The spluttering global economy could be Rudd’s real election bogey: Maley

Kevin Rudd and his team are facing a white-knuckle time in the lead-up to the next election. They know that the biggest risks the country is facing come from offshore, which means there’s precious little they can do to avert them.

Clearly the biggest risk that Australia currently faces is if the ongoing European sovereign debt crisis escalates into a full-blow global financial crisis, similar to the one that we saw in the final months of 2008. If that were to happen, Australian banks would again face difficulty in borrowing money overseas, and would likely have to pay significantly higher interest rates for offshore funds.

The banks would then pass these higher funding costs on in the form of higher interest rates for business and home loan borrowers, which would deal a hefty blow to local business and consumer confidence, and undermine local economic activity.

Over the past week, tensions in European financial markets appear to have eased off slightly, but Australia’s top policy-makers know they’re capable of resurfacing at any moment.

What’s more, there are several factors that have the potential to roil European financial markets in coming months.

The first is some concern that the recent moves by rating agencies to downgrade Greece’s credit rating to junk status could mean that Greek bonds may be removed from some of the global bond indices. Now, a lot of major bond funds have mandates that requiring their investments to replicate these global bond indices. If Greek bonds were removed from global bond indices, the managers of these funds would have no choice but to off-load their Greek bonds.

The recent controversial decision by the European Central Bank (ECB) to start buying up the bonds of troubled eurozone countries reduces the likelihood that these sales of Greek bonds will turn into a rout. However, there are some doubts whether the ECB has the appetite to absorb the amount of Greek bonds that could potentially hit the market.

Another major risk arises next week when European banks are due to repay $US540 billion in special, one-year loans that they borrowed from the ECB.

The trouble is that some European banks used their ECB loans – on which they paid an extremely low 1 per cent interest rate – to buy up the bonds of countries such as Greece, Spain and Portugal, which offered more attractive interest rates.

But now that they’re due to repay their ECB loans, the banks will be under pressure to off-load these bonds. And intensive selling of Greek, Spanish and Portuguese bonds could again ignite tensions in European financial markets.

Finally, the European Union’s decision to release the results of the “stress tests” run on the 25 largest European banks is something of a gamble.

As Marco Annunziata, chief economist at UniCredit, writes in today’s Wall Street Journal, publishing the results of the stress tests is one way of overcoming the enormous uncertainty that investors currently have about European banking system. “Uncertainty breeds contagion, so strong and weak banks alike find themselves under suspicion and under stress.”

Annunziata argues the stress tests are likely to bolster confidence in the European banking system if the methodology and assumptions of the tests are published, and if national banking regulators, in administering the tests, apply them to a sufficiently large number of their banks and financial institutions. In addition, he says, the stress tests are likely to show up some zombie banks and it’s vital that European policy-makers show that they’re ready to step in and take control.

However, he also points out that investors could be rattled by the stress tests if the banking regulators in different countries decide to take different approaches to testing their banks, or if some countries decide to be less transparent than others.

But even if troubles in European markets are kept under control in the next few months, Australia faces another major risk from the United States. It’s increasingly clear that US economic growth is going to slow in the second half of the year, although at this stage, it’s difficult to determine how sharp the slowdown is likely to be.

If the worst case estimates are realised, and US economic growth grinds to a halt in the second half of 2010, then this will undermine the global economic rebound currently underway and will likely cause a steep drop in the demand for Australia’s commodity exports and therefore the prices paid.

A sharp fall in export earnings would quickly flow through to the local economy, forcing companies to moth-ball planned investment projects and causing consumers to cut back on spending.

And Canberra policy-makers will be scrambling to explain to Rudd and his team why the economy has fallen so far short of the rosy forecasts that were used to craft the budget only a few months earlier.

This article first appeared on Business Spectator