By JP Goldman

It now seems increasingly likely that Europe will remain a dead weight dragging on the global economy over the next year or so. Indeed, just when we thought Europe may be getting its act in order, Greek Prime Minister George Papandreou has thrown a spanner in the works by suggesting his country should hold a referendum on its bailout package [since withdrawn- Ed].

Should European troubles continue, the question remains whether the Australian economy will be materially affected ? and whether Europe will also drag down our stock market.

In theory, Europe shouldn't matter much. But alas, such is the integrated nature of financial markets these days ? and the tendency of investor fear to overrule reason in the short-run ? that the risk remains that our market will be under pressure for as long as Europe dithers, even if our economy improves.

As Keynes once said, markets can stay irrational for longer than an investor may stay solvent. That may create short-term pain, but it could throw up bargains for patient long-term investors.

In terms of economic size, the eurozone is a major economic bloc (it's made up of countries that use the euro, therefore excluding European Union (EU) members like Britain). According to International Monetary Fund estimates, it accounts for around 15% of global output ? similar to that of China and just less than the United States' 20% share.

But as with the United States, the eurozone's contribution to global growth in recent years has not been great. The region grew by 1.8% in 2010, and the IMF forecasts even slower growth of 1.6% this year, and 1.1% in 2012.

The broader EU accounted for just 8% of Australian exports last year, with around half going to the UK. China, by contrast, took one quarter of Australian exports, and Japan another one fifth. Korea alone accounted for 9% of exports ? or slightly more than for the whole EU.

That said, should Europe go into recession, it will have knock-on effects for Australia given the region provides a lot of business to our Asian neighbours. For example, the EU accounted for about one fifth of China's exports last year ? a slightly greater share than that exported by China to the United States.

Indeed, in its statement announcing the cut in official interest rates this week, the Reserve Bank of Australia noted that Asian trade performance was "starting to see some effects of a significant slowing in economic activity in Europe, where the prospects are for economic weakness to continue."

In terms of financial exposure, Australian banks should be relatively immune from any write-down in European debts. Analysis by the RBA reveals that Australian banks hold virtually no sovereign debt from troubled countries such as Portugal, Italy, Ireland, Greece and Spain (PIIGS). And exposure to the debt of European banks as a whole amounts to $56 billion ? which may seem large, but is only 1.9% of total assets. Exposure to the PIIGS's banking sector is only $7.8 billion, or 0.3% of total bank assets.

But Europe's anaemic banks could have other consequences for Australia in that solvency concerns could lead to an escalation in interest rates in the wholesale funding markets, as evident in 2007 and 2008.

It's important to note, however, that Australian banks have reduced their reliance on often volatile short-term wholesale funding in recent years and increased their reliance on long-term funding and local deposits. Indeed, local deposits now account for around one half of bank funding needs, up from 40% in 2008. And fortunately, the debt exposures now in question are relatively more transparent then during the subprime crisis.

At the end of the day, moreover, to the extent that local banks face some wholesale funding costs pressures from abroad, the RBA should be able to largely offset this impact if need be through lowering the official cash rate further, which would reduce local deposit and short-term wholesale funding costs.

What the RBA can't control is animal spirits, or the risk that further financial market volatility undermines local business and consumer confidence. All it can do is what it did two years ago, and slash interest rates aggressively if need be. Even at 4.5%, the official cash rate could fall a lot further if required, which is luxury not shared by Europe or the United States. With relatively low public debt, Australia also faces much less aggressive fiscal tightening than other countries in the next year or so.

JP Goldman writes for the Switzer Super Report, a newsletter and website for trustees and members of self-managed super funds.

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