environment for FDI,
and its investments in the EU are far greater
than the reverse. In 2009, EU investment in
Japan experienced an atypical contraction
as the sovereign debt crisis hit. By 2010,
Japanese FDI into the EU resumed, but
the interesting scenario is one in which
Japanese firms, increasingly the source of
most Japanese savings, could uncover M&A
opportunities in a crisis-burdened EU.
US-EU FDI flows are by far the largest for
both economies. In 2008, however, with the
onset of the financial crisis, US investment
in the EU was significantly lower than EU
investment in the US. By 2010, investments
by both the US and the EU decreased
dramatically, with EU investment only 8%
of what it had been in 2008, and US investment in the EU at 64% of its 2008 level.
A eurozone crisis would further dampen
bilateral FDI flows, but as with Japan, could
create opportunities for US firms looking for
M&A opportunities abroad.
FDI inflows 2008–2010
FDI outflows 2008–2010
EU27 FDI from Japan
2010
EU27 FDI to US
2009
2009
2008
2008
-20
0
20
40
60
80
EU27 FDI to Japan
2010
EU27 FDI from US
100
Billion euros
Source: European Commission
Eurozone Risks Loom Large for US and Japan
Prepared for PricewaterhouseCoopers Co., Ltd. | 13 January 2012
-30
0
30
60
90
120
150
Billion euros
Source: European Commission
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