China and Greece are a pincer threat to Australia

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All day yesterday the furious consensus machine that is the Australian business media kept telling itself that China is a “bigger worry than Greece”. Why is anybody’s guess. It started with Alan Kohler in the morning and spread from there.

Today the AFR leads with the same straw man:

Global fund manager and PM Capital founder Paul Moore, who visited Greece on a fact finding mission earlier this year but declined to invest because of the political risks, said that the economy’s promise had been “smashed” by the leadership’s fumbling of talks with creditors and the unwillingness among lenders to budge on some key measures.

Mr Moore said the bigger concern for Australian investors was China. “Look at the size of the Greek economy, it’s a speck.

“China’s not a speck.”

Metal note: short Paul Moore. China’s stock market is pretty close to a speck. It may have a capitalisation of $10 trillion but it has zero offshore influence, took six months to inflate and will take far less to pop, is not widely or deeply held by Chinese households, had limited impact on consumption on the way up and will likewise have a muted impact on the way down. China remains a control economy and stimulus can be forced out at any pace it likes.

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Greece on the other hand is not confined to Greece. It is the fault line in the one of the two largest currencies in the world. Not done, the AFR tries to hose down Greek fears in another story:

Bill Sterling, chief investment officer of New York-based Trilogy Global Advisors, said in an interview that Greece was largely financially “ringfenced”.

“It’s a tragedy for Greece, but unless the markets are badly mistaken this is containable and not necessarily a systemic problem for the global economy,” he said.

“I think there is a view in the markets that if this occurred two years ago, it could be Lehman squared because of systemic financial risks that could create a run on the entire European banking system.”

European banks have cut their exposures to Greece and now only have €5 billion of exposure, out of their total balance sheet value of €32 trillion, JP Morgan says.

Howard Ward, chief investment officer of GAMCO Investors which manages $US47 billion from New York, said Greece would “ruffle” US and European equity markets but have no material impact.

“Greece is not much more than 2 per cent of the eurozone economy and about 0.4 per cent of the global economy so the fallout appears limited. From a financial market standpoint, Greece represents mostly headline risk.”

There’s reassurance in those JPM numbers. As I said yesterday, much of the Greek debt has been shifted onto public balance sheets. But nobody knows if Greece is “ring-fenced”. It has all sorts connections that will be tested if it exits. That is the first reason that European peripheral bonds yields are spiking. The second reason is that if Greece exits it will build a permanent ‘exit premium’ into every peripheral European bond. It won’t matter what the ECB does, the base level of European interest rates will shift structurally higher.

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It’s kind of pointless comparing which is a bigger threat to Australia. More important is that both are threats. The Chinese risk is not its stock market, it is its ongoing structural adjustment to slower and less commodity intensive growth, a known known. We’ve now been caught in a terms of trade adjustment for three years on the back of it and we’re a little over half way through it.

On the other hand, Greece is a known unknown. We don’t know what the contagion risks are if it exits the euro. More to the point it doesn’t matter all that much. As a risk premium is baked into the euro for every other potential exit, those externally funded economy’s globally that rely upon cheap finance in part from the continent will see the same. That is Australia and so bank funding costs are going to rise. We had a little taste of it yesterday with European bank funding costs jumping the most in seven years:

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They will continue to do so for as long as the crisis runs. The impact here was small with a 2 point rise in CBA CDS to 67.50:

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But if this situation deteriorates towards a Grexit more is to come.

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As for economic threats, recall that the Australian economy has two central pillars in houses and holes. We derive income from commodity exports then leverage that offshore via our banks to pump house prices and make ourselves feel rich. That is, we rely upon high commodity prices and low international interest rates to be prosperous. China is denuding the first and an ugly Grexit absolutely has it in its power to take away the second.

Markets yesterday traded on the China matters more meme with PBOC stimulus holding the Australian dollar aloft and bond prices down (yields up) relative to other nations. But if Greece exits, and it most likely will, that will not last.

Australia is caught in a developing global pincer and reassuring yourself by only looking one half of it is a recipe for mis-allocated assets.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.