Fending off Lagarde's apocalypse

It's true Australia's in a better position than most of the world to manage a European meltdown, but the inevitable shockwaves make it in everyone's interest to save Europe from itself.

The International Monetary Fund’s Christine Lagarde provided a dramatic and chilling warning overnight for the rest of the world – including Australia – if Europe isn’t able to defuse the ticking time bomb at the heart of the global financial system and economy that it has created.

Maybe it was melodramatic, but Lagarde outlined a future of "economic retraction, rising protectionism and isolation" unless the crisis was brought under control. She even referred to the Great Depression.

"There is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super-advanced economies that will be immune to the crisis that we see not only unfolding but escalating," she said.

Given the state of the rest of the world, Australia probably qualifies as a "super advanced" economy.

The crisis in Europe has generally, apart from bankers who’ve seen their access to term funding disappear, been viewed with concern rather than alarm here.

Solid economic growth, low inflation, low unemployment, a strong fiscal position with plenty of flexibility, a robust banking system and, most significantly, proximity and rapidly-swelling trade engagement with China and the rest of Asia have contributed to a sense of immunity from the worst that the crisis in Europe might produce.

The bank funding issue is manageable, albeit potentially at some cost to bank customers. The banks are extremely liquid, very conservatively capitalised, and strongly profitable and the Australian market has also demonstrated its capacity to supply them with more capital if required. If the worst came to the worst there are emergency liquidity arrangements in place with the Reserve Bank.

The banking system and its dependence on offshore funding has been the most-discussed transmission line for contagion from the European troubles.

A second-tier threat to the stability of the domestic system and economy lies in the fresh exodus of foreign lenders from the market and the unwillingness of the domestic banks to significantly grow their balance sheets, which is partly driven by a concern about their funding but also because of the brittle state of the non-resource side of the economy.

A lot of corporate debt that was raised or re-financed in the aftermath of the 2008 crisis matures in 2012 and 2013, much of it in the A-REIT sector. Traditionally foreign banks have been very active in property sector lending but it is obvious that European lenders – which are urgently contracting their balance sheets to minimise the amounts of new capital they will have to raise – aren’t going to be enthusiastic about continuing to lend this far from their home economies, assuming their regulators would allow them to.

As BlueScope Steel has demonstrated, it is possible for even stressed companies to raise equity to repay debt, albeit the equity is very expensive. We may well see another bout of distressed raisings next year, as occurred in 2009 during the worst of the original crisis.

It is also possible that the ‘RuddBank’ concept – the idea that emerged in the midst of that crisis of a government entity that would provide credit to the big end of the property sector in the event that foreign lenders withdrew completely – could also be revisited.

As Centro Retail’s new chairman (and former ANZ Bank deputy chief executive) Bob Edgar said in his KGB interview, the proximity to Asia, and China in particular, means the world does put Australia in a "different box" and if China continues to produce eight per cent-plus growth rates on an ever-expanding denominator that will provide some insulation from the chaos in Europe.

If Lagarde’s somewhat apocalyptic vision of where Europe’s crisis might lead were to prove true, however, she’s almost certainly right in her assessment that no economy would be immune from the fallout.

If Europe implodes there will be massive shockwaves that blow through the global financial system and the global economy and enormous pressure for a reversal of globalisation and an increase in protectionism. China, with its mercantilist stance, would be affected, as would we.

One assumes Lagarde was speaking partly for effect, to try to get the European leaders to act more decisively at a time when Europe is starting to get distracted by internecine political issues and power plays.

She also, however, made a valid point. Europe is clearly incapable of resolving the crisis by itself. Even as its lurches ever closer to economic meltdown, its leaders are preoccupied with the long-term structure of the eurozone and their own petty squabbles.

The French assault on the UK’s credit rating overnight was a remarkably stupid and inflammatory thing to do, but also provided an insight into the destructive tensions that have developed since the UK exercised its veto at last week’s European summit.

The threat Europe poses to global stability creates self-interest elsewhere to help do what it takes to stabilise its position, which at the moment requires a massive infusion of liquidity into frozen or malfunctioning debt markets and support for sovereign debt refinancings and bank recapitalisations.

Amidst the plethora of austerity packages across Europe, someone is also going to have to devise a mechanism for rekindling some economic growth.

It is unclear how a global rescue effort could be organised or implemented or where the leadership for it might come from (perhaps Lagarde and the IMF are positioning themselves for that role). Informal attempts by the Europeans to solicit funding from China and elsewhere have so far been unsuccessful.

If a collapse of Europe which would blow a massive hole through the global financial system and have unpleasant implications for global economic growth is to be averted, however, it is in the interest of the rest of the world to try to save the Europeans from themselves.