The Other School of Economics

Why Greece Sovereign Debt matters to Australia

If you thought Australians did not give a stuff about what is happening in Greece and Europe because they are too busy dealing with China, think again.

The PM is following up the situation closely and Mike Smith, CEO of ANZ bank (one of the 4 major Aussie banks) described the situation as *a mess*.

The picture speaks for itself

Nothing really surprising in a way, as this is the pure manifestation of the financial entanglement that comes out of building the European Union. It is probably just a shame that we only built a financial Union and never really got to the more noble part of the agenda: a political and social Union….
The points that jump at us is how exposed to the PIIGS, France, Germany and the UK are: The PIIGS owe France the equivalent of 34% of its GDP, Germany 21% and the UK 19%: there is no doubt a default would compromise them, notwithstanding the threat to the Euro currency itself…

Ose-Europe Web of Debt

Down under, the reason the situation is seriously worrying Australian Bankers and Policy makers is that Australian banks could face higher wholesale funding costs if markets go belly-up.

Wholesale funding – What does it mean?

A little digression is necessary: The Bank’s job is to gather deposits (people’s savings) in order to lend it back to borrowers who need to buy a house or a flat TV screen (Mortgages and Loans).The bank takes a cut on the way to make a little profit.

In a basic model, the bank lends only the money it receives (minus a little 10% kept in reserve). Everybody is happy and the Loan-to-Deposit ratio is below 100% (more on this in a later post)
Example: John brings $100 at the bank. The bank keeps $10 in reserve and lends $90 to Paul. Loan-to-Deposit ratio = 90/100 = 90%

The trouble is that our hyper-materialistic western model of society requires *a lot* of Mortgages and Loans because people want to buy truck loads of TV screens and very big houses. So banks need way more money that what depositors can give them when putting their salaries on their savings account. To satisfy this demand for Consumer credit, as well as for Business financing they can literally end up lending $150 for every $100 deposited. Just for the anecdote, Northern Rock had a Loan-to-Deposit ratio of 322% before its collapse: that is – it was lending £322 for every £100 deposited….

So the question is: since money is not created out of thin air, where is this extra cash coming from? If the bank receives $100 and ends up being able to lend $150, where do those extra $50 come from? Answer: wholesale markets. The money market – aka Wall street, aka la Bourse, aka the Stock-Exchange ….
This is where banks borrow money from each other and from other financial institutions to get their daily mass of cash. They borrow the money and pay an interest for that: the cost of funding, which they pass onto the consumers’ loans and mortgages.

Coming back to the point this post: Australia is small country (20m people) and is structurally lacking deposits to fuel the credit required to finance its industrial activity: not enough people put money on their savings, for the banks to lend to big industrials who want to build mines and harbours in the north (I’m being simplistic but you get the drift….)

So if things start to turn sour in Europe, wholesale markets will globally start to play up again, the price of borrowing money between banks will go through the roof, and mortgages interest rates will sky-rocket in Australia. Not a enviable situation for an incumbent government in an election year….

By the way, we’ll do a proper post soon to develop on how those markets work.

Another post should also be required to critique the credit intensive model that we run – this vicious circle of needing cash to build mines, to dig the dirt, to sell the dirt to China, and to spend the money made on consumer goods, etc…

So stay tuned….

{ leLaissezFaire }