Euro zone a car crash: best keep your eyes on the road

Lamborghini on fire... Italy?

You know how most of the traffic created by a car crash is not the crash itself, but everyone slowing down to have a rubberneck? Well, the same thing can happen with economies. And fair enough, the unfolding car crash that is the euro zone is a pretty horrific sight. It’s hard to look away.

While the past two years have seen a collection of pile-ups of smallish European economies – think Portugal, Ireland, Greece and Spain (the PIGS) – the spectacle unfolding over Italy’s public debt is of an entirely different magnitude – think head-on collision between a road train and a B-double.

Italy is the world’s eighth largest economy, with government debt of $2.6 trillion, exceeding the debts of all the PIGS combined. The markets seem unimpressed by the Italian Prime Minister, Silvio Berlusconi, finally falling on his sword.

On Wednesday night, investors pushed the market interest rate for Italian sovereign debt to 7.48 per cent, crucially above the 7 per cent rate that eventually forced the PIGS to seek bailout funding.

It’s also roughly the same rate Australian banks are charging homebuyers. Yep, in a rough sense, markets now think Australian households have about as much chance of making good on their debts as the sovereign government of the world’s eighth largest economy.

The markets are now trapped in a self-fulfilling prophecy, one in which their action of pushing up the cost of Italian borrowing increases the likelihood that their worst fear will come to pass – the Italian government being unable to make payments on its debts.

The potential ripple effects of such a default are much larger than a Greek default, with French banks sitting on an exposure to Italian debt of more than $400 billion, and German banks more than $150 billion.

What really scares the pants off investors is that Italy, although clearly too big to fail, may also be too big to save. The entire European Financial Stability Facility – the kitty euro countries have set up to bail out indebted nations – stands at only €1 trillion ($1.334 trillion) even after the last tin rattle around the European Council. Pressure is now building up on the European Central Bank to step in as a lender of last resort, a role it has so far shirked.

Whatever the precise outcome, it is likely this crash will scatter debris over the global economy. But what will it mean for Australia? As with all car crashes, the best thing to do is just grip the wheel, focus on the road and keep driving. Australians should remember we are a few steps removed from this euro crisis.

Broadly, there are only three channels through which the crisis in Europe can have an impact on us, and there is indeed cause for optimism on all three.

First, a collapse in commodity prices following slower world growth would affect our exports. But it matters which commodities we’re talking about. Although prices for hard metals such as steel and copper have fallen dramatically, declines in bulk commodity prices – for the coal and iron ore we ship to China – have been more muted.

While Chinese demand for our bulk commodity exports remains robust, we have a buffer. It is true Europe is a leading destination for US exports, and the US is in turn the main destination for Chinese exports, which have have already dropped off.

However, lower-than-expected Chinese inflation figures released this week also mean there is room for the Chinese government to stimulate the economy with lower interest rates. And there remains plenty of stimulus spending power in its kitty. Just as China acted as a shock absorber for the Australian economy in the first global financial crisis, so is it likely to act in any renewed financial crisis.

The second way Australia could be affected by the euro crisis is through the world banking system. Fears about sovereign defaults could conceivably lead to another near complete seizing up of the global banking system, with banks unable or unwilling to lend, except at exorbitant interest rates reflecting the perceived risk the money may never be repaid.

Depending, of course, on the depth and duration of any such seizing up, there is also good ground for optimism in the healthy state of Australian banks’ balance sheets.

Apart from making multibillion-dollar record profits, they have learnt the lessons of the first global financial crisis, when they were forced to pay high interest rates on their foreign borrowings, which made up more than half of their funding sources. Since then, the banks have amassed a bigger base of domestic deposits and moved ahead of the game in securing long-term international funding.

If funding costs did rise significantly, there would be room for many banks to hold off, for a period, on rolling over foreign debts. And even if banks did pass on higher borrowing costs to mortgage holders, the Reserve Bank stands willing and able to cut its interest rate dramatically to keep the rates paid by borrowers down. Australia comes into this turmoil with one of the highest cash rates in the world.

The third, and perhaps least predictable, way that European troubles could impact on the economy is through consumer and business confidence. If consumers become unnecessarily spooked about the euro crisis, they could delay spending decisions, harming businesses. Business, in turn, could delay investments and stop hiring. Yesterday’s jobs figures showing the unemployment rate remaining at near historic lows of 5.2 per cent are encouraging in that regard. A lower Australian dollar, as investors seek the safe haven of the US dollar, while bad news for holidaymakers to the US, would also provide relief for embattled manufacturers and domestic tourism companies.

It’s hard to look away from the car crash that is the euro zone, but Australians would do well to remember our strengths.

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This entry was posted in Banks, Budget, Currency, Employment, Gillard Government, Global Financial Crisis, Interest Rates, Mining Boom, Reserve Bank. Bookmark the permalink.

One Response to Euro zone a car crash: best keep your eyes on the road

  1. Magpie says:

    Dear econogirl,

    Glad to see you posting again.

    For you amusement or amazement, here’s some declarations of Signore Mario Monti in a Italian TV show (looks a bit like SBS’s Insight):

    “Today we’re seeing (…) the great success of the euro. And what’s the more concrete manifestation of the euro’s success? Greece!

    “Why? Because the euro was created (well, yes, to have a unique currency) but, especially, to convince Germany that did the big sacrifice of renouncing to the Deutsche Mark in order to have an European common currency, that, through the euro, the culture of stability that President (I couldn’t catch the name), the German culture of stability will disseminate [all over the Eurozone]“.

    My translation (my Italian is a bit rusty, sorry)

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