The cancer spreads from Europe

The contagion from the European debt crisis has now “gone global”, having “infected global financial markets”, thanks to a disturbing “crisis of credibility” that bedevils policymakers, caution economists.

The spread of the crisis has enormous implications for everything from the fragile global economic recovery to currency action in China to risk aversion in financial markets, which could impact capital inflows into India.

“Contagion is spreading,” says Societe Generale analyst Aneta Markowska. “What began as a localised fiscal crisis has morphed into a funding crisis, which has now infected global financial markets.”

Analysts at Standard Chartered concur with that grim assessment. “Just as US subprime was once seen as an isolated issue, so was Greece.” But that, they add, is no longer the case. “Of late, global investors appear to be taking a much broader view, seeing the various events of subprime, Dubai, Greece and others as part of a larger context of questioning global sovereign debt credibility.”

To some analysts, the European Central Bank’s blase business-as-usual attitude at its governing council meeting on Thursday raised red flags. “Europe now appears to be undergoing an emerging market-like credit crisis,” points out Nomura Securities analyst Laurent Bilke. “But the ECB has said nothing so far.”

In Bilke’s estimation, the crisis could spill over onto the economy if it was not contained rapidly. “Serious contagion would start when euro-area banks were hit by the sovereign situation.”

Markowska already sees signs of pressure building up. “Inter-bank liquidity conditions continue to tighten on the back of sovereign debt concerns. These are evident in rising Libor rates and widening swap spreads.”

As funding strains prompt institutions to liquidate assets, they can “easily transform into a broader financial market contagion,” she adds. And in fact, that contagion was evident across all asset classes on Thursday.

The euro-area crisis “could yet expand to the UK, the US and Japan, given their equally troubling debt dynamics,” point out Standard Chartered analysts. At its core, they see a “credibility crisis: policymakers have responded by blaming the ‘irresponsibility of speculators.”

But in fact, it is the market that is finally demanding responsibility on the part of the policymakers.

For all the recent positive economic data from the euro area, Barclays Capital analyst Julian Callow says “there is an increasing danger that financial market developments could cause business confidence to turn lower in the months ahead.” And even though it appears that the European Central Bank disregards this risk, “we would not count it fully out.”

The US economy too is “not completely immune from financial contagion,” says Markowska. However, the “transmission mechanism” in this case is not as pronounced as it was, for instance, when the subprime episode, which originated in the US. Yet, if the contagion continues to spread through the financial markets, the Federal Reserve Board’s exit plans “will almost certainly be put on hold.”

Policy action in far-off China could also be impacted, reckons Barclays economist Wensheng Peng. China was widely expected to allow its currency, the renminbi, to appreciate against the US dollar, but Peng believes that policy call is now at risk.

“Our previous view was that a widening of the currency band could happen as early as before the China-US strategic economic dialogue in late May. We now believe that the probability of a change in the exchange rate policy in the near term has declined materially.”

The evolution of the debt crisis inEurope is now a key risk factor in estimating the timing of a policy change in the exchange rate in China, adds Peng.