Standard & Poor’s decision to downgrade the credit ratings of nine Eurozone countries, including Austria, France, Italy, Spain, and Portugal, is another symptom of the contagious and vicious debt cycle affecting the economies of Europe and the US.
This crisis is attributable to high government debt levels in Europe and the US, in combination with high funding and derivative costs. The chart below shows the increase of debt levels for major economies since the beginning of the global financial crisis in 2007:
Two outliers are apparent. The first one is Italy, which has always had relatively large government debt levels in combination with low household debt levels. Generally speaking the level of government debt needs to be seen in the context of the size of government activities.
Japan (J), the second outlier, has been exposed to a prolonged period of economic difficulties, which started around 1993, and recent natural catastrophes. Other countries such as Germany (D), England (E), France (F) and Spain (E) have increased their debt levels recently to mitigate the consequences of the GFC.
In comparison, Australia’s current debt level of 30% of GDP is relatively low.
These increased debt levels in American and European economies have coincided with distressed financial markets, where the cost of raising funding has climbed as increased risk transfer costs outweigh declining base interest rates, such as the cash target rate set by the Reserve Bank of Australia.
Risk transfer costs are generally measured by the gap between the return on a risky financial instrument, such a Greek government bond, and an almost risk-free and liquid financial instrument, such as a German government bond.
The credit crunch has been exacerbated by the market reaction and the consequences of market regulation. For example, maturities for financial instruments have been reduced, resulting in the need for countries to raise funds more often. The current economic downturn has lasted much longer than its antecedents, so governments have been required to refinance multiple times.
At the same time, a vicious cycle has started where financial intermediaries and investors anticipate larger costs for credit losses and make larger provisions. On top of this, bank regulators require larger amounts of capital to cover future losses. This is evident in the assignment of lower credit ratings for governments and firms.
The combination of increased provisions and capital result in higher costs for lenders, which are passed on to borrowers. With an increase in the costs of risk transfers, as well as reduced new loan and credit line volumes.
The impact on Australia
Australia’s economic growth and confidence has in large kept its strength relative to its American and European counterparts. However, the country’s economic size and reliance on overseas demand for its key exports, such as commodities, education, and tourism, poses a threat.
Most products’ and services’ competitiveness relies on the exchange rate of the Australian dollar to other currencies. The recent increase in the exchange rate has already created hardship to manufacturers, universities and tourism providers. As a result, corporate and household income may decrease in relative terms. Consumer spending and risk-taking investments may be low as individuals worry about the future.
The discussion around interest rates over the past few weeks has revealed that Australian banks, which secure their wholesale, non-deposit funding predominantly overseas are facing difficulties – despite the fact that they rank at the top globally in terms of financial stability and credit ratings.
Australian banks raise these funds in overseas currencies and swap them into domestic currency by the means of multi-year, forward-looking derivative contracts. Both of these markets are currently constrained in terms of volume and pricing. This is why Australian banks continue to argue that the decreases in the RBA cash target rate cannot be passed on to borrowers.
The crisis has led to increased credit and liquidity costs as well as future foreign exchange conversion costs. Exchange rates and credit costs are forceful mechanisms for changes in global financial markets, and Australia may have been sheltered in the past due to its proximity and linkages to booming Asian markets. It is uncertain whether this protection mechanism holds in the future, as the first signs of a forthcoming recession in Asia have been detected.
The way out of this crisis is not apparent, nor is an immediate change of the situation in the US and Europe. New Italian Prime Minister Mario Monti’s austerity measures in his country and the recent package agreed by German Chancellor Merkel and French President Sarkozy may be the first steps of a slowdown of the downturn. But it is doubtful whether these will cause an immediate turnaround, and more rounds of the vicious cycle appear to be likely.
The consequence may be a drop of wealth and income in the near future. This may impact most of us through our assets, incomes, pensions or inheritances.
But on the other hand, in every crisis lies an opportunity. Australia’s debt levels are low, companies have vast amounts of cash available while overseas competitors are struggling. For example, Australian banks have grown in terms of profitability and stability to the top of the world.
We could see this as an unique opportunity to provide leadership and shift the world’s attention to Australia.