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(originally published by Booz & Company)


A Continuous Quest for Economic Balance

The slowdown in U.S. consumer spending has caused an inverse — although equally vexing — problem in countries such as China, Russia, and Germany, which all have a sizable percentage of their GDP tied to exports. In China, for example, 37 percent of GDP comes from export activity, mostly to a single trading partner: the United States. When the U.S. economy contracted in 2009 and its consumers slowed their purchasing, the economy in China suffered and the government was forced to spend considerable funds to stimulate domestic demand. The export issue is equally pronounced in Germany, which had 47 percent of its GDP tied to exports during the crisis in 2008. The appreciation of the euro that year caused a spike in the price of goods produced in Europe, and German exports contracted sharply. Although its export activity has recovered somewhat since then, and it has made an attempt to diversify in emerging markets, Germany is now becoming increasingly dependent on China, and any contraction in that market could have severe ramifications for German exports.

Other countries find their economies overly dependent on one kind of company, with their enterprise bases either consisting primarily of small businesses or dominated by a few large conglomerates — each of which presents its own problems. Italy, for example, has a preponderance of small and medium-sized companies: Roughly 95 percent of Italian companies fall into this category, and they employ more than 80 percent of the Italian labor force. These companies are the first to shed jobs during a recession, making the country less able to ride out downward trends in the business cycle.

And then there are countries with a disproportionate amount of economic activity tied to a few large companies, as demonstrated by the U.S. banks that undermined the national economy in 2008. In 1995, the five largest U.S. banks held 11 percent of total deposits; in 2009, they held 40 percent. The fact that these banks were too big to fail and were operating under a lax regulatory system made them a serious liability for the state. In South Korea, the chaebol system experienced financial difficulties in the late 1990s and dragged down the entire nation’s economy. (See “What’s a Chaebol to Do?” by Tariq Hussain, s+b, April 3, 2007.) Of the 30 largest chaebols (the Korean term for powerful, multinational conglomerates), 11 failed between 1997 and 1999; the Daewoo group collapsed with US$80 billion in debt, making it the largest corporate bankruptcy at the time. Many of the chaebols had taken on substantial debt to finance their expansion. In the aftermath of the crisis, when they could not service their debt, banks could neither foreclose nor write off bad loans without themselves collapsing.

Finally, some countries are over-concentrated in their sources of investment, particularly foreign direct investment (FDI). In Ireland, Bulgaria, and Estonia, FDI is a principal source of economic activity, making up a large share of GDP. This is problematic because FDI can fluctuate significantly from year to year, due to circumstances beyond a country’s control. In Ireland, for instance, FDI constituted 2.2 percent of GDP in 2006, soared to 8.8 percent in 2007, and plummeted to –1.2 percent in 2008.

Iceland’s recent economic woes stemmed in part from two FDI issues — an excessive reliance on such investments and the fact that these investments came from too few sources (primarily Belgium, Luxembourg, and the U.K.). Iceland also suffered from a lack of diversity in its industry base, having allowed its banking sector to dominate, which threw the overall economy out of balance. Bank liabilities increased more than fivefold from 2005 to 2008, and assets reached 10 times the size of the country’s GDP. By 2008, the three largest Icelandic banks had $60 billion in debt, and the financial crisis triggered a depreciation in which the krona fell 98 percent against the euro. Only a $10 billion multinational aid effort and a $2 billion government injection averted a total economic meltdown in the country.

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