Professor Fariborz Moshirian

The ongoing financial turmoil in Europe has led the IMF and the World Bank to downgrade the global economic growth outlook for 2012.  The financial market expected a much faster resolution to the sovereign debt crisis in Europe.

The currency crisis of 1992 in Europe led to the breakdown of the European Monetary System. However, when the financial markets sold off weak currencies such as the Italian lire and the French Franc, European leaders decided to come up with a Monetary Union with one single currency and one interest rate as a way of protecting themselves against ongoing currency volatility. While the Euro zone agreed to fiscal discipline with the debt to GDP ratio of 60 and a deficit to GDP of 3 percent, there was no monitoring system in place to enforce the fiscal rules amongst the Euro-zone member countries.

The current sovereign debt crisis provides a unique opportunity for the Euro zone to forge ahead with the process of fiscal union. Given the political nature of the Euro zone, bad news from the market is often an impetus for national leaders to justify actions to their electorate and pursue policies that promote fiscal union.  While the Euro zone has a long way to go, one cannot underestimate the progress made so far in bringing the Euro zone and indeed the European Union closer together.  Given the rise of 800 million middle income consumers in Asia, the European Union could either become more integrated and create a formidable block to compete against the US and Asia or return to a nationally based system that could make it difficult for each of the current member countries of the European Union to compete against Asia, the US and others in the 21st century.

The current European Financial Stability Fund with a lending capacity of up to €440  does not allow them to potentially rescue Italy and Spain, should these countries’ sovereign debt crises intensify.  Therefore, the IMF has decided to increase its financial firepower by $500 billion, as the existence of a global fund with the capacity of one trillion dollars could contribute to the stability of the global banking system. 

Countries such as China and Russia may now contribute more to the IMF’s stability fund, as financial uncertainty and a possible recession in Europe will affect the economic prosperity of emerging countries.

Furthermore, European banks have to increase their capital to asset ratio in order to assure the market that they can withstand the onslaught of the market, should more funds leave the Euro zone and less business activities be undertaken by European banks in US dollars. One of the Strategies adopted by banks to increase their capital to asset ratio is to reduce their lending activities. This in turn could further slow down the economic activity of the Euro zone. In  the meantime, Japanese banks are interested in increasing their ownership of European banks. This may well assist the European banks to improve their balance sheets and address their challenges of meeting the new capital to asset ratio requirements by June 2012.

At the same time, as austerity measures in Europe slow down the economic activities of the Euro zone this will reduce demand for borrowing from European banks.

As a result of the sovereign debt crisis investors an the money market reduced the amount of funds lent to European banks. The European Central Bank ( ECB)  has responded to this major liquidity challenge by allowing banks access to a three-year refinancing operation. This has eased the liquidity challenges within the Euro zone banking system to the extent that it appears that banks are now active in purchasing new bonds issued by Euro zone member countries.

Whether decoupling of the Asian economy from Europe and the US could take place is a matter of wait and see. However, Asian countries, including China, are developing their domestic  market capacity for a large share of demand and less reliance on their export market. This policy, coupled with the massive increase in foreign capital flowing into China and other emerging countries could ensure sustained economic growth in emerging countries in 2012, despite the negative economic outlook predicted by the World Bank and the IMF.  An increase in investors’ interest in buying emerging countries’ bonds and other assets may well increase economic activities in these countries regardless of the ongoing financial turmoil in Europe.

China’s economic growth was less in 2011 compared to 2010. However, this is mainly a deliberate policy to cool off the real estate bubble and contain inflation. With China’s policy for social housing which is designed to create a large number of cheap houses for more than 80 million people in China, the demand for iron ore and other resources from Australia will continue to grow in the medium term. It appears that while the European financial turmoil could have a negative impact on the Australian economy in 2012, as long as China and India’s domestic demand keeps growing, Australia’s economy will be less vulnerable to the financial events in Europe.

Professor Fariborz Moshirian is the Director of the Institute of Global Finance at the Australian School of Business.

This article first appeared in CFO Magazine, February 2012.