For those with a tendency to hit tl;dr, skip to the bottom paragraphs.
Economic Note: Europe Update
Politics re-enters the crisis…
In recent weeks the European sovereign debt crisis has entered a new, uncertain phase, on the back of a change of President in France (one of the “gang-of-two” countries that have been staunch advocates of austerity policies) and an inconclusive election result in Greece.
The right-leaning French President Nicolas Sarkozy (one half of “Merkozy”) was defeated by Socialist Party candidate Francois Hollande, in a result which was seen as a vote against further austerity measures . Commentators in Europe have predicted that Hollande will be on a “collision course” with German Chancellor Angela Merkel (the other half of “Merkozy”) given Hollande’s election rhetoric about the need to target growth as the crisis circuit breaker, rather than further austerity which has been the Merkozy mantra . However, in a meeting between Hollande and Merkel overnight, the rhetoric did not seem to translate into immediate action, which could indicate the Hollande victory may not be the “game changer” it was predicted to be.
By stark contrast, the inconclusive result in Greece appears to be a real game changer. A summary of the election in Greece can be found in last week’s Trendline , but in essence two key things occurred: the two ruling coalition parties, which held almost three quarters of the vote between them, received just under one third of total votes; while a number of extreme left and right wing parties managed to gather enough votes to enter parliament . As a result of this, many attempts have been made since the election to form workable coalition governments, with three distinctive phases: first through the two major parties, second through a coalition of left-wing parties completely opposed to the European Union (called Syrzia), and finally a group of “technocrats and personalities” – all of which have failed. Subsequently, the Greeks are heading back to the polls on 17 June , injecting a fresh wave of uncertainty.
…but the economics isn’t much better
In the middle of all of this, the data flow out of Europe and China has been somewhat weak, with a surge in German exports saving the European Union from entering a technical recession in the March quarter . The EU economy recorded a flat (0.0 per cent) growth outcome in March, which followed a 0.2 percentage point contraction in December. This result was supported heavily by an unexpected 0.5 per cent growth in Germany, with France flat and most other nations recording falling GDP.
Compounding this has been a range of weaker than expected data from China; with industrial production, trade volumes and asset investment all coming in lower than market forecasts . This caused Beijing to ease lending conditions for banks over the weekend, and many China economists expect further easing in the months ahead (contingent on a continued easing in inflation, which was the driver behind tighter policy over the course of 2011).
What does this mean: short term
At this stage, it appears the turmoil has been confined to financial markets – although not interbank lending.
The renewal of the debt crisis has sent significant shockwaves through global markets over the past two weeks, with investors pulling out of risky assets and fleeing to safe havens like US Government Bonds, German Bunds (both of which are at record lows) and gold. European stock markets have been the hardest hit, naturally, with the Grecian index hitting a multi-decade low and is now sitting at 11 per cent of its pre-GFC peak. Commodity prices have also been hit, with oil back around US$90 a barrel (from US$115 about a month ago).
Australia has not been immune, with the Aussie dollar falling to around US$0.98 – its lowest level this year. This trend emerged following the Reserve Bank’s meeting in May (where rates were cut by 50 basis points) although it has accelerated in recent days. Meanwhile, the stock market has fallen for six of the past nine sessions by up to 2.5 per cent, with resources stocks particularly hit.
However, key interbank lending rates, which measure the price banks charge to lend to one another, continue to remain moderate, with no significant movement over the past couple of weeks – although in saying that the downward trend which had commenced following the two LTRO (aka money printing by the European Central Bank) issues has halted.
Negative news will no doubt be impacting confidence, with the results of our June quarter Survey of Business Expectations particularly timely (given we mailed out in the week following the Greece/France elections).
Any economic impact at this stage would appear to hinge on the outcomes of a fresh Greek election. The caretaker government in Greece is continuing to fulfil its EU-IMF bailout obligations, and so the prospect for a default in the next couple of weeks is remote. The only way this could occur is if the European Central Bank decided to cut Greece loose, which would no doubt create financial turmoil at a similar scale to the Lehman Brothers crisis.
What does this mean: A Greek exit (aka Grexit, actually no, Greek exit)
As the weeks have progressed, more and more chatter has turned to what the “exit strategy” for Greece and the Euro area would potentially mean for the world economy. This could come in two ways: a Greek default, which would almost certainly lead to an expulsion from the EU; or Greece is simply cut adrift by the ECB and European Union.
Greek Default
While a country defaulting on its debts is nothing new (the most recent case has been Ecuador in 2008, while the US defaulted as recently as 1971 and the UK has defaulted five times); the advent of a default in a common currency area such as the Euro Zone has not happened before. The complicating factor is that all 17 nations use the same currency, and also have the same monetary policy (ie interest rates), which would be thrown completely out of joint in the event of a default. The European banking system is also quite intertwined, with private banks in most European nations having direct exposure to Greek government debt, while the ECB – and therefore all European governments – have direct exposure to Greece’s banking system.
So if the Greek Government was to default, it would send shocks directly to both its domestic banking system and the wider European banking system. This would likely cause a “credit event” like that which occurred following the Lehman Brothers bankruptcy and would likely see wholesale funding markets (ie interbank lending markets) freeze up. The scale could be larger, given the amount of money that has been given to Greece over the past few years in order to prop it up.
There would be a rush to pull money out of Greek banks and institutions, which would cause further issues in the Greek domestic banking sector and would likely see a number of Greek banks themselves declare bankruptcy. A cascading effect may also occur in this regard, with investors pulling out of other peripheral countries such as Portugal, Ireland, Spain and even Italy; which would magnify the impacts described in the previous paragraph. This is perhaps the worst case scenario, but one which would have the most impact and cannot be ruled out all together.
A Greek Exit
The other potential outcome, which could come either as a result of Greece defaulting or lead to a Greek default, is for Greece to leave the Euro Zone and stop using the Euro as its currency. Increasingly, the chatter from a number of journalists and commentators has been turning to how this would occur, how it would be managed, and the fallout for the global economy. The consensus is, however, that this kind of event will need to be “sprung” on markets, otherwise the consequences of investors, financiers, banks and governments preparing for this to happen on a certain day will lead to more financial chaos than would otherwise occur.
The likely course of action would be a complete, immediate containment of Greece from financial markets and the global economy, until such a time as a new, much cheaper, currency could be developed. The immediate impact of this would be significant stress on the Greek economy (not being able to export or import), its banking system (which would almost certainly collapse through lack of funds) and its people (who would have their living standards cut overnight through devaluation). Some economists have indicated it would take about six months for this initial shock to work through the Greek economy before they could tentatively step back into the global economy. This would also cause default, and would cause the issues outlined in the previous section to occur in sync with this.
However, over the medium to long term, this would mean that the Greek economy would have a much greater chance of standing on its own two feet, with policy settings (the currency, interest rates and fiscal policy) that are much better suited to its economic capacity.
Global economic impact
If either or both of these events were to occur, the impact on the global economy would be similar to the Global Financial Crisis – as this is really a financial crisis with economic roots not an economic crisis with financial roots. The transmissions would occur through domestic banking systems, via frozen wholesale funding markets and almost no interbank lending.
The complicating factor this time around is that most central banks have almost no room to move to support their domestic banking systems: they are out of ammunition already. Interest rates in the UK, US and EU are already at or below one per cent, while the balance sheets of these central banks are bloated with government debt. Stepping up to save domestic banking systems for a second time in five years would likely cause significant stresses on the money supply, although this impact would be countered somewhat by increased demand for safe haven currencies like the pound and US dollar.
Governments in major economies are also stretched to their limit, with high debt levels and most remaining mired in deficits as a result of stimulus in the GFC. The scope for further stimulus is therefore quite limited.
Trade finance (ie banks lending to shipping companies that transport cargo around the world) would also be affected, as banks who deal in this area work to bolster their own balance sheets so they can survive the shock. This would see international trade flows impacted severely as they were in the first few months following the collapse of Lehman Brothers. There would also no doubt be confidence effects, with consumers and businesses “battening down the hatches”, which would spill over into economic activity.
In essence, the impact on the global economy would be very similar to the GFC, although the scale is not known at the moment due to the unique circumstances we now find ourselves in.
Topic: France vs. Germany (Read 3637 times)
