Reserve Bank canvasses effects of major European downturn, Greece leaving eurozone

By Alex Tarrant

The Reserve Bank has presented a glum outlook for New Zealand if Greece or other countries leave the euro, and is set to cut the Official Cash Rate from 2.50% to help offset the effects.

Even if the euro area stays intact, the Bank warned in its June Monetary Policy Statement that economic conditions in Europe could turn out markedly worse than in its central projection.

While New Zealand’s direct trade link with Europe was relatively small – the euro area accounted for 7% of New Zealand exports – the size of the European economy as a proportion of the global economy  meant a deterioration there would have a severe impact on the rest of the world.

The euro currency area accounted for about 14% of global GDP, adjusted for purchasing power, while the European Union as a whole accounted for a fifth.

“In particular, European countries are a significant export destination for China and South-East Asia. A more marked slowdown in Europe would result in much weaker exports from Asia,” the Reserve Bank said.

“Recent experience from the global financial crisis suggests that the effects of an inventory cycle on industrial production in these countries can be large,” it said.

This would consequently reduce imports by these countries from New Zealand and Australia.

“Asian economies and Australia combined account for about two thirds of New Zealand’s exports. Hence the major impact of a sharp downturn in euro-area activity on New Zealand’s exports will be via the indirect effect on New Zealand’s other trading partners,” the Reserve Bank said.

A major downturn in the euro-area would put downward pressure on commodity prices.

“Given the preponderance of commodities in New Zealand’s export basket, such a fall in commodity prices could result in a large reduction in the terms of trade, reducing national income,” the Reserve Bank said.

In the past, sharp declines in world growth had been matched by falls in the New Zealand dollar. However, while this helped to cushion exporter incomes from the reduction in world prices, depreciation in the currency would impact some cost on the rest of the economy.

“A lower TWI would increase import prices, making investment more expensive for firms and increasing the cost of imported consumer goods, generating tradable inflation,” the Reserve Bank said.

Default by Greece or other European borrowers could also cause bank failures across Europe.

Funding costs

“International funding markets could become prohibitively expensive, which would boost New Zealand lending rates and potentially reduce the amount New Zealand banks would be willing to lend,” the Reserve Bank said.

“For a given level of inflationary pressure in the economy, 90-day interest rates would have to be correspondingly lower to offset the effects of these higher funding costs,” it said.

European banks were also involved in trade finance in Asia. Significant losses in their home markets would likely bring about a reduction in trade finance activity, which would further impinge on Asian exports.

The worsening situation in Europe was also likely to affect New Zealand confidence, like after the bankruptcy of Lehman Brothers in 2008.

“The consequent decline in economic activity was faster and sharper than pure trade flows justified. A similar reaction would be expected to an unplanned European default, with firms reducing investment and households reining back expenditure,” the Reserve Bank said.

“Overall, one or more countries leaving the euro area, or a disorderly major default, could significantly reduce inflationary pressures in the New Zealand economy,” it said.

“This would be expected to result in materially weaker monetary conditions in New Zealand.”