Europe and US wait to see if the spillover effect will dent growth

Now that Japan has fallen victim to the financial crisis rippling through Asia, the spillover effects on the US and Europe will be more pronounced. But, as Diane Coyle, Economics Editor, discovers, the experts are not sure how serious they might be.
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On the day when the collapse of Yamaichi Securities gave the clearest sign so far of the scale of the financial crisis in Asia, the Organisation for Economic Co-operation and Development (OECD) published its authoritative annual report on the US economy. The assessment could not have been more glowing; but other economists warned that the Asian contagion could seriously dent growth in both the US and Europe.

The main channel for any slowdown as a result of the crisis will be weaker exports to Japan, Korea and the Asian tigers. Not only will their demand for foreign goods shrink, but the exchange rate has also moved markedly in the favour of Asian exporters.

Estimates vary, but this is expected to shave up to half a percentage point from European GDP growth and up to 1 per cent from the US growth rate.

The buoyant state of the American economy offers the rest of the world its best insulation from Asian contagion. The OECD report concludes: "US macroeconomic outcomes continue to be extraordinary. Output growth has reached a new high for this cycle, the unemployment rate has fallen to a level not seen in a generation, and yet inflation shows no signs thus far of reacting to capacity pressures."

The think-tank, which prepared its forecast before the latest developments in Japan and Korea, predicts US growth of 3.8 per cent this year and 2.8 per cent next. This upbeat outlook suggests the crisis might take the economy back to its trend growth rate in 1998 but not much lower, especially as the Federal Reserve Board is expected to keep interest rates unchanged as long as the uncertainty lasts.

Some European economies are in much a weaker position than the US, and analysts disagree over how serious the impact on them will be. The recovery in France and Germany has been based on exports, and they therefore look more vulnerable to a downturn.

Gerard Lyons, chief economist at DKB in London, argues that the Asian crisis therefore means there is a tendency towards global deflation.

But lower exports are not the only possible spillover. For the UK, one of the biggest worries is whether direct investments by Japanese and Korean companies will be hit. Although there are many more Japanese-owned plants, they are mostly well-established and in a strong financial position.

However, Korean plants, such as LG's massive pounds 1.7bn investment in South Wales, are thought to be at some risk of being affected by South Korea's impending recession.

Professor Garel Rhys, head of economics at Cardiff University's business school, said: "It could be that LG came to Wales just in time and it could be some time before we see another major Korean investment."

The Asian turmoil would continue to affect the financial markets as well as casting a direct shadow over economic prospects outside the region, analysts said.

There will be a dimmer outlook for corporate earnings in sectors either most exposed to competition from South-east Asia or most dependent on exports to the afflicted countries.