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Special Topic:  International economic developments

During November sovereign debt and monetary policy developments took centre stage. Sovereign debt problems in Euro area peripheral countries escalated, with Ireland requiring a bailout package and fears of contagion raising spreads for bonds and CDSs (credit default swaps – the cost of insuring against a bond default). Showing the continuing divergence in growth prospects between the two groups, advanced countries continue to ease monetary conditions, while emerging economies and others, which benefit from their growth, tighten monetary policy.

European sovereign debt woes resurface...

Ireland became the second Euro area country, after Greece in April, to require a bailout package. The package will total €85 billion and be made up of €17.5 billion from the Irish National Pension Reserve Fund and €22.5 billion from the IMF and €45 billion from the European Union financial stability funds and bilateral loans from the UK, Denmark and Sweden. In terms of the use of the package, €35 billion is for the banking sector and €50 billion for government funding. As part of the conditionality of the loan, the Irish government has announced austerity measures, to be approved in a December 7 Budget, to reduce the budget deficit from 12% currently to under 3% of GDP by 2015. The measures involve €10 billion in spending cuts, including increasing the pension eligibility age, and cuts to public sector jobs and wages. There is also €5 billion of increased value added, property and income taxes.

Economic growth in the peripheral Euro area countries will likely be subdued for some time as households and banks work through earlier property market excesses and restore solvency. In addition, in the absence of offsetting expansionary monetary policy actions, which would also have helped with buoying credit and property markets, fiscal policy adjustments needed to restore sovereign solvency will further weigh on economic activity. Euro area membership means that monetary policy decisions are made by the European Central Bank (ECB) for pan-European conditions rather than specifically for the needs of the periphery.

Following the bailout announcement Standard & Poor’s cut Ireland’s foreign currency credit rating two notches from AA- to A. In reaction to the developments, Irish bond and CDS spreads have risen and contagion worries led to Spanish and Portuguese CDS spreads hitting record highs (Fig 8). However, spreads have fallen back slightly on speculation of a larger European bailout fund and the ECB extending the length of one of its liquidity facilities.

Figure 8 – 5-year government CDS spreads
Figure 8 – 5-year government CDS spreads.
Source: Bloomberg

...but core countries show strength

On the other hand, data from Germany and France continue to be strong, shrugging off problems in peripheral economies. Q3 GDP in Germany rose 0.7% to be up 3.9% for the year. Also, the Euro area manufacturing and service PMI surveys are at multi-month highs, led by strength in France and Germany, while German business confidence hit a record high.

The US announced quantitative easing...

The US Federal Reserve (Fed) announced a second round of quantitative easing (QEII), where they will purchase US$600 billion of Treasury Bonds up until June 2011. The reason given for QEII was that unemployment is too high and inflation too low, shown by core CPI inflation being at its slowest annual rate since records began in 1957, at 0.6%. The aim of QEII is to decrease long-term interest rates by purchasing bonds, in order to stimulate the economy. Markets initially reacted positively to the Fed’s announcement, with risk assets rallying and the US dollar and bond yields falling, before reversing some of their initial movements.

As balance sheet concerns remain high, the direct impacts on the US of QEII are not expected to be large, because of cautious attitudes by firms, consumers and financial institutions. Accordingly, the greatest impact for the US economy is likely to be indirect, through the global ramifications via the exchange rate falling, which will boost exports and create jobs, and asset markets will rise with growing corporate earnings. However, higher import prices from a lower exchange rate will have some offsetting negative impact on activity.

For New Zealand, QEII has mixed implications. A stronger global economy and extra liquidity is good for commodity export demand, access to funding markets and a higher NZD helps contain inflation pressures. However, a stronger NZD will negatively impact on non-commodity exporters to the US and countries pegged to the USD, but sales of manufactured goods to Australia should be less affected, as the exchange rate against Australia has remained relatively stable. The impact of QEII is now being reduced with European sovereign debt worries.

...while Asia and Australia continue tightening

In contrast to the monetary easing occurring in the US, Asia excluding Japan (AxJ) and Australia continue to tighten monetary policy. Australia, Korea, Thailand and India all raised their policy interest rates in November. In addition, China announced two bank reserve requirement ratio (RRR) rises totalling 100 basis points, taking it to 18.5%. The RRR increases follow an interest rate rise last month and show the government’s commitment to containing inflation and moving the economy to a more sustainable growth path. These monetary policy developments highlight the divergence in growth between those countries in the AxJ region and developed economies. However, there are signs growth momentum in the region may be turning, with slower and below-expected Q3 GDP growth in Australia, Malaysia, Thailand and the Philippines. Also, some weaker Australian activity data, including retail sales and the manufacturing PMI, suggest further monetary tightening may be delayed.

Economic data has generally been positive...

While developed countries’ growth continues to lag their emerging economy counterparts, there have been positive signs that it will continue at a moderate pace. US and Japanese Q3 GDP rose 0.6% and 0.9% respectively, both above the market’s pick. In addition, Australia, the UK and the US all showed strong employment growth, which in Australia’s case continues the labour market’s strength and in the UK and the US may be the start of sustained job growth allowing the unemployment rates to drop from their currently-high levels. PMI surveys continue to hold up and indicate that manufacturing and service sectors continue to show expansion in most developed and developing countries around the world.

...but financial markets were volatile

World equities and commodities rose early in the month as the announcement of QEII led participants to believe that some of the extra liquidity created will flow into these markets and strong GDP, employment and PMI data suggested the global slowdown will not be as sharp as was expected. These markets then mostly reversed their gains, as Irish debt problems and China tightening monetary policy led to increased risk aversion.

The commodity currencies also experienced ups and downs in November with the Australian (AUD) and New Zealand (NZD) dollars initially rising to multi-year highs (the AUD hit parity with the US dollar, its highest post-float level) as QEII led to a fall in the US dollar, the Reserve Bank of Australia unexpectedly raised interest rates and New Zealand’s export commodity prices hit record world price levels. Lower risk appetite has subsequently seen these currencies fall back to lower levels (Figure 9).

Figure 9 – Australian and NZ dollar exchange rates
Figure 9 – Australian and NZ dollar exchange rates.
Source: Datastream, RBNZ
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