Eurocrisis Is 2012 Bound

The European sovereign debt crisis has continued to hog the attention of global markets, with little sign of immediate resolution. The latest development in the drama has been a Europe-wide plan to move to a more centralised approach to setting national budgets in the region. This would involve European governments having to stay under certain deficit and debt limits or face fines for breaching them. It was also agreed that the International Monetary Fund (IMF) will play a greater role in helping out financially troubled countries in the region. The hope is that these changes will be enough to give investors confidence to buy the bonds of Eurozone countries, particularly those with high debt levels such as Italy and Spain.

The problem is that changes to the European Union constitution are required. This in turn will require ratification by the parliaments of individual European countries. Britain has said from the start that it will not be part of the latest proposed deal because it is detrimental to the competitiveness of its financial sector. And although the other 26 European nations have given their initial approval to the deal, the fear is that some of them will be unable to ratify it.

In the meantime the financial state of the European banking system has deteriorated substantially. In response to bank pressures, the European Central Bank (ECB) and the US Federal Reserve have pumped an extraordinary amount of emergency short-term funding into the European financial system. So far this has had only limited effect on bank funding costs and credit pressures. However, one side-effect of the ECB actions has been to support European bond markets through the back door. Banks are taking advantage of the cheap short-term funding available at the central bank and then buying European government bonds with much higher yields, thereby making sizeable margins.



Despite ECB efforts so far, many investors and commentators are calling for a "big bazooka" - aggressive ECB buying of Italian and Spanish government bonds. This would lower the interest rates Italy and Spain pay on their debt even further, making the debt easier to service. It would help support the value of those bonds, helping to protect the capital of European banks. But Germany, and the ECB itself, is vehemently opposed to such action. Their fear is that lowering the interest rates on European sovereign debt will take pressure off governments to undertake the reforms required to get their finances on a truly sustainable footing.

So the crisis stumbles on. My view is that the situation will muddle along until such time as markets have sufficient confidence that Eurozone members are on the road to consummating a European fiscal accord. This could be around March/April next year. In the meantime the ECB will continue to provide backdoor support for sovereign bond markets, although this may become more direct once the accord has been ratified by a critical number of European countries. Europe is heading for recession next year as a consequence of the contraction in bank credit and the uncertainty stalking the financial system.

There remains a small but significant risk that the crisis could deteriorate to the extent that the European banking system begins to crumble - some banks either go bust or have to be taken over by their governments. In this case the ECB, IMF and national governments, in cooperation with other central banks around the world, would intervene massively to support banks. Under this scenario a break-up of the Eurozone and sovereign debt defaults would create havoc in financial markets. Global growth would certainly suffer under such an outcome.

On a positive note, it is now clear that the US is no longer heading for recession. In fact, indicators over the past few months suggest the US economy is gradually building momentum and is likely to reach annual growth of 3-3.5% by the end of this year. And although China's economy has slowed to around 9% annual growth, inflation has abated, which gives the Chinese authorities room to free up access to credit to stimulate activity. These developments will blunt the negative influence of Europe on global activity.

Europe's woes will continue to emphasise the risks of excessive debt whether that be government, business or household debt. New Zealand government debt is relatively low, but rising as we continue to run significant budget deficits. New Zealand households are still carrying a high level of debt primarily backed by property. This is the age of deleveraging or debt reduction; we ignore the message at our peril.

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