The Australian economy is standing at the crossroads of competing international forces.

Continued strong demand for our natural resources and increasing commodity prices are driving our economy in an upwards direction. By contrast, the global credit crisis, local inflationary pressures and steepening interest rates are threatening to pull the economy in the opposite direction.

Since the US sub-prime mortgage crisis raised its ugly head last year, global financial markets have grappled with a deepening global credit crisis and reassessment of risk premiums.

In this timely interview, ANZ chief economist Saul Eslake shares his insights on the global credit crisis, Australia's economic shape and the outlook for businesses.

How has the sub-prime crisis heightened risks across world foreign exchange, credit and interest rate markets?

The price of risk has increased dramatically and there has been a loss of confidence in credit ratings and in the ability to assess risk and price accurately. For a very large category of borrowers the securities markets have, for the time being, shut down while for those to whom credit is available through the securities markets, it is only available on much more demanding terms.

As a result, the cost of credit is rising at the same time as its availability is being constrained, which is having a wide range of implications on economic activities around the world.

So what are the key risks to Australian financial and investment markets going forward?

The biggest risk is that of ongoing stresses and strains in the banking system. Australia has the fourth largest current account deficit in the world, predominantly financed through the overseas borrowings of the major Australian banks. If credit continues to become more expensive and difficult to attain globally, Australia will find it much more expensive and difficult to finance its current account deficit. This will flow through to the Australian economy and business borrowers.

With economic conditions worsening in the US, what is the outlook for Australian companies who rely on international business?

It depends on where their business comes from. Businesses whose primary markets are in the United States or Europe will find it tough as these economies are experiencing sharp slowdowns. Japan is also facing a fairly fragile business outlook.

Conditions for businesses that predominantly export to developing countries such as China or India will be pretty good. Although in the short-term, these businesses may suffer an adverse impact on revenues and competitiveness due to the rising Australian dollar.

The other thing to remember is that Australia's interest rates are much higher than in many comparable countries. In the middle of 2007, Australia's cash rate of six per cent was less than a percentage point above America's cash rate and before the crisis hit it was a quarter of a percent. Today Australia's cash rate is four percent higher than the US and is likely to increase to 5.5 per cent by the middle of the year. This, combined with high commodity prices is continuing to put upward pressure on the Australian dollar.

Which poses the greatest threat to the Australian economy - inflation or the credit crunch?

I don't think you can say yet. In aggregate the impact of the credit crisis has largely offset the positive effects of ongoing increases in commodity prices and that will continue through 2008-09. Unfortunately, that will intensify the pressure on inflation and on official interest rates.

Australia is unique among developed economies as it stands at the intersection of two very powerful global forces. Like the advanced economies of the United States and Europe, Australia is feeling the pinch from the unfolding credit market crisis. By contrast, ongoing industrialisation and the rapid growth of developing countries such as China is putting upward pressure on the prices of commodities we export and boosting our economic growth. Our unique position makes it difficult to judge the net outcome of these two global forces. Inevitably, some parts of the economy, not withstanding the credit market crunch, will do quite well while others will feel the full force of factors.

It sounds like these global forces will be key challenges for the Australian economy going forward.

The Reserve Bank and the Government have a very delicate task in managing the Australian economy with these powerful global forces at play, especially in light of rising inflationary pressures. The Reserve Bank effectively has to make room for the manufacturing and farming sectors to grow in response to Chinese demand. At the same time, other sectors of the economy will need to grow at below average or shrink to ensure Australia doesn't exceed its natural speed limit. The rising exchange rate will do that to some degree by squeezing the manufacturing and tourism sectors, but it probably can't do it on its own.

The Reserve Bank has voiced its frustration at the slow response of the economy to its gradual raising of interest rates. It appears they may adopt a more aggressive approach going forward to bring inflation back within its target band - we expect two more rises in official interest rates before the middle of the year. The possibility that rates could increase further as banks pass on the higher costs of funds to borrowers poses a further threat to the economy. There must be a level of interest rates at which the economy could be seriously affected. Unfortunately, we won't know what that level is until we reach it.

Is the credit crunch likely to have long-term implications for financial markets? I guess the million dollar question is how long do you expect it to last?

Although some of the characteristics of credit markets in the last five years will probably never regain their previous depth or height. The present crisis is likely to get worse before it gets better. We still don't know the full extent of the losses that are likely to be incurred on various credit market instruments and I think that the crisis and its consequences will be around for somewhere between one and three years.

Finally, what is the outlook for investment markets?

Businesses and investors should continue to expect volatility around a declining trend in the short-term and probably continuing uncertainty beyond the next three to six months.

Protecting your business in uncertain times.

The volatility in financial markets looks like it is here to stay for a while. So, now is the time to put in place strategies to protect your business if you haven't already.

Your ANZ Relationship Manager can discuss a range of strategies to protect your business against financial risks and introduce you to your ANZ Markets Advisor - an expert in interest rate and foreign exchange rate risk management. Together, they can recommend strategies specifically designed to protect your business during uncertain times.

For more information on how to protect your business from interest rate and foreign exchange rate volatility please call your ANZ Relationship Manager.

Useful links

For regular Australian and international economic updates and selected speeches, articles and presentations by ANZ's Chief Economist, Saul Eslake and other ANZ staff please visit economics@anz