Three European scenarios ... none good

Published 01 December 2011 05:01, Updated 08 December 2011 05:15

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Leading indicators point to recession in Europe. The question is now how deep and disruptive will it be? Put simply, three scenarios are possible for Europe.

•Muddle through: the cycle of “revolt, response and respite” continues to repeat, with periodic interventions that never go far enough but avoid a big blow-up. This is what Europe has been going through over the past 18 months but it’s questionable it can continue thus with core countries now being affected.

•Blow-up: the crisis comes to a head with a deep recession – euro zone gross domestic product falling 5-10 per cent in 2012 – and a financial crisis rivalling the global financial crisis. This would be bad for growth assets – shares, commodities, the $A and the euro.

•Aggressive European Central Bank monetisation: the ECB finally realises the crisis is threatening deep recession and price deflation and undertakes aggressive quantitative easing to push down bond yields and head off calamity. This would probably be too late to avoid a mild recession and there would be a lot of mopping up, but it would at least head off the blow-up scenario. This would be positive for growth assets.

Ultimately the ECB will capitulate and become lender of last resort but more pain in the markets may precede this. While a mild euro zone recession is expected, the risk of a blow-up and deep recession is rising as the crisis spreads into core countries, fiscal austerity intensifies, economic confidence slides and social unrest increases. Even Germany appears headed for recession.

The recession in Europe will affect the rest of the world, including Asia and Australia, via three channels: trade, the global financial system and confidence.

The euro zone absorbs about 25 per cent of US exports, less than 20 per cent of Chinese exports and less than 10 per cent of Australian exports. Rough estimates suggest a 1 per cent fall in euro zone GDP would knock just 0.1 per cent off US GDP, 0.4 per cent off OECD growth (including the direct effect of the euro zone contraction), 0.1 per cent off Chinese growth and less than 0.1 per cent off Australian growth via trade impacts alone.

If the euro zone contracted 5 per cent in a blow-up scenario, it would knock roughly 0.6 per cent off US growth, 2 per cent off OECD growth, 0.5 per cent off Chinese growth and 0.4 per cent off Australian growth.

However, these figures are likely to understate the impact. First, European banks are shrinking their balance sheets to strengthen their capital ratios. A lot of this will come out of their foreign operations.

A 10 per cent shrinkage of euro zone banks’ $US25 trillion in loans could pull $US1.2 trillion of debt out of the global economy, equivalent to 2 per cent of world GDP. Of course this doesn’t mean a 2 per cent contraction in global GDP (as companies can rely on record cash holdings) but the impact is still negative. Although Asia and Latin America are self-sufficient in terms of funding (being net global creditors), they will still be affected as euro zone banks play a big role in trade finance.

Second are the financial effects if a big euro zone bank fails, the impact on the cost of funding as credit markets tighten and the loss of wealth associated with sharemarket falls. A fall in the euro would also have a dampening impact on global growth and euro zone-sourced profits.

Finally, there is the impact of the European debt crisis on consumer and business confidence. Confidence levels are clearly depressed globally but with no widespread impact on actual spending. Obviously the impact could rise if the European crisis worsens.

Overall our assessment is that a mild recession in Europe would dampen global growth but would not cause a global recession.

A blow-up scenario, however, with a 5-10 per cent EZ contraction and significant financial dislocation would threaten a return to global recession.

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