Financial markets in most countries have been in turbulence in recent days due, at least in part, to growing concerns about prospects of a U.S. recession and implications thereof for growth in foreign economies. Although our view is that the U.S. economy will narrowly miss recession in 2008, we proceed in this report under the assumption that the U.S. economy will indeed experience a downturn this year. Would the rest of the world follow the United States into recession? If not the entire world, then which countries would be most affected by an American recession?
The most direct way that an American recession would spread to the rest of the world is via the weaker exports to the United States. In that regard, Canada and Mexico stand out as being the most susceptible to an American downturn, especially a severe one. Although the European Union is the least exposed nation to exports to the United States, at least as measured as a percentage of local GDP, Europe does not have much cushion due to its relatively low overall GDP growth rate. Contrary to popular perceptions, the Chinese economy would not collapse if the United States experiences recession. Small open Asian economies, such as Singapore and Taiwan, might feel more of an impact, but these economies are better able to withstand an American downturn than they were during the last cycle. Most Latin economies probably would not fall apart either.
Economic fundamentals in many economies, especially in the developing world, have improved over the past decade. Many developing economies are no longer incurring sizeable current account deficits, which makes them less vulnerable to sudden outflow of foreign capital that would sharply weaken growth. Significantly lower inflation rates give foreign central banks more leeway to cut interest rates if growth starts to weaken, and fiscal policy could turn expansionary because fiscal deficits in many countries have largely been reined in. Although most countries have not completely "de-coupled" from the U.S. economy, they are better able to withstand an American downturn than they were previously.
