The European Debt Crisis has dragged on so long and taken so many torturous twists and turns it is virtually impossible for the average Australian investor to fully comprehend all the potential scenarios that could result. 

Simply put, countries in Europe borrowed too much money in relation to their economic revenue through sales of sovereign debt and now there is concern about their ability to repay.  That concern has led the investing community that funds these governments through bond sales to demand higher yields for their increased risk.  This raises borrowing costs and pushes indebted countries deeper into the hole in which they find themselves. 

The yields on European sovereign debt in countries at risk like Italy and Spain have risen and fallen in proportion to market concerns about the crisis in its entirety.  The European Central Bank (ECB) and the International Monetary Fund (IMF) have pledged bailout money to get through the crisis; but the money is contingent on several conditions.  Along with austerity measures requiring deep cuts in government spending, they are demanding private bondholders share some of the pain.

Center stage at the moment is Greece, which some fear might be the first European nation to actually default on its debt payment obligations to holders of Greek government bonds.  After months of back and forth negotiations and starts and stops, a deal is in the works that would provide a near term solution for Greece.  Greece will get bailout money to meet its obligations and continue to operate in the short term.  The money will not be forthcoming unless the Greek government negotiates a bond swap deal with private investors.  Basically the investors will have to swap out current holdings for longer term debt instruments at lower rates.  The end result will be losses of 50% or more for private investors holding Greek government bonds.

In a way this deal resembles the legendary horse statue the Greeks presented to the Trojans at the end of their war.  The horse surely looks good but lurking inside this contemporary gift lie not Greek warriors, but credit default swaps and the risk of contagion.  Contagion risk has gotten much coverage to this point, but the issue may be real.  If Greece can force bondholders to accept less than full payment, why should other European countries in trouble pay the full amount?  In addition, the deal on the table may prevent credit default swaps from being paid.  As you may know, these financial instruments were a prime mover that led to the original Great Financial Crisis.  

A credit default swap is like an insurance policy to hedge against losses incurred in case of default on bond payments.  In the Greek case, the International Swaps and Derivatives Association has already ruled that a partial loss voluntarily accepted by investors does not qualify as a technical default.  If that ruling holds up against legal challenges, the credit default swaps on Greek debt will not be paid.  The opinion of financial analysts on what can happen if the credit default swaps are triggered regardless of the current bond exchange deal is split.  Some say payments will put European banks and other financial institutions who sold the swaps themselves at serious risk.  Others feel even a partial payment of these hedging instruments will calm the nerves of large investors who are asking themselves why they should continue to buy government debt if the government can force them to accept changes in bond payments.

What does all this mean for Australia?  In a speech delivered to the Australian Finance & Banking Conference back in December of 2011, RBA Deputy Governor Ric Battellino warned that the Australian economy will feel some impact from the European Debt Crisis.  However, he went on to say we can weather any negative effects; highlighting the following three reasons:

1.    Australia has few direct trade links to Europe.
2.    Australian government finances are strong.
3.    Australia has a resilient banking system.

The Australian Bureau of Statistics tells us only 4% of Australian merchandise exports go to countries in the European Union.  Although Australia may have minimal trade links with Europe, Australia’s major trading partners in Asia do.  Many investors are surprised to learn the European Union, not the United States, is China’s largest export market.  Although some experts feel China’s policy of looking for new export markets in India, Russia, and emerging market countries will allow them to withstand a drop in European exports, there are troubling signs out of China.

For the first time in seven years, China has lowered its growth forecast for 2012 from 8% to 7.5%.  The official statement released on 04 March, 2012 also cautioned that the days of the Chinese economy being driven by infrastructure and housing stgelopment are over.  Their strategy going forward is to concentrate more on domestic consumption.  While some analysts are pointing out Chinese results always top forecasts and a slowdown in infrastructure spending has long been expected, others see this as clear evidence the Chinese economy is slowing.  The question for us is will it slow enough to hurt Australia.

Recently released Australian GDP figures suggest we are beginning to feel the impact, although there is disagreement as to the cause of the slowdown here.  Expectations were for .8% GDP growth in the final quarter of 2011, but on 06 March, 2012, the Australian Bureau of Statistics reported growth of only .4%.  And there’s more.  The ABS reported a .5% increase in household spending during the quarter; the worst showing since the first quarter of 2010.  Profits for Australian businesses for the quarter slid to the lowest level seen in two-and-half years.  This result includes mining and financial companies, as commodity prices have dropped and the demand for home lending is at levels not seen since 1977.

On the surface these results seem bleak at best, yet there is disagreement as to their interpretation.  Some experts imply a link to the European Debt Crisis and suggest the need for further interest rate cuts in Australia.  Others fail to see anything in the data to support a rate cut and attribute the numbers to declines in farm inventories and other factors.  Indeed, on 08 March, 2012 the government’s Bureau of Resources and Energy Economics reported that resources and energy exports in Australia reached a record level in 2011 of $190 billion, a 15% increase from 2010.

Despite this fact, BHP reported financial results back on 08 February which included a 5.5% profit decline in half-year profit.  This is their first decline since 2009 and the company attributed the drop to rising costs, lower output, and lower commodity prices.

In summary, a case could be made from these numbers that despite our minimal direct exposure to the continent, the situation in Europe is hurting Australia.  Now what about our “resilient” banking system?

On 24 February 2012, credit agency Fitch finally caught up with the opinion of Standard & Poor’s and Moody’s Investors Services and downgraded Australia’s big banks, citing the same opinion expressed by the other rating services – Australia’s biggest banks rely on foreign debt markets to fund about 40% of the capital they need to issue loans.

If the European Debt Crisis drives up the cost of borrowing, our banks could be in some trouble.  The sad truth is that the crisis in Europe is not likely to end anytime soon.  As of last week, it appears that around 95% of the private holders of Greek bonds have agreed to the swap.  For the moment, it appears Greece will not default, but the saga continues.  What happens to the debt held by those remaining bond holders who may not agree to the swap when all the counting is done?  

Here is where the credit default swaps crouched inside the Trojan horse come into play. No one at this point knows for sure the dollar value of these financial instruments, but considering the vast majority appear to be willing to take the losses in the bond swap, the payout of the credit default swaps should not be high enough to have a substantial impact on borrowing costs.  It is a rise in the cost of buying foreign debt that is the concern for Australia.  Some experts actually believe paying some of those credit default swaps will have a positive impact by boosting investor confidence in the sovereign debt markets.  As investors gaze on the Greek debacle, how willing will they be to continue to invest in sovereign debt of other European nations for fear of the same result?  The feeling of some is that triggering some credit default swaps can ease investor concerns.

While the end of this crisis is in reality a long way off, what are Australian investors to do in the meantime?  Although profits may be down for the major miners, exports are not.  Although it may be slowing slightly, the resources boom may not be over.  Although China may be slowing somewhat, there is India to consider as well.  For the most conservative investor, going to cash may be the obvious choice.  However, if you believe there is money to be made, you should consider the following ten year price movement chart for Australia’s two premier miners – BHP and RIO:

You can see the dramatic rise in share price of both companies as the resources boom heated up in the middle of the last decade.  While both companies suffered as a result of the GFC, both have recovered and BHP actually reached levels above the pre-GFC highs.  In short, while some investors view the European Debt Crisis as cause to get out of the markets, others see it as a buying opportunity.

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