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Investors gain reassurance as interest rates remain the same

12 February 2012, The Canberra Times

The reserve bank's decision last week to leave the official short term interest rate unchanged at 4.25 per cent a year may have disappointed the Federal Government and home borrowers but it provides reassurance for investors on several key fronts.

A strong banking system is essential to maintain both a healthy economy and a strong government financial system. The serious financial problems in several European countries including Ireland and Britain have arisen largely from the huge cost to the respective governments of bailing out the private banks.

In this process of saving banks that were too big to allow to fail, the banks' bad debts were funded by large government borrowings. This led to the sovereign debt blowouts now plaguing several European countries.

Compared with situations of artificially keeping interest rates low by printing money and quantitative easing strategies, charging lenders commercial rates of interest is an efficient way of prioritising the use of borrowings. By retaining high interest rates compared to those in other developed economies, the Reserve Bank has also retained the flexibility to deal with a major collapse in European credit markets.

The Reserve Bank's announcement suggests that the European situation is improving. However, Asset Check's investigations suggest there will be no easy solution to European sovereign debt problems because of the increasing concern about owning euro currency and euro denominated financial assets.

As is currently being negotiated, private owners of Greek government debt will lose at least 50 per cent of their assets and still retain euro-denominated assets for their remaining investments. If Greece is driven or decides to opt out of the euro zone, this remaining debt will still be denominated in euros and Greece's new currency will inevitably depreciate in value against the euro. This would increase the possibility of a second Greek default.

Similarly, if Germany were to leave the euro zone, its currency would appreciate against the euro. Consequently, Germany would profit at the expense of bond owners by being able to repay its euro debt with the higher-value new German currency. Either way, if the euro zone were to break up, serious losses would be incurred.

Daryl Dixon

The high level of uncertainty about future developments in Europe alone is sufficient reason for the Reserve Bank's caution about reducing interest rates.

Read more about the author, Daryl Dixon, Executive Chairman of Dixon Advisory

 

Daryl Dixon