Return of the GFC

There’s been an unpleasant sense of déjà vu in financial markets over the past few weeks. Many of the symptoms of heightened investor risk aversion that characterised the global financial crisis of 2007-09 have re-emerged, including double-digit falls in many sharemarkets from their highs of earlier this year, substantially higher levels of volatility, falling commodity prices, declining bond yields, and a strengthening US dollar.

And even though Australia came through the crisis of 2007-09 in much better shape than most economies, Australian assets seem once again to have been harder hit - as they were in 2007-09 - with the Australian sharemarket among the worst-performing over the past few weeks, and more recently the Australian dollar experiencing an abrupt decline.

The renewed risk aversion of global investors appears to have been prompted by mounting concerns over two quite separate issues.

The first is the way in which European governments have responded to growing market concerns over sovereign debt.

There are some eerie parallels between the determination of contemporary European governments to avoid a Greek debt default, and to preserve the existing membership of the euro zone, with the efforts of their predecessors in the early 1930s to avoid defaulting on the debts incurred or imposed during and after World War I, and to remain on the gold standards. These efforts were not only ultimately futile, they actually made the Great Depression worse than it would otherwise have been.

The rhetorical and regulatory assaults by European governments on "speculators" in recent weeks also have striking parallels to that era.

Markets appear to believe that the most recent bailout package assembled by European governments, the European Central Bank and the International Monetary Fund have only deferred a Greek debt default, rather than averted it, and in so doing they have committed themselves to more contractionary economic policies than would have been required if the "inevitable" were allowed to happen sooner. This may eventually turn out to be wrong; but for the time being this view is driving investor behaviour.

Given the opprobrium that has been heaped on financial institutions, and markets more generally, for their role in bringing on the financial crisis of 2007-09, it's perhaps worth noting that the European debt crisis is almost entirely the making of governments.

It was a former Greek government that lied about the amount of debt it had incurred, and which entered into complex transactions designed to get around limits on borrowings by aspiring members of the euro zone. Other European governments (and the European Union) turned a blind eye to the fact that Greece (and other countries besides) had manifestly failed to meet the criteria for euro zone entry, and admitted them anyway.

And European governments failed to put their public finances in a sustainable condition during more propitious economic times. It's thus not entirely surprising, nor unwarranted, that European governments' pronouncements and actions in response to this crisis have been viewed so sceptically.

Although the focus of attention in recent weeks has been on members of the euro zone, other major economies also face an onerous task of restoring their public finances to a sustainable condition - including Britain, Japan and the US.

The possibility therefore exists that market attention will at some point turn to the credibility of any, or all, these countries' debt-reduction strategies, meaning the pressures now emanating from Europe could appear elsewhere.

A second trigger for the recent increase in risk aversion among investors has been the measures announced by Chinese authorities aimed at dealing with that country's property market bubble, which have prompted concerns that China's growth rate could slow significantly.

There's no denying that property markets in several Chinese cities are displaying "bubble"-like features, including a combination of rapid increases in prices and mortgage debt. But it is also apparent that the measures the Chinese authorities are taking in response have been specifically targeted at speculative property investment and development (such as higher down-payment requirements for the purchase of second homes), as opposed to broader measures (such as higher interest rates) which could carry the risk of "collateral damage" to other sectors of the Chinese economy. Significantly, the measures include requirements that local authorities increase the supply of land and housing, especially at the "affordable" end.

The fact that measures such as these have been taken in less than 18 months after China's great November 2009 policy "U-turn" attests to the authorities' confidence in the sustainability of the broader economic recovery, and to their determination to ensure that it isn't derailed by the emergence of large bubbles.

Thus, although property-related investment is likely to slow (indeed if the latest round of measures don't work, further measures can be expected), there's no compelling reason to believe that China's overall economic growth will decline significantly as a result.

Nonetheless, these concerns have contributed to the sharp declines in the Australian sharemarket and the Australian dollar over the past two weeks, along with the now-familiar pattern where Australian assets tend to fare relatively badly during periods of heightened investor risk aversion.

Given the size of the resource sector in the Australian sharemarket, the adverse reaction to the government's proposed resource rent tax hasn't helped, either.

The abrupt shift in investor sentiment will probably reinforce the Reserve Bank's inclination to leave official interest rates on hold for some time, given that the increase earlier this month achieved the RBA's stated objective of returning interest rates paid by borrowers to "normal" levels appropriate for an economy growing at around its trend rate.

There may now be some greater risk to the RBA's (and Treasury's) latest forecast of above-trend growth in 2011.

There will be no harm done in a period of cautious monitoring of global developments, backed by a preparedness to change course swiftly if warranted.