Why the Greek debt crisis could hit Australia: SmartCompany Q&A

News that ratings agency Standard & Poor’s had downgraded Greece’s debt to junk bond status has sent shockwaves through global financial markets.

The Greek economy now appears to be headed for insolvency, which commentators fear could spark a tidal wave of problems for Europe’s banks – and from there the contagion is likely to spread through global markets.

So how badly could Australia be affected? Time for a SmartCompany Q&A.

Why is everyone so worried about Greece? It’s not like it’s one of the world’s major economies, is it?

No, Greece isn’t a huge economy by world standards, but the interconnectedness of the global financial system – that is, everyone loans money to everyone else – means that even problems in small economies can have huge impacts on global markets.

The Greek economy is simply in an awful state. Years of lavish spending (including ever-increasing salaries for the huge percentage of Greek citizens employed by the state) and heavy borrowing have left the country with a budget deficit running at around 13% of GDP. Since the onset of the financial crisis, the debt position has become worse and try as it might, the Greek Government is struggling to ram through austerity measures such as lower spending and higher taxes, mainly because of rolling strikes and protests by angry citizens.

Now the country needs $60 billion in emergency loans from the International Monetary Fund and the European Union – and that’s really just to get through the next 12 months. But after the Standard & Poor’s downgrade, there are fears that political pressures in the European Union could see the bailout blocked – and that could cause Greece to default on its loans.

So what would happen if Greece did default?

Well, for starters, the global banks that loaned money to Greece are going to suffer huge losses – big enough, argues Robert Gottliebsen from Business Spectator, that we could be looking at the start of a new Lehman Brothers-like disaster (the collapse of this Wall Street bank really sparked the GFC back in late 2008) that leads to a new credit crisis.

There is also a fear that the contagion from a Greek default would spread throughout Europe, as global banks refuse to lend to some of the other European nations currently facing similar problems to Greece.

Who are they?

Portugal, Ireland and Spain are all running big budget deficits and are seen as potential trouble spots if a Greek default caused a credit crisis.

Another credit crisis – could things really get that bad again?

It probably not as bad as we saw in late-2008, mainly because global banks have had time to get their balance sheets back into far better shape, with far less debt.

But the problem is contagion. When one economy gets sick, that sickness can infect other economies very quickly as lenders get nervous about handing over their cash – to companies or countries.

“Investors are increasingly thinking about the risk of the unthinkable in Europe,” Stu Schweitzer, a global market strategist at JP Morgan Private Bank, told the Wall Street Journal last night.

From the GFC we know that what happens in overseas debt markets does have a big impact on the cost of wholesale funds for Australian lenders. A European crisis would undoubtedly lead to a sharp rise in funding costs that the banks would be likely to pass on, particularly to business customers who they see as more risky than mortgage holders.

Great. So as the RBA is putting up rates, the banks are going to be making funding even more expensive.

You would have to think that the troubles in Europe might give the RBA Board something to consider very closely when they meet next week, particularly if Greece or its struggling neighbours move any closer to actually defaulting.