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Was the euro really worth the effort?

David Bassanese
Wednesday, July 08, 2015

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By David Bassanese

A common question bandied about in Australian economic circles these days is whether the ructions in China are more serious for our economy than those of Greece.

As China is clearly a more important trading partner, the usual answer is China. 

Greece has only a population of 11 million – about half that of Australia – while China has a population of 1.3 billion. Greece imports around $12 billion worth of Australian goods and services each year, while China imports around $107 billion – almost 10 times more.

Clearly, if the Chinese economy implodes it would be far more serious for Australia than if the tiny Greek economy imploded. Arguably the Greek economy has already imploded, with an (official) unemployment rate of around 25%.

Greece still the bigger issue

However, as I mentioned on Peter’s Sky Business Show last night, I’m still more worried about Greece than China. The first reason is that I’m still a lot more confident that Chinese authorities have the will and capacity to avoid a major economic slump – despite the apparent “crash” in the share market. 

Although Chinese shares have fallen hard in recent times, this comes after a major surge over the past year. While the Shanghai composite (A shares) index is down 26% from its mid-June peak, they’re still up 85% on year ago levels. 

Valuation wise, Chinese shares have broadly moved from cheap territory to modestly expensive, and are now trading back at closer to fair value. The price to 12 month forward earnings ratio for the China MSCI equity index, for example, is now trading at around 11 at the end of June – in line with its long-run average – compared with a peak of 23.8 during the last surge in shares in late 2007.

What seemed bubble like in China was not the surge in share price valuations per se, but rather the sheer speed of the surge in prices. The Chinese market had gone nowhere for a long time and seemed cheap – as I have pointed out in previous Switzer articles. As a result, I’d be surprised if Chinese shares crashed a lot further. The heavy handed tactics of the Chinese Government – in desperately trying to support the market – have possibly made things worse by panicking a lot of investors needlessly.

Not the first time

Even if the Chinese share market crashed hard – we’ve been there before. China’s immature stock market is prone to wild swings – with the previous wild surge taking place in 2007 during the height of optimism concerning all things China. Shares then crashed during the GFC and remained in an entrenched bear market up until last year – with little, or importantly, any real impact on the economy. 

Compared to countries such as Australia, less of Chinese household wealth is caught up in the stock market – and while there will no doubt be media stories of some crazed mum and dad traders losing their shirts due to margin trading, I doubt it will be reflective of the impact on the broader economy. 

China’s stock market and the economy have for a long time danced to the beat of different drums.

What about Europe? The consensus there is that the risks of contagion are far less than during the last Greek flare up in 2012. Judging by government bond spreads, markets are attaching less risk to debt problems blowing up in other peripheral economies such as Italy, Spain, Greece and Ireland.

Whatever it takes

In turn, a major reason for this confidence is because the European Central Bank under Mario Draghi has famously declared it would do “whatever it takes to save the Euro zone”. Traders are not aggressively bidding up bond yields in these countries because they fear the ECB will all too readily bid them back down again.

Another reason for confidence is that these economies are considered to be in a better position than in 2012 – with some having already paid back their official assistance and generally having lower budget deficits. 

That maybe so, but the economic rebound in these countries has still been sluggish – not helped by the fact that the European economy overall has been far from flash. 

Unemployment rates in these countries – with the exception of Ireland – are still close to the elevated rates prevailing in 2012. Spain’s unemployment rate is not much better than that of Greece, and the Italy’s (likely understated) rate continues to trend higher.

Debt levels are also far from comfortable. Only in Ireland has there been any notable decline in the government debt to GDP ratio at this stage. 

Against all odds

It’s not the ECB that worries me. It’s the voters and fringe political parties in these still struggling economies that could cause mayhem should Greece default on its debt, and possibly even leave the Euro zone.  

Ironically, the worst case scenario for the euro project is if Greece does leave the single currency and – against all odds – stages a spectacular economic come back due to a vastly improved competitive position. That’s not unlike what the UK pulled off when it exited the monetary system in the early 1990s. Unlike the UK, however, Greece’s political system seems far less likely to produce decent structural reforms and allow the national central bank to keep inflation in check.

But if Greece did succeed, it would make the rest of Europe green with envy and left wondering whether the euro is really worth the effort.

Published: Wednesday, July 08, 2015

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