Europe Bail Out Fears

Last week it was all eyes on America to see if the politicians would come to some agreement over raising the debt ceiling and to reduce government spending. It was compromises all round, with the only joy being that the USA Government would not default on its debt.

The agreement hammered out by the Americans has potentially opened another can of worms. If America reduces expenditure most other countries will also be impacted. The major European country with the most delicate economy is Italy. Italy exports significantly more to the USA than it imports. This excludes tourism. If the USA economy slows, there will be fewer Americans visiting Italy.

For Italy to reduce its expenditure there needs to be a comprehensive reform pact with unions and employers. This is what Italian Prime Minister Berlusconi has been trying to achieve.

In true political speak, Berlusconi repeated assurances that the Italian economy was solid and that markets which have pounded its bonds and bank stocks over recent weeks did not appreciate its fundamental strengths.

While much of Europe has adopted the Euro as a common currency, the yield on each countries debt varies considerably. This is because the markets have factored in a risk component for each country. Germany has the strongest European economy. The spread in yield between the Italian Government Debt and the German Government debt is currently around 3.92%. This means that any new debt issued by the Italian Government will most likely be double the interest rate that the Germans would pay.

As we should all know, if you are a borrower and interest rates increase, it means that you have less money to spend on essentials and discretionary items. For Governments, this should mean spending cuts. Unfortunately when governmental spending is cut, it can significantly reduce overall economic activity. That usually means there will be a lot of job losses, which leads to a reduced tax take. It becomes a vicious circle. We then see protests, riots etc., and changes of government.

Italy, virtually since the downfall of the Fascist leader Benito Mussolini in 1944, has not been very politically stable. Over the past sixty years there have been 15 elections and 38 Prime Ministers. This is Berlusconi’s third turn as Prime Minister.

What does this mean for New Zealand investors? In the short term there will be a lot of market volatility. If Italy needs to be bailed out, the bailout amounts will be very large. This will impact on all global markets, and we could see a repeat of 2008. It may create great buying opportunities, and inevitably it may prove unnerving for those investors who have exposures to shares above their comfort levels.

Disclaimer

Steven Barton (FSP 32663) and Susan Pascoe Barton (FSP 32382) are Certified Financial Planners and Authorised Financial Advisers.  Their initial disclosure statements are available free of charge by contacting them on (07) 3060080 or they can be downloaded from www.pascoebarton.co.nz. This column is general in nature and should not be regarded as personalised investment advice.