The Eurozone crisis: between suspense and rebound

Jonathan Assia

The Eurozone is in the midst of a crisis of debt and trust and a number of member states are on the verge of bankruptcy as a result of fiscal mismanagement. This article explores how events are unfolding in Europe and likely implications should the Eurozone disintegrate.yoni

The economic situation in the Eurozone is dire, of that there is little doubt. The Greek government is in the midst of negotiations with private bondholders who are unwilling to take further losses. The European Central Bank is considering how to deal with its own potentially huge losses from their holdings of Greek sovereign debt. There is seemingly no consensus among the E.U.’s leaders as to how to proceed. The head of the International Monetary Fund, Christine Lagarde, has said that now was the time for action, else the Eurozone is headed for a 1930’s style depression.

The European Central Bank (ECB) has been thrust into a lender of last resort role. Although it has recently stepped into secondary markets, buying sovereign debt to keep interest rates from rocketing skyward, it has failed to instil confidence in markets because it is an unwilling participant in the market. This was made clear by Mario Draghi during the question and answer session of his first press conference as the newly installed head of the ECB when he said, “I do not think that this is really within the remit of the ECB. The remit of the ECB is maintaining price stability over the medium term.” A simple promise by the ECB to do what needs to be done, when it needs to be done, in whatever amount needs be, is what is being called for by investors, analysts and economists. The French government has made it fairly clear that they would like to see the ECB step into that role. Last week, a senior ECB policymaker said that designing a lender-of-last resort mechanism was feasible though would need careful orchestration to avoid eroding already fragile market-confidence.

Indeed, too many unfounded, unsubstantiated and potentially damaging rumours are steering markets. “Is the Eurozone in the process of being dismantled?” “Is it true only the richest countries will be invited to stay in the Eurozone?” The Eurogroup’s president, Jean-Claude Juncker, has denied these rumours saying, “We don’t want to have the euro area exploding without reason. » But once a rumour is released, the damage is done; the hope is that the rumours are quickly quashed, to minimise repercussions.

Despite rhetoric and assertions to the contrary, there remains a general lack of political will for promised infrastructural and fiscal reforms. Take a look at Italy and its new prime minister, Mario Monti, who was well received and widely respected. Since he revealed a plan for some €34 billion in spending cuts and tax increases, his popularity has plummeted among his constituents and the little political goodwill he came into office with is already eroding; a mid-December poll conducted by Italy’s IPR Marketing found that his popularity among Italians had slipped from a high of 62 to 58. If he is forced to face a confidence vote, this will further unsettle potential investors, who are already well aware of a growing anarchical mentality.

Spain’s recently elected government was originally seen in a favourable light, but the proposal of desperately needed labour reforms has caused a great deal of dissension and breaking of the ranks. The Spanish government has already acknowledged that this key Eurozone economy missed its fiscal deficit target of 6.0% for 2011 and that growth will further deteriorate. Olli Rehn, the Economic Affairs Commission for the E.U. has said, nonetheless, that Spain must meet this year’s target of 4.4%. It could be difficult for the Spanish government to push through more austerity measures in the face of these obstacles.

The proposed fiscal reforms in Greece are well behind schedule. The new prime minister, Lucas Papademos, is also striving to muster political goodwill but as with Monti, his popularity is warning. A mid-December poll showed that 40% of respondents viewed him negatively as compared to 39% who saw him in a favourable light. It is uncertain whether the public clearly will support his proposal to push through more austerity measures. It is also uncertain whether private bondholders would be willing to “voluntarily” take even larger haircuts on existing debt. Without that support, the Greek government could find itself once again on the brink of default.

Greece’s debt is massive, with debt-to-GDP edging toward 170% and likely continuing higher. The most recent negotiations between the Greek government and private bondholders appear to be going nowhere fast, and time is not on Greece’s side. Without an agreement between the parties, there is a possibility Greece won’t be able to dodge a default this time around. A “technical credit event,” which is the negotiation of new terms other than those originally and contractually agreed, could also be triggered even if there is a voluntary agreement, should the participation rate fall significantly below 100%. In the event of a technical credit event or a disorderly default, sovereign debt markets could be further strained and spreads could rise, not just in the periphery, but among the now-downgraded core members.

So what would happen if the Eurozone breaks up? This would trigger a severe recession in the Eurozone as there would be a major collapse in global demand. Corporate profitability will also be hard hit. Eurozone liquidity would be almost non-existent, and investors would flee the Euro and the Eurozone for the safe haven US dollar and the US economy. There, at least, the Federal Reserve can provide the liquidity needed, given that they are a lender of last resort.

Then, the US bond market would re-establish itself as the safest debt market in the world. The most immediate response, which is already being seen, is a decline in borrowing costs for the US government. This could compel the US government to hold off on its deficit reduction strategy and increase government spending. As a result of huge and overwhelming demand for US debt instruments, the US dollar would rise sharply. Government spending would continue to increase as commodity prices dropped (when there is no liquidity, inflation quickly turns into deflation). Borrowing costs would continue to drop and the US position as the safest long term bet would be reinforced.

Overall, the collapse of the Eurozone would greatly benefit the US economy, but the rest of the world could be plagued by years of stagnation.

How Australia will be affected?

The Australian economy will be only moderately affected by the Eurozone crisis and that primarily during the first half of the year. The slowdown in China, which is Australia’s biggest trading partner, will be the most significant headwind for the Australian economy. The Chinese slowdown, an indirect effect of the European debt crisis given that Europe is China’s largest trading partner, in conjunction with the slowdown in Chinese real estate will reduce demand for Aussie goods and that will eventually transmit into lower growth. The impact in the first half of 2012 would be slightly muted by overall global liquidity injections and monetary easing, specifically in China, and a pro-growth policy of the RBA which is keen to hold the economy afloat with looser monetary conditions.

Nevertheless, we expect the European crisis to escalate towards the end of the year, with Sovereign Credit Defaults of Greece and Portugal seen as highly likely. We, therefore, expect a negative shockwave in the global credit system to follow, which will hammer global demand for commodities. Since the Asian credit markets depend on around $1.5Trln of credit from European finance institutions the effect on Asian growth will radiate throughout the entire region. And with Commodities prices and demand both slashed we expect the Aussie rate to deteriorate and Australian growth to decelerate.

We expect China’s GDP to grow in the range of 8% to 8.2% in 2012 in “official terms” and closer to 7% in real terms.  In our view, this will likely bring Australia’s annual GDP growth to an average 2% for 2012. The negative effect of the Chinese slowdown will be somewhat amplified by the strength of the Aussie Dollar, which we expect to continue to rise and gather steam from rate differentials at least until the end of the first half of 2012. However, as we would like to emphasis once again, as the Australian growth path will decelerate this will eventually cause the Aussie interest rate differential with other nations to narrow and could cap the Aussie around the 0.90 per US Dollar.

Finally, I would like add that, in the event global liquidity injections reaches overwhelming proportions (and €2Trillion from the ECB would be considered overwhelming), it would simply postpone the inevitable. Deleveraging will eventually materialize, despite the liquidity injections, and our envisioned scenario, too, will merely be postponed.