Strategic Insights with the Institutional Bank.

Friday, 04 November 2011 Russell Jones

Its All Greek To Me

It is becoming harder and harder to keep up with the Eurozone pantomime. Much of yesterdays View From the Boundary publication was out of date within hours, as the Greek Prime Minister, his government and other European leaders tied themselves in knots on the issues of a Euro referendum, bailout funding, Papandreous future and precisely how to run that increasingly dysfunctional country. As we remarked last night, Mr. Papandreous sudden call earlier this week for a referendum on Greeces Euro membership, while perhaps understandable as a means to shore up waning domestic electoral support, appeared naive and misguided in broader practical terms. Indeed, it risked being a spectacular own goal (and indeed probably is where his own political career is concerned). At a stroke it threatened to shatter the multilateral approach to the sovereign crisis pursued since its outset and demolish the latest torturously assembled plan to paper over Europes cracks, in the process encouraging the belief that, consistent with the historical record, the Greeks remained serial defaulters and were quite simply not to be trusted. Looking on from outside, once again, one was amazed by the apparent inability of European policymakers to manage the sensitivities of the nancial markets and by the lack of understanding of the need progressively to build condence in a course of action, rather than intermittently undermine it. With the referendum abandoned and some sort of coalition or technocractic government in prospect for Greece (the opposition has now expressed its support for the latest bailout deal), for now at least, we have pulled back from the brink of a disorderly default and chaotic exit of a member of the single currency. But this hardly marks the end of Greeces travails, the Eurozone sovereign risk crisis or the uncertainties and downside risks for the global economy, including Australia and New Zealand. It is noticeable that peripheral Eurozone spreads, and not least Italian and French spreads, remained under upward pressure overnight, even as stock markets rallied. Meanwhile, we would emphasise the following: The well documented shortcomings of last weeks latest Eurozone lifeboat remain a fact of life. Greece and the Eurozone periphery still face years of painful austerity and little or no growth, so that social and political uncertainty and unrest are likely to remain a fact of life for the foreseeable future. The Eurozone as a whole, as Mario Draghi effectively admitted in his rst ECB press conference, is headed for recession and probably not the mild downturn intimated by Draghi. Hence, budget targets will continue to be missed. Even if the IMF may provide additional nancial assistance, the notion of China and other rich developing countries riding to the rescue of the Eurozone looks increasingly implausible. It has become obvious over the last 48 hours that the exit of one of the members of the Eurozone is no longer out of the question. Messrs. Merkel and Sarkozy were ready to see Greece leave. Econ Chairman Juncker suggested that the European authorities were prepared for Greeces departure (although God only knows quite how). The agreement setting up the European single currency was originally described as irrevocable and permanent. Clearly, this is no longer the case. Countries will not be allowed to stay at any price. Hence, the credibility of the Euro project has been dealt a powerful, potentially fatal, blow. The ECB may have eased conventional monetary policy rather earlier than many expected and begun to unwind its error of earlier this year, but short rates are something of a sideshow. The key issue is how to reduce the level of peripheral long rates to more sustainable levels (that is to the underlying growth rate of nominal GDP or less) and, for now at least, the Draghi ECB appears as opposed to an open ended policy of sovereign bond purchases and balance sheet expansion as was the Trichet ECB. Its bond buying programme remains limited and temporary. The prevailing ECB denition of its lender
AU & NZ Insights. Global Strategy.

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of last resort function effectively stops at the banks. It certainly does not fully embrace sovereigns. And until it does, there is little or no prospect of an end to the crisis. But to happen this will require a seachange in the attitude of the Bundesbank and the willingness of European politicians (and especially those in Berlin) formally to backstop the ECB against the losses it will incur in the process. The bottom line is that global markets will probably remain at the mercy of the European situation and the headlines associated with it and the crisis retains the potential to deliver a further enormous shock to the entire global economy. As long as this is the case, central banks in general will have good reason to err on the side of accommodation. This means that whatever the domestic Australian case for further easing (and we would stress it remains reasonably strong), market bets on the RBA having to deliver one or more emergency rate cuts because of the broader international environment are unlikely entirely to disappear. What is more, the AGB market will continue to benet from the global shortage of low risk assets which has latterly only been exacerbated by the decisions of the Swiss and Japanese authorities to cap their currencies. Finally, we would also stress that the policy bias in China is beginning to evolve in a more dovish direction as it and other emerging market economies in Asia and beyond wake up to the fact they are not immune to Europes woes and the tightening of credit and funding conditions. This too will lend support to Australian xed income assets.

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Key Contacts.

Rates Strategy
Russell Jones
T +61 2 8254 8668 E russelljones@westpac.com.au

FX Strategy
Robert Rennie
T +61 2 8254 8063 E rrennie@westpac.com.au

Damien McColough
T +61 2 8253 4212 E dmccolough@westpac.com.au

Sean Callow
T +61 2 8254 9583 E scallow@westpac.com.au

Timothy Jung
T +61 2 8253 4971 E tjung@westpac.com.au

Jonathan Cavenagh
T +65 6535 3466 E jcavenagh@westpac.com.au

Imre Speizer
T +64 9 336 9929 E imre.speizer@westpac.com.au

Richard Franulovich
T +1 212 551 1816 E rfranulovich@westpac.com.au

Altaz Dagha
T +44 207 621 7620 E adagha@westpac.com.au

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