Understanding the crisis that embroils Europe

Understanding the crisis that embroils Europe

Dean Pagonis
EuropeGreek Debt Crisis
February 29, 2012

I am sure you have heard of the commotion unfolding in Europe, dubbed by many news media outlets as the ‘European sovereign debt crisis’. But what does this all mean?

Ric Battelino, Deputy Governor of the Reserve Bank of Australia, spoke in Sydney about the ‘European Financial Developments’ and what it means for the world economy and Australia. This is an overview of his insights, which explained what is occurring in Europe, how the impending crisis came about, and what the consequences are for the world.

European debt:

The problems in Europe stem from a longer-term economic flaw in the European fiscal policy process. There has been a lack of fiscal discipline over the past 40 years in many European countries – they have loosened fiscal policy (cut taxes and increased government spending) during recessionary periods, but have not scaled back this expansionary fiscal stance during the subsequent recoveries. Economic theory dictates that fiscal policy must ‘balance’ over the business cycle. Instead, Europe had a debt-GDP ratio of 40% during the boom years of 2002-06. When the global financial crisis hit in 2008, European governments loosened fiscal policy again to protect their economies during the downturn – however, this pushed their fiscal position to unsustainable levels. The first concerns of debt sustainability were at the end of 2009, when Greece told the markets that their fiscal position is worse than they had been reporting. By April 2010, Greece needed external assistance from the IMF. What this created was fear in the markets – if Greece has an unsustainable position, which others could be in fiscal trouble? Ireland and Portugal followed Greece, gaining external assistance in early 2010. The measures brought in by European politicians since then have brought short term respite for the markets, but no lasting reassurance – yields on government debt throughout Europe have been rising substantially (to unsustainable levels in Greece and Italy).

How does the debt issues in Europe cause problems in its banking sector?

  1. Valuation losses: many European banks hold sovereign debt bonds from European countries; higher yields on European bonds causes valuation losses on these holdings (Greek bond values have fallen 70%, whilst Italian bond values have fallen 10%). 1/3 of European sovereign debt is held by its banks. They mostly hold their home country debt, but there are also cross border holdings.
  2. Falling bank deposits: cautious depositors have caused a fall in bank deposits across Europe – this reduces the funds available to loan out to consumers, and hence brings credit tightening. (Greek deposits have fallen 25%, Irish deposits down 10%). Due to this, The European Central Bank has had to increase its lending to those banks to fill the void.
  3. Asset sales: new rules have pushed European banks to get their core tier-one capital ratio to 9%; this is equivalent to 150bill euros of new capital. European banks have been struggling to raise equity capital, so instead they have been selling bank assets, which has subsequently brought further credit tightening by these banks

Effect on the world economy

The biggest impact of European debt problems is on the continent – austerity packages have cut government spending (including pension payments, wages) and increased taxes (including value-add consumer goods and services taxes, income taxes, company taxes). The impact has been significant – Europe is now in mild recession, with consumer confidence collapsing and business investment faltering as future European growth prospects looks abysmal (and in some cases non-existent). This has flow-on effects on the rest of the world – lower consumer spending in Europe impacts its trading partners, with a subsequent slowdown in China (Europe’s biggest importer), India and the rest of the emerging economies. Furthermore, lower consumer confidence hits business profits and causes a selloff in world equity markets, consequently lowering consumer wealth and spending (and the downward cycle continues, known in economics as the downward multiplier).

The impact on the Australian economy has been muted – this is due to its minimal trade and financial linkages with Europe. Australia is affected indirectly by the consequent slowdown in Asia, the countries driving Australia’s current resources investment boom. Reduced demand for commodities from Asia lowers world commodity prices, which is the main driver for the Australian dollar and Australia’s share market (which has fallen 10% in 2011). Despite this, consumer and business confidence has rebounded in the last few months, as the gains from the resources boom has spread across the Australian economy. With trend growth still expected in 2012, the federal budget in a good fiscal position (unlike Europe!) and the huge investment pipeline in resources, Australia is in a great position to ride out the current European crisis.

Despite all this, investors continue to watch every move and policy decision of European politicians and economist, and await a proper long-term solution that builds trust and brings confidence back to the markets.

Listen to the full speech from Ric Battellino here:

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