Debt concerns intensify in Europe, US

There has been a fresh proliferation of negative sentiment on international markets in recent weeks.   The Euro-zone has been slipping further into crisis while concerns over the US debt ceiling and a weak US economy are coming to a head.   Expectations of US GDP-growth in the near-term are beginning to drift downwards again with the labour market and domestic demand expected to remain sluggish for some time.

Europe’s sovereign debt crisis

Severe sovereign funding pressures in Greece, Ireland, and Portugal have seen their governments turn to the European Union and the IMF for help.   Banks in these countries have found themselves significantly exposed to sovereign debt, and French and German Banks also carry a level of exposure through bond markets.   Bank failures or a sovereign debt default would quickly spread through Europe’s financial sector. According to the Bank for International Settlements (BIS), European bank exposure (excluding domestic banks) to the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) is US$2.1tn.

The long-term commitment of Germany to the euro will be a key factor directing debt restructuring negotiations overcoming months.   A full fiscal union is likely to be unpopular in Germany, and sharing liability for national debts does not seem like a way to encourage good fiscal management.   If Greece, Ireland, and Portugal are cut loose then their currencies would be able to adjust to reflect the lack of competitiveness of their economies.

Whatever the eventual solutions, policymakers in Europe know that they need to act fast to stop Italy being absorbed into this crisis.     According to BIS data, Italy is the third-largest bond market in the world, making it "too big to bail". Ten-year government bond yields in Italy have shot past 5.5%, the highest level since the euro was introduced in 1999.   Italy’s economy is characterised by weak GDP growth, high debt-to-GDP ratio, and a low, independently controlled inflation rate making them vulnerable to rising interest rates.

The United States’ debt ceiling

The US is facing some of the same issues as Europe at present with the August 2 deadline to raise the government’s debt ceiling fast approaching. However, unlike in Europe credit markets seem to be pricing in very little chance of a US default.     Ratings agency Moody’s has warned there is a small but rising risk of a short-lived default, and the US’s long-held AAA credit rating appears to be under significant threat. Standard and Poor’s has estimated a 50% probability that America’s rating will drop from AAA to AA in the next 90 days (even if the debt ceiling is raised).  

The possible risks of a downgrade to confidence in the US economy may have been overstated.   However, the collateral requirements of certain banks and institutions could mean US debt is no longer as attractive, putting some upward pressure on interest rates.

Along with concerns over debt, The New York Fed Empire State survey for July suggests general business conditions and new orders are currently weak.   The University of Michigan consumer confidence index is also now at its lowest level since March 2009.   All signs point to the fact that immediate growth prospects for the US economy look shaky and that there is a long way to go before America can put the global financial crisis behind it.

China

China has been evolving in line with expectations over the last few weeks and remains the bright spot for near-term world growth prospects.   As the central bank progressively clamps down on inflation the most recent data has helped allay fears of a pronounced pull-back in economic growth.   GDP expanded at an annual rate of9.5% in the June quarter, despite recent policy tightening in terms of both tighter interest rates and increased reserve ratio requirements.   Although CPI inflation is currently running at 6.4%pa, it is mostly being driven by food (a familiar story), and most commentators are suggesting inflation has peaked.

New Zealand dollar outlook

The worsening crisis in Europe and the risk that the US debt ceiling is not addressed could negatively affect investor demand for our currency. But the balance of risks still suggests the New Zealand dollar will remain at or above its current level over the coming year given the recent positive GDP data, the likelihood of at least one increase in the official cash rate before the end of the year, and ongoing strength in our export prices.

The author thanks Gareth Morgan Investments for their help in preparing this update

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