Reserve Bank keeping worried eye on Europe

Financial markets are awaiting Greece's second general election this weekend. Democratic Left leader Fotis Kouvelis speaks to his supporters during an election rally in Athens yesterday. Photo / AP

The Reserve Bank is closely monitoring developments in Europe because of the risks posed by the region's sovereign debt crisis to economic growth in New Zealand.

The "political and economic stresses in Europe" have helped erode growth in New Zealand's trading partners, which is hampering the country's growth outlook, Governor Alan Bollard said in today's monetary policy statement. There's a "small but growing risk that conditions in the euro-area deteriorate more markedly".

"The bank is monitoring euro-area developments carefully given the potential for rapid change," he said.

Europe's debt woes have left global financial markets in a fug this year after more of the so-called PIIGS (Portugal, Italy, Ireland, Greece and Spain) put their hand out for a bailout. Last week, Spain was given the thumbs-up for a 100 billion euro package to shore up its banking system.

Financial markets are now awaiting Greece's second general election this weekend after the first failed to deliver a Parliament that could form a government, and there are fears the Mediterranean nation may quit the euro-zone rather than embrace harsh budget cuts.

The Reserve Bank said if an exit occurs a negative flow-on may force other smaller nations to quit the euro-zone, which would cause "substantial disruption to the world economy".

New Zealand does not have much direct exposure to Europe, with just 7 per cent of the nation's exports going to the euro-area. Where the biggest trade risk lies is though its Asian trading partners, which have a greater contact to Europe and may have to cut back on buying New Zealand products.

Deterioration in Europe would also put pressure on commodity prices, which would hurt local exporters of raw materials. That would in turn push the currency down, "making investment more expensive for firms and increasing the cost of imported consumer goods, generating inflation".

European banks and financial markets would also be impacted by a Greek exit, increasing bank funding costs, which would ultimately be borne by New Zealand households.

"For a given level of inflationary pressure in the economy, 90-day interest rates would have to be correspondingly lower to offset the effects of these higher funding costs," the bank said.

The central bank trimmed its forecast for the 90-day bank bill rate, often seen as a proxy for the OCR, with the rate unchanged at 2.7 per cent until June 2013, before peaking at 3.4 per cent in March 2015. It had previously expected the rate to rise in December this year.

"One or more countries leaving the euro-area, or a disorderly major default, could significantly reduce inflationary pressures in the New Zealand economy," the bank said.

"This would be expected to result in materially weaker monetary conditions in New Zealand."