What to watch for during the sovereign debt crisis

Note:  Europe is where the real crisis is now – hence why this is the focus of the post, not the US.

While Europe tries to figure out how it can use the ECB as a lender of last resort, the current credit issues are likely to have some impact on the New Zealand economy.  In order to understand how, and what to look out for, we can use the same framework we did following the failure of Lehman Brothers.

This crisis is not on that level in its current incarnation – but the fact that it is borne of issues in the financial market does give us an idea of what we should look at, namely:

1. What’s happening to our commodity prices?
2. What’s going on with bank funding costs and access to credit?
3. In what ways will uncertainty about the outlook lead to a delay in investment/durable good spending.

Note:  S&P noted these factors as well (when mentioning NZ) – but their discussion was premised on a future significant global slowdown.  Remember that we aren’t there yet, so the outcomes they mention are risks – not the most likely outcome persee.  Just a point to keep in mind.

Just over a year ago the crisis in Greece really got going.  That had an undeniable impact on New Zealander’s willingness to invest, and had some impact on the availability of credit (although this point is more debatable).  We even saw a slight slip in export prices.

In the current situation, I’d expect to see the same again – unless the ECB can convince markets that it is a credible lender of last resort we are going to see some damage to the New Zealand economy.  We are a small open economy, and as a result we are always going to be driven around by movement around the world.

However, unlike 2010 and most definitely unlike September 2008, I don’t expect this crisis to completely derail the economic recovery in New Zealand.  Our financial system is strong enough to deal with this, and a slowdown in Europe is unlikely to have a huge impact on our export prices.

My main concern actually lies with China – we have seen the Yuan appreciate substantially and we have heard repeated calls of strong wage-price growth throughout the Chinese economy.  A sharp correction in either prices or output in China will have a significant impact on living standard in NZ (through our terms of trade) – and would force a significant correction in terms of the level of consumption we can afford as a country.  If growth in Europe and the US is softer than expected this becomes more likely.

So although the US is getting all the media coverage, and although Europe is showing the most distinct signs of dysfunction, New Zealand should be able to muddle through as long as China can keep itself together.

Although …

In this case, also keep an eye on Italy.  A lot of Italy’s public debt is held in Italy and Europe – however, if things are allowed to get out of control here, this could be a more concerning crisis.

And the US

The US economic outlook has been weakening for sometime, and although the drop in equities is concerning I would say it has more to do with current uncertainty amd the realisation that growth is underperforming than any sudden US crisis.

The things to keep an eye on here are long-term Treasury yields (in part these represent risk, sure, but they also represent a weak outlook for the long-run price level – and ergo output), and what the Fed decides to do.

If we want to think about the S&P downgrade, lets remember that it was the ridiculous negotiations regarding the debt ceiling that lead to this downgrade – with elected officials genuinely suggesting default was an option, S&P didn’t have any choice but to downgrade the US.  This doesn’t mean default is likely in the slightest, it just means that S&P is doing its job and taking into recent US political factors when coming up with its credit rating for the country.

Although I’m concerned about the downgrade in the sense that the US is still the “risk-free currency” (and so how can it be rated at a lower level then other riskier currencies), I suspect that many people stating the US should have kept its S&P rating do not realise how poor the US debt ceiling debaucle looked overseas – and how if a similar thing happened in any other country, they would really expect a downgrade from credit agencies.  I don’t believe you can have a large number of elected officials suggesting default and NOT respond as a credit rating agency – this would suggest political capture.