Reserve Bank warns of pain from Europe

16.12.11

THE Reserve Bank is bracing for Europe's economic crisis to slash Australia's growth next year and has warned it is already pushing up bank funding costs.

Deputy governor Ric Battellino said Europe was heading for a "very significant weakening" next year, squeezed by a vicious circle of government spending cuts, credit tightening and falling confidence.

The crisis would cause most damage to Australia through its effect on business and consumer confidence here and the weakening of trade, Mr Battellino told a banking conference in Sydney yesterday.

Consumer confidence is already suffering, with the December Westpac-Melbourne Institute survey showing an 8.3 per cent fall, despite the Reserve Bank's second monthly rate cut being passed on in full to borrowers.

Mr Battellino's speech followed similar warnings of an imminent European recession from Treasury Secretary Martin Parkinson on Tuesday, as policy makers try to prepare the public for a change in Australia's economic fortunes.

In comments that are likely to be used by the big banks for withholding a portion of the next round of Reserve Bank rate cuts, Mr Battellino said: "The main effect of the European crisis on Australian banks is through the increased cost of funds in global markets".

Mr Battellinosaid it was still possible that a combination of believable budget promises, and short-term support from the IMF and European Central Bank could produce a "benign" outcome in Europe.

However, he said it was impossible to rule out more disruptive outcomes, such as countries leaving the euro, deflation caused by prolonged government austerity or inflation caused by large-scale printing of money by the ECB.

The euro fell yesterday to its lowest value since January amid legal doubts about the proposed pact for closer fiscal union agreed at the weekend.

Mr Battellino said Australia could not be expected to be insulated from the downturn just because it does relatively little trade with Europe, which takes only 4 per cent of our exports.

Europe is a lot more important to Australia's major trading partners, particularly China and India, taking 15 per cent of their exports.

"History shows that when exports slow, domestic demand in Asia also slows," he said.

"It would be prudent to assume that, if the European economy were to slow markedly over the next year or so, Australia would be affected, particularly through indirect trade exposures."

Below-average household confidence through most of this year was the result of the "unsettling financial news coming out of Europe and the associated large declines in share prices". Last month's fall in the Westpac-Melbourne Institute consumer index to 94.7 points shows a clear majority are pessimistic about the outlook.

Westpac chief economist Bill Evans said more people were nominating the repayment of debt as the best use for spare funds than at any time since the financial crisis, while the 6.6 per cent nominating equities was the lowest since 1993.

By David Uren | The Australian