Eurozone crisis and SA

WHEN you find a message in your inbox saying: "It's almost time to panic," you can't help feeling very uneasy. That's the message I got from Rand Merchant Bank's (RMB's) currency analysts on Tuesday, saying the eurozone debt crisis has entered a "new and more dangerous stage".

The key issue is that the crisis is spreading to Italy and Spain, the eurozone’s third- and fourth-largest members. "We can say, without exaggeration, that this creates risks of another crisis at least as bad as the Lehman's bankruptcy," RMB says.

This is a reference to the filing for bankruptcy by US bank Lehman Brothers in September 2008, which set fire to the smouldering embers of the global financial crisis.

The focus at the moment is firmly on Italy, where Finance Minister Giulio Tremonti delivered a budget amid confusion, divisions and insults last week. The budget aims to save €40bn, but this was at first reported to be as high as €68bn because of the confusing way in which Tremonti delivered the figures.
 
Italian and Spanish bond spreads over safe haven German Bunds soared to their highest level since the inception of the euro, approaching a threshold viewed as unsustainable by the markets as concerns grew that a potential Greek default could engulf larger economies.

German Chancellor Angela Merkel said on Monday that Italy must send a "very important signal" to nervous investors by enacting credible plans to consolidate its budget plans. She also urged eurozone officials to come up with a new aid plan for Greece soon.

Tremonti said on budget day, July 7, that it would be a "disaster" if Italy didn't balance its budget by 2014 as envisaged under the three-year plan. Italy doesn't have a very big budget deficit, but its problem is public debt accumulated in the past, which is astronomically high.

Italy's budget deficit in the first quarter was 7.7% of gross domestic product (GDP), down from 8.5% in the same period a year earlier. The budget deficit tends to balloon early in the year due to the fiscal calendar. For 2010 as a whole, Italy's budget deficit was only 4.5% of GDP. In Greece and the US, deficits were more than twice that level.

How could the shenanigans affect SA?

Trouble is, though, that Italy is vulnerable because it has one of the world's highest public debts at around 120% of GDP and has endured more than a decade of stagnant growth. If European leaders are unable to contain a debt crisis that has already forced Greece, Ireland and Portugal to take bailouts, Italy is seen as the next "domino" after Spain.

Up until Italy's budget last week, markets had been less concerned about the country because it had kept its budget deficit in check better than most countries and had low private debt.

But the Italian spread over 10-year Bunds widened 43 basis points to a record wide of 286 basis points. The 10-year Italian bond was yielding 5.54% while the equivalent Spanish bond was at 5.92%, dangerously close to the 6% theshhold traders cited as a possible warning sign.

As these yields rise, it becomes more difficult for the countries in trouble to raise new debt, possibly leading to default and full-blown crisis.

If Italy tumbles, disaster strikes for the world. It might first be Spain, which has introduced austerity measures, and then Italy, but the focus is firmly on Italy because of its recent budget. It doesn't help that Prime Minister Silvio Berlusconi was forced to withdraw a measure slipped into the budget - apparently without the knowledge of most ministers - that would have directly benefited his Fininvest financial holding company.
 
What does all this mean for SA? The key is that risky assets will fall from favour if the sense of crisis deepens. We have already seen a depreciation in the rand; this could worsen substantially. If the euro cracks, the rand will crack too. Equity markets will also be under pressure.

The question is what will happen to interest rates. Though the rand may weaken, the Reserve Bank might feel that a weakened Europe – one of SA's biggest trading partners – is bad news for economic growth and may decide not to raise rates at all. This would be the right course of action, even if inflation pierces 6%, as the economy will take a pummelling if the European dominoes actually fall.

RMB believed on Tuesday morning that calm would soon return: "Many may yawn, and say that we've seen this before: risks rise, the rand weakens but soon we're recovering once again. A repeat of that pattern is indeed the most likely outcome. But it is by no means assured."   

 - Fin24

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