Deserting the good ship Merkozy

Europe has been able to keep its leaky ship together through the remarkable combination of Nicolas Sarkozy and Angela Merkel. Now that's unravelling, markets are trembling.

One step at a time, Europe is unravelling. And because there are trillions of dollars of debt from governments, local bodies and companies measured in euro, the world shivers every time the European situation worsens. Any full-scale unravelling of the euro will be very painful.

And it just so happens that this round of European worsening comes at a time when China is slowing and Australia’s big miners are investing a fortune increasing the supply of minerals (Struck by Canberra's mining curveballs, April 23). Accordingly, mineral stocks are in the market gun.

But according to The New York Times China’s banks are under pressure from the government, which accuses them of being too profitable. They are now short of capital and although they have raised large sums more is required. This shortage of capital may restrict lending.

All this means that both debt and equity markets are going to carry a higher risk premium than we have seen in recent years.

Europe has been able to keep its leaky ship together because of the remarkable combination of two leaders – French president Nicolas Sarkozy and German Chancellor Angela Merkel.

Now it seems that French voters reckon the Germans are doing too well out the deal and so they are supporting the left, which wants a better deal for France. The trouble is that France has deep structural problems and if the voters are not prepared to endure the pain of fixing them then they only way out is for France and Germany to have a different currency. But a separation will be very painful.

The French problem is duplicated in many countries. The Dutch government cannot agree on budget cuts, making elections almost unavoidable. There is therefore now doubt on Holland’s support for future eurozone measures.

Meanwhile, the markets have again discovered that Spanish bonds require much higher rates of interest, given the risk. And so the foolish European banks who had already lost their capital have borrowed from the European Central Bank at one per cent and gambled much of the money in Spanish bonds, only to lose more. Their balance sheets are now in deeper trouble.

And that’s just this week’s crop of disasters.

At the heart of the problem is the fact that Germany is just too strong and it is completely inappropriate for it to have the same currency as most of the other European countries. However, even German industries are now being affected by the decline in Europe and in April German manufacturing shrank at its fastest pace in nearly three years.

Last night markets experienced the ripples from the muddy pond spreading. At the core were the key euro equity markets like Germany, which was down 3.4 per cent. The British market was down just under 2 per cent and the US market was down just under 1 per cent.

In Australia we are fortunate that our banks have been working so hard to lessen their dependence on European capital markets but they will have to do more.