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Aug 30

A short piece on the Euro Sovereign Crisis

The Global Financial Crisis (GFC) started out as a credit crisis. In simple terms, the credit crisis was a situation whereby banks stopped lending, credit markets stopped operating and the availability of money to many businesses (and individuals) became so scarce that those most exposed became insolvent. The survival of the biggest banks around the world was in question, companies had to lay off staff, sharp increases in unemployment reduced further spending which further reduced business profits and the vicious cycle was in play. The method used by governments to break this vicious cycle was to take the place of the failed (or failing) banking systems and they borrowed (and printed) money to inject into the global economy in an attempt to save the day. With the global economy returning to growth, albeit sluggishly, many governments of the world are left with extremely high debt levels and combined with high unemployment and weaker revenues, many show signs of difficulty in paying off these debts. The most well known and written about are the several Euro denominated countries including Greece, Ireland, Spain, Portugal, and Italy.

The biggest holders of government debt are banks and there has never been an insolvent government that has had a solvent banking system. So, if the Greek Government becomes insolvent, so too do the Greek banks. Banks also lend to each other, so if one bank system becomes insolvent there is potential for this to ripple throughout the global banking system and produce another credit crisis…this is a worst case scenario and one of the main reasons for the extreme sharemarket volatility we have seen since the Euro sovereign crisis started at the end of 2009.

From an Australian perspective, this worst case scenario of another credit crisis could have a similar economic impact on our economy as the post-Lehman Brothers crisis and this is why our sharemarket has been effected in recent months like overseas markets. This has also resulted in increased concern from the Reserve Bank of Australia which has eased talk of the need to increase interest rates and the short term outlook for its cash rate appears to be one of stability. Current market expectations are for it to stay at 4.50% over the next few months (unless there is surprising inflation data).

In terms of currency the European debt concerns have produced weakness in the Euro which has meant it is cheaper for us to purchased goods and services in Europe. This currency effect should also assist the European economies exit their current economic mess. Of course a cheaper European holiday would appeal to many Australians which would be good for the European economies.  Unfortunately, in countries, like Spain, where inflation in the years leading to the GFC has made them uncompetitive with Germany the rest of Europe, a weaker Euro does not help their competitiveness so countries like Spain will unfortunately experience years of deflation to be competitive again.

Moving forward, the European crisis is not over. The European Central Bank has produced a $1trillion package to assist governments in trouble but economies do not improve overnight. Euro sovereign credit spreads are high again, markets are volatile, and the strong prospect of a double dip recession in the US, could mean it is many years before we have clarity on the global economic recovery from the GFC.

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