The eurozone’s longest recession – six quarters – has finally ended and encouraging figures on jobs, consumer confidence and industrial production suggest the GDP expansion should continue in the second half of 2013. However, we still believe growth over the next two to three years will not be strong enough to stabilise debt burdens in many member states or raise inflation.
The improvement in eurozone activity has been most convincing in the industrial sector, but further expansion will have to be largely export-led, so the global environment is still critical.
China’s reduced growth prospects have implications for German exports in particular, though it would be wrong to assume that Germany’s exports to Asia face a persistent downward slide. While the slowdown in Chinese import demand has hit Europe’s peripheral states, China accounts for a much smaller share of their exports and they continue to benefit from the strength of other emerging markets, notably in Africa and Latin America. That helps to explain why Italian and Spanish exports have seen a stronger revival than Germany’s.
Improving competitiveness probably also plays a role in some countries. We estimate exports were a key driver of Spain’s smaller-than-expected second-quarter GDP contraction and Portugal’s remarkable 1.1 per cent rebound.
Domestically, the pace of government austerity measures has eased, particularly since the European Commission gave some countries an extra two years to hit the 3 per cent of GDP deficit target.
The improvement in eurozone activity has been most convincing in the industrial sector
Nonetheless, public spending cuts will continue into at least 2014 and 2015 in many eurozone states and further tax rises cannot be ruled out: Italy’s latest VAT rise is slated for October 2013.
Consumer spending has already shown some signs of stabilisation, and even growth in some eurozone countries, as the squeeze on real wages has finally abated. German annual real wage growth has been close to 2 per cent but falling inflation also allowed Italy’s figure to turn positive, despite ongoing wage moderation.
However, we are not convinced that data showing lower unemployment in all the peripheral countries is the beginning of a trend. We still expect a gradual upward drift in eurozone unemployment that will limit the upside for household spending. Although consumer confidence is well off its lows in much of the eurozone, surveys suggest “intentions to buy” data has not recovered outside Germany.
Investment is still the eurozone’s main area of weakness, with even German machinery and equipment much weaker than would be expected, given its export performance. This suggests there may be pent-up demand that could come through if confidence continues to recover. There is little sign of companies looking to borrow more for fixed investment.
As with consumer spending, an upside surprise to investment spending is more likely to come from Germany than the periphery, where banking systems still appear poorly placed to facilitate a strong recovery and ongoing uncertainty about future demand is likely to remain a constraint.
Nonetheless, exports from the rest of Europe would benefit from a strong German rebound, whether tied into to the country’s manufacturing process or domestic demand.
But while there are now some upside risks to growth, stemming mainly from a better-than-expected industrial rebound, there are plenty of downside risks – not least the strengthening of the euro and the rise in long-term interest rates.
And while the near-term outlook has improved a little, the medium-term challenges remain. A sustained period of above-trend eurozone growth is required to lower the unemployment rate significantly. Without that, it will be very hard to put the public finances back on a sustainable path.
If eurozone growth, especially in the periphery, is largely export-led, it is likely to be very cyclical, slowing every time world trade dips. This implies that the very high unemployment will fall only gradually in many member states, resulting in persistent downward pressure on wage growth and, therefore, inflation.
We still therefore believe the European Central Bank should examine other options in its toolkit as it may not be long before it has to consider further monetary easing to address potential downside risks to price stability.
This research was first published on 14 August 2013.