Strategic Insights with the Institutional Bank.

Friday, 11 November 2011 Russell Jones

The Four Horsemen of the Apocalypse

The European sovereign risk crisis is depressing the global macroeconomic outlook in a number of ways. Europe (dened here as the Eurozone plus the UK) accounts for around 20% of global GDP, 30% of global exports and more than 40% of global banking assets and the regions slide back into recession is reverberating around the globe via slower demand for imports, via negative condence effects and, perhaps most importantly, via nancial stress and tighter credit conditions. For example, as a percentage of the absolute level of 3 month OIS rates, the prevailing 3-month Euribor-OIS spread is now signicantly higher than it was in the GFC (see chart on the next page). As a result of the burgeoning strains in the European nancial sector, liquidity is being sucked out of global markets and this process is, according to anecdotes from commercial bank executives, increasingly manifest as far aeld as Asia. Even if the US and other parts of the world economy avoid a similar recessionary fate to Europe over the next year, the likelihood is that global growth will be slower than previously forecast and that unemployment will be signicantly higher. And in an environment where jobless rates are already historically high not least in the US, where the level of long term unemployment is particularly elevated the pressure for governments to respond with further stimulus will be considerable, especially should, as is likely, this situation encourage deepening social and political unrest. Unfortunately, however, the room for conventional monetary and scal policy is now more or less exhausted in the major economies, so any new initiatives will necessarily have to encroach further into unorthodox territory. More quantitative easing is in prospect in the US and elsewhere but the OECD policy reaction could stray into altogether more controversial and repressive elds. Meanwhile, policymakers in the developing world, and not least those in Asia, may be tempted further to embrace the neomercantilist strategies that have characterised much of their macro management since the Asian crisis of the late 1990s. There are, in particular, four regrettable areas into which economic policy could encroach over the next 12 months, all of which would generate considerably greater longer term costs for the global economy than they offer short term benets to individual countries or politicians. Indeed, these are policy responses that came to the fore during the 1930s. This was a decade in which recovery from the Great Depression was uneven, fragile, and incomplete; global trade and capital ows collapsed; competing trading blocs emerged, and political confrontations, which often grew out of economic distress, dislocation and rivalry, ultimately led to total war. Competitive Devaluation. As the Gold Standard system of xed exchange rates progressively collapsed after Britains forced exit in September 1931, governments sought to maintain industrial competitiveness through the deliberate manipulation of their nominal exchange rates relative to those of their major trading partners. Such approaches are already making a comeback. Both the Swiss and the Japanese authorities have acted to cap their exchange rates via ofcial intervention in the fx market in an effort to offset safe haven ows into their respective currencies, minimise the damage being done to their tradable goods sectors, and reduce deationary pressures. At the same time, since 1997 many developing economies, not least China and much of the rest of Asia, have actively managed their exchange rates to a greater or a lesser degree via the accumulation of huge stockpiles of foreign exchange reserves in order to encourage export-led growth. Such policies are only likely to become more popular as global demand growth softens. Protection. Protection is a very seductive policy in that it offers immediate political gains in tough economic times by safe-guarding jobs in those industries threatened by international competition, and where more often than not vested interests are most vocal, while any costs in terms of higher prices or compromised productivity growth are typically delayed and more thinly spread across the population. Resort to import tariffs and quotas and export subsidies proliferated in tit for tat fashion in the 1930s, especially once the US and UK, the two dominant economies of that era, had adopted such policies.
AU & NZ Insights. Global Strategy.

Strategic Insights continued

Today, both President Obama and a number of the Republican candidates for the White House have already adopted some alarmingly protectionist rhetoric (not least towards China) as the 2012 White House election campaign gets under way. There is a risk that should the domestic US economic environment deteriorate dramatically, and scal policy remain compromised because of the polarisation of Congress, the President runs on an explicitly protectionist ticket. This can only be a red rag to a bull for the USs trade competitors, especially those in the developing world. Default. History suggests that sovereign defaults are rarely isolated events. Rather they occur in temporal and geographical clusters. The 1930s saw a catalogue of debt repudiations and restructurings most compulsory, some voluntary - as the Gold Standard collapsed and scal deation proved self defeating in an aggressively deationary environment, with Europe and Latin America particularly prone to default. In the current environment, Greece has already restructured its debts and the likelihood is that other economies in the Eurozone periphery, if not the outer core, will have to follow suit before too long, especially if the developing downturn proves serious. Financial Repression. Ever tighter capital account restrictions, exchange controls and increased domestic regulation of nancial sectors proved to be consistent features of the 1930s. These traits continued during the Second World War and its aftermath as governments grappled with hugely expanded levels of debt, often combining policies of regulatory coercion with a dose of ination to ease the real burden of those liabilities. The OECD economies are now facing similarly rapidly escalating levels of public sector debt to those which emerged 60 or 70 year ago. Hence, there is good reason to believe that the policy response will be comparable. Governments are likely to encourage home bias or endeavour to create captive audiences for their debt via supposedly prudential regulatory changes applied to banks and pension funds, transactions taxes, or the outright public ownership or control of nancial institutions. Aside from the potential for greater geopolitical conict, not least between the developed and the developing worlds, the net effect of these kind of policy departures would be enhanced market volatility, higher risk premia on government debt, and a tendency for international capital (where it is allowed to move) to seek out those markets and economies which eschew these responses.

3mth Euribor OIS Spread

1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Jan-00 May-02 Sep-04 Jan-07 May-09 Sep-11
3mth EU Libor-OIS Spread as a Percentage of 3mth OIS (lhs) 3mth EU Libor-OIS Spread (rhs)

%
Source: Bloomberg, W estpac

bp

200 180 160 140 120 100 80 60 40 20 0

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Key Contacts.

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

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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
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Timothy Jung
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Jonathan Cavenagh
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Imre Speizer
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Altaz Dagha
T +44 207 621 7620 E adagha@westpac.com.au

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