Special analysis: Making sense of Cyprus - What you need to know

Cyprus has been making headlines because it is an economic disaster. Its banking sector has failed. This is a quick, easy to digest analysis of what that means for you.

First, how does an economy ‘die’?

In the case of Cyprus, its business model, if you like, has failed. Its banks were heavily exposed to foreign capital: investments from both Greece and Russia. The state of the Greek economy has been well publicised so it’s easy to understand how Cypriat banks may have lost money there. In terms of Russia, well Cyprus is addicted to Russia. It’s understood a group of Russia’s investing elite use Cyprus to both launder money and use it as a tax haven. Therefore the country has been running on ‘dirty’ money for quite some time now.

About a week ago it came to a head when European finance ministers decided to draw a line in the sand. They canned the idea of 17 billion euro bailout and told Cyprus it would receive 10 billion euro instead, but it would need to raise the other 6-7 billion euro.

The first proposal was simply to tax depositors. That included slugging depositors with as a little as 20,000 euro in the bank with a 6 per cent levy. The bill was tabled in parliament but not one single MP voted in favour of it. That’s when things got nasty and Russia was brought into the equation.

The commentators started to speak up and say, ‘why on earth is the European Central Bank asking Cypriat deposit holders to pay for the mistakes of the banks?’  The answer: There were two key players calling the shots: Russia and Germany, and they have a score to settle. It was just bad luck for ordinary Cypriat deposit holders.

The German taxpayer’s fed up with supporting Cyprus. They were saying Greece is bad enough, but do we have to baby sit Cyprus as well?? They wanted to end it all and decided to refinance the government by taking money off Cypriat deposit holders and handing it to the banks. The key here is that the Germans were mainly looking to take money off the Russians (being very large Cypriat deposit holders) and clean up the banking system. Ordinary Cypriat deposit holders ended up being caught in the cross fire.  To add insult to injury the Cypriats are also too frightened to test the banking system to see if it still stands without the Russians.

The cat, as they say though, was out of the bag. Now the world knew the European Central Bank (and Germany’s) plan for Cyprus. It was to attack depositors and walk away from a potential euro zone financial disaster without taking any losses. By that I mean it could quite easily have written down the value of its debt holdings in Cyprus, but that clearly wasn’t going to wash with bank’s board. No, they were washing their hands of the problem and in so doing give the small island enough money to get by.

The rest of Europe heard that though and thought, bugger! If the European Central Bank’s idea of rescuing an economy in crisis is to target depositors, and avoid taking a financial hit of its own, what does that mean for other countries like Greece, Spain and Italy? Suddenly the potential for a widespread bank run was on. Would Cypriat deposit holders, and deposit holders in Greece and Spanish banks rush to withdraw money to avoid the government/European Central  Bank taking it first. Of course a bank run would also then lead to a financial contagion - an economic disaster big enough to bring about another global financial crisis.

The Cypriat government actually attempted to quash the problem by physically closing down the banking system and limiting the amount deposit holders could withdraw. The banks are still closed. Shops and businesses have responded by demanding that customers pay using only cash.

The only reason why the whole system hasn’t collapsed already is that the European Central Bank, along with the other lenders (which also comprise German interests) have allowed Cyprus to come up with a Plan B.

That plan, some of which has gone through parliament, involves two key aspects. First is the pooling of assets into a ‘solidarity investment fund’ – which will then be used as a legitimate investment vehicle to generate more money. The second is a banking overhaul which will involve making sure the banking sector has tighter and more secure capital controls, as well as a possible bank merger. It also looks like a Greek financial institution may buy one or two Cypriat banking assets in Greece.

Whichever way you cut it, the task for Cyprus has been straight forward: raise some cash, and European lenders will help you out. Cypriat deposit holders weren’t prepared to cough up the money so the government’s working out an alternative, and cleaning up the banking system in the process.

So is the problem solved?

The short answer is no. We now know the European Central Bank will consider attacking deposit holders when it wants to rescue an economy, and it’s now understood the European Central Bank cares more about its balance sheet than sparking a possible bank run.

And whether or not Cyprus will ultimately be successful this time around in cleaning up its economy is unclear. Nevertheless it’s still in danger of being kicked out of the euro zone altogether. The possibility of a near term bank run, and a financial contagion in the euro zone has now increased substantially.

From an Australian and global point of view, the position I’ve always had still stands. The risk of an economic shock that disrupts financial markets around the world is very real. At the moment, equity investors are being rewarded for taking on risk, but that may not always be the case.
 
David Taylor

Have you ever been caught in a rip? It’s an extremely unpleasant experience. It’s the same feeling you get when you find yourself briefly lost in the bushes. It’s a feeling of not being in control, coupled with the sense of being in danger. While, thankfully, investing is not a life or death pursuit, the evidence is stacking up that Australia’s investment tide is running out. What does that mean? Simply that there are more Australians choosing to invest overseas, than there are foreigners investors choosing to invest here. How does that affect you? I think it’s helpful to know where the investment tide is flowing so you can swim with it. It sure beats swimming against it. Now, even if you’re still not entirely sure where I’m going with this, stay with me.

First let me briefly explain how important money flows are. Last year, the head of the European Central Bank said the bank would do ‘whatever it takes’ in order to save the euro zone from disintegration . That meant offering to open the debt garbage bag. He promised to buy up as much debt as was needed to keep interest rates in the euro down to sustainable levels. He was mainly referring to the interest rates of countries like Greece, Italy and Spain.

No surprises, it worked. It worked very well in fact. The rising yields (or cost of debt for the euro zone’s periphery countries) stopped rising, and in fact fell. That’s because the debt market saw a wall of money coming at it should it decide to ‘bet against’ the euro zone, and therefore it shied away.

The reason for illustrating what happened in the euro zone bond markets last year is to highlight how difficult investing can be if you are moving against the general flow of money.

An obvious example would be if you bought a portfolio of blue chip shares in a bear market. No matter how carefully you selected your portfolio, the returns you receive would not be as attractive as if you invested during a bull market.

So where am I going with all this? Last week I attended a private equity forum. Leading figures in private equity from around the world gathered to share ideas on how to attract new investment and promote Australia as an investment destination. So far their efforts have been quite fruitful. One Hong Kong-based private equity deal maker said Australia has become quite skilled at attracting mid-sized funds – so deals starting at around $300 million. He also said deal sizes can be as large as $1 billion. And the attendees at the forum were hopeful the good times would continue. In fact they pointed to the fact that investors had been turning away from previous financial hubs like India and China and choosing to invest in Australia instead.

No if you’re waiting for the “but”, here it comes… the official data from Canberra show the investment flows into Australia have actually peaked. It’s just past high tide, and the water is receding.

Let me briefly explain a few reasons for this.

Firstly, Australia’s bond market has been relatively popular in recent years, given Australia’s relative stability, and the Commonwealth Government’s AAA credit rating. Global banking giant UBS, however, says there’s now evidence some of that money is leaving.

Secondly, as money has flooded to Australian shores, the Australian dollar has risen in value. Investors have been selling their foreign currency and buying Aussie dollars in order to invest in Australian assets. Naturally, as the Australian dollar has become more and more expensive, investing in Australia has started to lose its appeal.

Finally, it seems Australia has met some stiff competition from some of the emerging economies in the Asia Pacific region. Namely countries like Indonesia. That’s because Indonesia is a coal producer, located closer to China than Australia, and its economic growth record in recent years has been more robust and consistent than Australia’s.

The reality is that money chases yield (return/reward). The higher the yield, the more money will come running. Now don’t get me wrong, Australia’s economy is relatively robust, but there’s more evidence the emerging economies of south east Asia may provide more attractive investment opportunities. According to Reuters, Capital flows to emerging markets were $1.5 trillion last year, close to the pre-crisis peak.

The result of all this is that, now, more money is leaving Australian shores than is coming in. The latest figures from the Bureau of Statistics confirm this.

If you add to that the recent data showing the Australian economy is now growing below trend, with evidence Australia’s services and manufacturing sectors remain in contraction, you don’t need to be a genius to work out Australia’s economic superiority may be slipping. I should add that capital flows aren’t necessarily correlated to GDP growth, but much of the capital inflows into Australia were related to the mining boom, and that now appears to be near its peak.

So if you’re serious about investing, or even looking to do be more than just a ‘mum and dad’ investor, consider what’s happening on a global level. I’m not suggesting avoiding the Australian market altogether, just be aware that the big money is looking more and more offshore, and emerging economies in South East Asia may be providing the new premium returns or ‘alpha’ – there’s a new bit of jargon for you.

What this also means is that Australia may not be considered a ‘safe haven’ economy any more. In fact investment banking giant UBS says calls of Australia being a safe haven investment destination last year were “premature”.

Australia has some strong investment opportunities, and, at least in the short term, is proving resilient at a macroeconomic level, but you never make money from looking in the rear view mirror. If you have the time, and the interest, explore the wider world of investing. It seems quite a few people are already.

David Taylor
 

Last weekend in Sydney I was reminded of how powerful nature can be. Strong winds and rain lashed the coastline. I went for a jog first thing in the morning and had to work extra hard as the wind pushed me back. The weather is something that affects us – physically, even. We can’t always ‘feel’ the economy, but its affects can be just as powerful, especially when you lose your job or see your retirement nest egg halve in value!

Today’s column is a ‘weather warning’ of sorts. It’s for those hard working folks that want to know what’s really going on in the market. I want to set the record straight about recent global developments and explain why the share market had a little tantrum last Thursday.

Let’s first go to Italy. I’ve never been there myself but I hear it’s a nice place to visit. This weekend there’s a general election. Pier Luigi Bersani, Mario Monti and Silvio Berlusconi are all fighting it out to claim victory. Normally an election in Europe might make global headlines for a day or two, but that’d be all. This time around, it’s a little different. See Italy, like many of the euro zone’s periphery countries, is trapped in a recession. The country’s debt level is almost unbearable and the austerity policies being used to tackle all the problems that the debt is creating are equally as painful. So market watchers are getting a little anxious about who the country will decide to elect amid all this mess. In many ways, the last person the market would like to see in charge again is the man who was at the helm during the global financial crisis, Silvio Berlusconi. There are fears he will create even more problems for the debt riddled country.

That said, I spoke with the Co-Dean of Sydney University’s Business School, Tyrone Carlin, late last week and he told me that it didn’t really matter who was elected. He said whoever gets elected will face the same fundamental problem: an economy that's got a chronic debt challenge. So he said unless someone can really tackle the kinds of hurdles that Italy faces in terms of competitiveness, and in terms of getting rid excessive red tape, and the lack of productivity in the country, then it doesn’t matter whether it's Berlusconi or Bersani that wins, we'll just see more of the same problems.

In short, it’s easy to forget that Italy, along with Spain and Greece, has serious challenges ahead of it. And just because Italy hasn’t been getting quite the same level of bad press recently as countries like Spain and Greece, make no mistake, it’s got just as much potential to wreak havoc on financial markets. In fact Tyrone Carlin says he sees many similarities between Italy and Spain. Italy though has one of the deepest bond markets in the world so any serious question marks around Italy’s solvency has the potential to create a financial contagion.

Italy has been hauled back into the spotlight and economists will be watching economic development there very closely in the coming months.

Now to the United States and the market blow-up that occurred after the US Federal Reserve minutes were released.

Last week saw one of those classic market reactions – a reaction that tells you a lot about what’s actually going on in the market. Let me put it to you this way: have you ever driven with someone who’s been in a bad car accident? You’ll find they get more nervous in a close call than someone who’s never had an accident. That’s because they are all too aware of what can happen in the event of a crash… and what it feels like. Investors can behave in a similar fashion. If there’s very little underlying confidence, a relatively small incident can really spook market participants. That’s what happened last Thursday. Reports circulated the globe that some members on the board of the Federal Reserve were growing tired of throwing $85 billion a month of ‘free’ money into the banking system. There were even reports that members were considering slowing down or stopping the quantitative easing program before unemployment falls to that coveted 6.5 per cent level that’s been flagged as the goal to be reached.

The market didn’t like that at all. Traders are all too aware of how much the quantitative easing programs in both the United States and Europe are supporting financial markets.
Any suggestion, no matter how small, that it could be coming to an end will rattle the market. If the economic climate wasn’t as electric or as sensitive as it currently is, those reports would not have done as much damage as they did.

In addition to that, rumours were also flying around that a major US hedge fund had run into trouble. Speculation was rife that it had sold out of commodities and resources positions. Mining companies fell sharply on the Australian stock exchange and the Australian dollar fell by a full US cent in the space of 24 hours. In fact the benchmark S&P/ASX200 fell over 2 per cent, and below the so-called ‘psychologically’ significant level of 5,000 index points. I spoke to stock broker Marcus Padley as the drama was unfolding and he said it was typical of a market just following the herd. He said it only takes one big hedge fund to wind out of a position and the rest of the market turns around. Importantly, he added that it was indicative of a nervous and volatile market.

Let’s now come back down to Australia because it’s a good way to tie things off.

The Australian half year reporting season is now two thirds of the way over. So what have we seen? Well the job cuts and restructuring programs that began in earnest last year are helping to refresh corporate Australia. But it’s not enough. Profit margins, in some cases, are growing but it’s more related to cost cutting than bottom line revenue growth. The Fairfax result was a good example of this. The media group turned last year’s billion loss into a profit, but only after sacking 1900 workers and selling of its Trade Me business and some US assets. Media researcher Andrea Carson described it simply as housekeeping and said nothing has really changed, and that Fairfax was still dealing with a weak advertising market.

The share market has been pushing higher and higher over the past few months, but is it all really justified? Given analysts are still concerned about the bottom lines of some of Australia’s major companies, and the CEO’s of Australia’s top two mining companies have now been shown the door, I have to say it doesn’t pain the most robust picture. In addition to that, the market’s shown us it’s not in the mood to handle even the smallest of shock waves. And, as always, the euro zone remains an on-going concern, with even some of Australia’s most senior academics viewing it as a serious threat to the global economy.

By all means enjoy the share market ride to the top, but my view is that this ride is a roller coaster, with plenty of sharp drops, and all sorts of twists and turns. Given how overvalued some of the market’s most ‘defensive’ stocks are (according to one financial planning contact of mine), it seems investors may even be on a ride they’re not all that keen on.

In all my time of watching the market, the downside risks have not been as clear as they are now.
 
David Taylor

It’s becoming more and more obvious that Australia’s economy is growing tired. After a decade-long mining boom, the economy is worn out and in need of a fresh start. As of yet, there’s no clear indication as to where that fresh start may come from. Far from sugar coating the problem, the two major bodies responsible for economic policy in this country are fessing up. The game’s up.

The confessions started late last year when the federal government conceded it will not live up to its budget surplus promise. It was clear a budget surplus was out of reach well before December, but all credit to the government for holding onto the promise until it was bordering on the absurd.

To put it simply, the government is spending more than it’s earning. At this point in the economic cycle, that’s precisely how it should be too. The economy is in need of stimulus. I speak regularly with the chief economist of the Bank of America Merrill Lynch Australia, Saul Eslake, and he argues that as the effectiveness of monetary policy begins to fade, the responsibility does rest with the government to cradle the economy.

One of the government’s many policy failures these past 12 months has been the implementation of the minerals resource rent tax (MRRT). Late last week the Federal Treasurer, Wayne Swan, announced that after 6 months, the tax had netted the government just $126 million. Last October the government gave a budget update. In that update it estimated around $2 billion would be collected in revenue from the tax. Now, I’m not a brilliant mathematician, but those two numbers are a long way from one another.

The two responses were very predictable. The government argued that the opposition hyped up how much the tax would actually bring in and then claimed it would lead to a huge economic leakage out of the resources sector. Meanwhile an industry analyst I spoke to last Friday said the revenue collapse was largely to do with the sharp drop in the price of iron ore last year (from around $140 to around $90 US/tonne). The Fat Prophets researcher said the government’s been caught out by the big miners taking advantage of tax breaks received through the development of new projects, and the dramatic fall in the price of coal. He said it was unlikely the government would receive any additional revenue from the coal industry this financial year.

The simple truth is that the government missed the boast on one of the greatest mining booms the country has ever seen.

You could in fact argue that it was a legitimate policy – depending of course on your political persuasion. The fact is that the government’s view was that the wealth dug up by the country’s miners belonged to all Australians. A tax on the miners would help redistribute income away from those who were comparatively well off, to those in more need of assistance. It’s not a Liberal view, but it’s a view, and it’s valid – especially for those on the receiving end of the cash that haven’t done anything for it in return. Legitimate policy or not, it was poorly timed. If anything, the Howard government would have been in a better position to implement the tax, but the Coalition held the view that bigger, stronger, more profitable miners would bring heavy amounts of direct foreign investment into the country and that would help contribute to higher living standards for all Australians.

I still find it curious though how badly the government misjudged how much money would come through its doors. A poorly estimated figure in July could be forgiven… but by October it should have been clear the revenue targets set would not be reached. Graciously though, the federal treasurer has come clean and owned up to the shortfall. At least now too he is speaking more and more of the risks facing the global economy and how much they are threatening Australia’s growth.

The Reserve Bank is the other major body opening up about Australia’s economic realities: a weaker labour market, lower inflation, and lower economic growth.

Sometimes it’s hard to see change when things happen so slowly, but make no mistake the Australian economy is transitioning from healthy, robust economic growth, to something less attractive. What that is exactly I really don’t think anyone can say. That’s partly because the drama playing out on the world economic stage is some way off its final act.

The Reserve Bank seems to be following the script. It decided to leave the cash rate on hold at 3 per cent last Tuesday. That was widely expected. The reasons were straight forward. While Australia’s growth rate remains below trend, the global economy had stabilised, and there’s some evidence that dwelling construction is picking up. In addition to that, inflation sits at a level that will allow the Reserve Bank to cut rates again if domestic demand deteriorates further from here.

The last Friday the central bank went further. It released its Quarterly Statement on Monetary Policy. Now bear with me here. I know that sounds like an incredibly boring document, but this time around it had something important to tell us.

You see it revealed that the Reserve Bank had lowered its forecast for economic growth in 2013 from 2.75 per cent to 2.5 per cent. The bank has conceded that the non-mining sectors of the economy have not yet, and probably won’t for some time, fill the growth hole left by the retiring resources boom. Don’t be misled, the resources sector is still powering along, and the associated investment boom is still growing, but both are showing signs that they will slow down in coming months. While the Reserve Bank waits patiently for another sector, or sectors, to fill the space, it will keep on cutting its economic growth forecasts.

The danger for policy makers is that they may end up being squeezed. What do I mean by that? Simply that it’s one thing for the economy to be left without a major sources of growth, but it’s entirely another to then have the weight of the world’s economic problems bearing down on you. That would indeed happen if any number of exogenous shocks took hold of global financial markets in the near term.

The story does have one silver lining in it. The economic events of the past 10 days (including data showing the country’s retail sector contracted - of all times - during the Christmas period), sent the Australian dollar down below 103 US cents. Any relief on that front will be welcomed by industry. Many Australian manufacturing companies would prefer the dollar be well below parity with the US dollar. The chief executive of Qantas, Alan Joyce, recently said he would prefer it fall to around 70 or 80 US cents. So a fall of just 2 cents will hardly provide material support for the economy, but at least it’s a sign that the dollar isn’t too sticky at its current levels.

Another welcome piece of economic data last week was from China. Its trade figures came in better than expected. That perhaps was part of the reason the dollar didn’t fall below 102.5 US cents.

In many ways the Australian economy is still far better off than many others right around world, but it does face its own challenges. I am relieved that both the Federal government and the Reserve Bank are being straight forward about how the business cycle is progressing. Anything else would be self-defeating. I do get the sense though policy makers are preparing markets for leaner times ahead.

The economic story may be slow-going, but you’d be wise to follow the narrative. The plot’s certainly set to thicken as more confessions come to light.

David Taylor

The global financial crisis was a point in time. That’s precisely what a crisis is. It comes and it goes. At the crisis point you can go one of two ways: you can recover and become stronger; or you can sink deeper into the mess that led to the crisis.

The world was met with a global financial crisis several years ago, and I would argue we are now moving further into the mess that could have been tackled head-on in 2009. This week just past saw yet another symptom of a global financial system still in major need of repair. It’s another example of how fragile the world’s global economy remains.

I refer to the Japanese economy. It takes the number three position on the word economic stage… behind the United States and China. It’s one of those economies that doesn’t tend to make the headlines unless something particularly good or bad happens. Last week the Bank of Japan (BoJ) announced that, from January next year, it’ll inject $137 billion into its banking system every month. It’s already working a trillion dollars into its economy, but that’ll run out by the end of this year.

On the bank’s agenda is inflation – but not in the same way as Australia. Japan has been fighting off deflation, not to mention several recessions, for a decade. The bank’s set a target rate of inflation of 2 per cent. That’s fairly ambitious and pretty close to Australia’s inflation rate of 2.2 per cent (released at the end of last week).

In addition, the BoJ says it will hold its cash rate steady at 0.1 per cent. That’s roughly in line with the rest of the world. It’s just another bank with its foot firmly on the accelerator, hoping the wheels will gain traction with the road at some point.

So there you have it. Billions of dollars are literally going to be handed over to the banks in the months ahead (in exchange for mortgage-backed securities, i.e. quantitative easing) in an attempt to get the economic wheels turning again, boost demand, and hopefully bring about some reasonable level of inflation.

I just have two questions: Why do this now? And second, just how serious a state is the Japanese economy in to warrant such an enormous stimulus measure? And yes it is enormous. I say that because the BoJ has indicated it will keep pumping $137 billion into the banking system every month until it starts to see some healthy level of inflation.

On the question of why do this now…  It’s partly political and partly necessary. Fact is the Japanese Prime Minister, Shinzo Abe, is under pressure to put the Japanese economy onto a sustainable growth path. Perhaps even more pressing is the need for the economy to seize the opportunities available to it now. The opportunity I’m talking about is the ability to print money.

Printing money has become politically palatable. Here’s why.

 The global financial crisis came about because credit markets froze. To save the entire financial system from collapsing, federal governments stepped in (using taxpayer’s money).  When that money ran out, government’s began to borrow more (hence the problems that the United States and Europe are currently facing). To make borrowing cheaper for everyone, central banks from all around the world began dropping interest rates to zero. Again, it proved relatively ineffective. The only ‘trick’ left is to literally hand money to banks for free in the hope that they will lend it out for extremely low interest rates. Central Banks too are promising to keep interest rates low for governments.

This strategy is having mixed results. It has achieved somewhat lower unemployment in the US, but nothing to write home about. In Europe and China, the policy settings have been a little different but the effects have been the same. There’s been a marked decline in the cost of money, but no real evidence of improving economic growth or significantly lower levels of unemployment.

Japan has now decided to crank up the volume. And this goes to that second question about just how much in need of repair the Japanese economy is. The market reaction alone would suggest Japan was in need of a serious shot of adrenalin. You see having already pumped billions and billions of dollars in to the banking system, the idea of creating money to do it all over again would normally be laughed at. Today it’s treated with respect by financial markets. In fact in the lead up to Prime Minister Shinzo Abe’s announcement last week (and with some level of ‘money printing’ already underway), the Nikkei shot up around 25 per cent higher and the yen had dropped around 10 per cent. The conclusion: It’s effectively become ‘politically correct’ to print money when your economy is in obvious distress.

Here’s where it gets really interesting.

The rule book has been thrown out. Governments and central banks are now primarily concerned with survival.

Japan’s primarily focused on achieving inflation and avoiding yet another recession. The Unites States is focused on driving down unemployment, while euro zone countries are looking to get out of a deep economic contraction while reducing their deficits and government debt.

The data within these economies also highlights the seriousness of the problems. Spain’s unemployment rate released at the end of last week stood at 26 per cent. Youth unemployment is over 50 per cent. Unemployment in the US is hovering just under 8 per cent despite billions of dollars having been thrown at the economy already. And prices in Japan are still in reverse.

It wouldn’t pose such a problem to the stability of the global financial system if these countries didn’t dominate so much of world trade, but they do. In fact the two countries that have announced some of the most serious central bank action are the largest and third largest economies in the world. It would also not be such a serious problem if both Japan and the United States weren’t using the same strategy to work their way out of the economic malaise.

This is a point being missed by a lot of market commentators at the moment but it’s a crucial one. The managing director of the International Monetary Fund even made reference to it at the World Economic Forum in Davos last week. The United States and Japan have decided the best way to emerge from their economic crises is to lower the value of their currencies through quantitative easing.

It’s the one policy solution that the euro zone doesn’t have because they share a common currency. It’s been made possible in both the US and Japan because markets have become addicted to central bank ‘money printing’ and the affect it has on short term borrowing rates and equity markets.

A ‘race to the bottom’ currency war between the US and Japan though has risks attached to it. I was speaking to a senior strategist from Morgan Stanley Wealth Management during the week and he said it was something we need to keep an eye on. That was an understated way of saying something could go wrong.

His argument was that with any extreme policy measures, especially when taken on by the world’s largest and third largest economies have obvious risks attached. One is that inflation will become a problem, but more likely, is that another asset bubble will be created. This is even separate from the trade distortions (crowding out) that’s created from two of the world’s major economic powers driving their currencies down to stimulate export demand.

We are in a world now where all major world economies are looking shaky. We’re also in a world where extreme economic policies are not only accepted but are also welcomed by markets. It’s led to two of the world’s major economies into a currency war that’s been fuelled by cheap money and artificial interest rates. As the strategist from Morgan Stanley said it’s all very well to put these policies into place to assist with the ‘great escape’, but who’s decided when or how they will be unwound. The US Federal Reserve says it’ll all come back when unemployment comes down. But what if it doesn’t?

From a strictly Australian point of view, the economic risks fell back a little last week with better-than-expected manufacturing data out of China. The local share market is now around 20 month highs.

However given Europe, Japan, and the United States are among China’s largest trading partners  the conclusion is simple… around 5 years after the global financial crisis, Australia is still very much at risk from bad decisions being made on the global economic stage. Even the normally sanguine Wayne Swan conceded that in a press conference last week. You know it’s serious when the politicians put politics aside and just tell the truth. It’s when the stakes have become too high.

David Taylor