A Fragile Return to Confidence in the Eurozone

With the risk of an imminent eurozone breakup now reduced, economic growth is expected to resume from mid-2013. However despite the signs of improving global business confidence since the beginning of the year many economic fundamentals in the euro area remain weak and unpredictable, according to the spring Ernst & Young Eurozone Forecast (EEF).


The forecast predicts a mid-year turning point. Despite economic growth picking up in the second half of the year, an overall decline of 0.5% in GDP is still expected for 2013, after a similar fall in 2012. Sluggish growth of 1.1% is predicted for 2014. This will be followed by slow-paced expansion in subsequent years averaging 1.4% per annum from 2014-17, almost a full percentage point below the 2.3% average in the eurozone of a decade before.


The contrast between low growth in the core eurozone nations and ongoing recession in the peripheral countries will remain stark this year, although productivity improvements in the latter will narrow that gap in 2014.


The eurozone still faces challenges that could undermine even this fragile confidence. The inconclusive elections in Italy and political challenges in several other Eurozone countries remain sources of uncertainty as does the continuing high levels of unemployment, weak business and consumer spending and fiscal tightening.


However with both the US and Asian economies showing a real sense of momentum and the ECB’s gauge of systemic risk having fallen sharply since July, and now back to levels last seen in 2007, there is a sentiment that the worst may be over .


“There is no doubt that the eurozone is looking in much better shape than it was six to nine months ago and we are seeing that improvement reflected in share prices across Europe," comments Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast.


"There remains however a significant lag between the relative exuberance we have seen in the financial markets and confidence in the real economy. We do expect confidence to return in businesses and households, but much more gradually than recent financial market movements would imply.”


Mark Otty, Ernst & Young Area Managing Partner for Europe, Middle East, India and Africa adds, “there have been many false dawns along the road to recovery in the eurozone and this may yet prove to be another. However the sense we have from companies across Europe is that corporates are beginning to raise their expectations in terms of plans for future investment. There remains a huge amount to do though in terms of improving longer term productivity and innovation if European economies are going to compete with other developed markets and new emerging players.”


Closing the gap between the core and periphery
Despite the contrast in growth between the eurozone core and periphery there are some tentative signs that the situation beyond the core nations is improving. EEF expects the pace of contraction in the periphery to slow from 1.9% in 2012 to 1.4% in 2013, before a return to growth in 2014. This is primarily due to painful work being undertaken by certain countries in the periphery to reform their economies which is already yielding results in the form of improving international competitiveness.


Since 2008, employment in the periphery has fallen by 9% or 5 million people. In the case of Spain, Ireland and Portugal, employment has fallen further than output, thereby providing a boost to productivity. The falls in relative unit labor costs have made the goods and services produced in these peripheral economies more competitive than they were five years ago.


By 2014, EEF expects the peripheral eurozone countries with the fastest export growth to be Greece, Ireland and Spain – 9.3%, 4.4% and 4.1% respectively. These are the three countries that have seen the largest improvement in their relative unit labor costs, and hence competitiveness, since 2008. This will help these countries exit recession and allow gains in economic activity to accompany job creation.


Marie comments, “The return to very modest growth that we expect to see in the peripheral countries in 2014 will initially be driven by business investments and exports and subsequently, once the labor market starts to improve, by consumer spending.”

A slow decline in unemployment expected from 2014
A further rise in unemployment in the short term, and only a slow decline from 2014 is likely to be an impediment to growth. EEF predict that unemployment in the eurozone will reach a record high of 12.4% by the end of 2013, with the jobless rates in Spain and Greece at more than 26.5%. Even with recovery, the number of people out of work across Europe will remain stubbornly high. By the end of 2017, EEF estimates the unemployment rate will remain above 11%, and the number of unemployed will be around 6.5 million higher than a decade before.


Consumers’ willingness to make new purchases will be hampered by further increases in unemployment in 2013. Ongoing fiscal tightening and austerity measures will also have an impact on household spending. Consumer spending is expected to fall again in 2013, by 0.6%, before starting to grow slowly by an average of just 1% a year in 2014-17.


Banking sector deleveraging will also continue to constrain growth over the forecast horizon. Although the banking system is now much less of a systemic threat to the broader economy than a year ago, it is not yet in a position to drive an economic upswing through rapid lending growth. Generally, tight credit conditions will weigh on investment and consumer spending.


Strong euro unlikely to pose threat to growth
Although the economic climate remains difficult, confidence among businesses and consumers should return gradually, as some of last year’s major threats recede. But business investment is still expected to shrink by 2% in 2013, before recovering slowly to post average growth of 3.5% a year in 2014-17. Over the last six months there has been a marked decline in risk premia priced into eurozone financial markets. EEF thinks that markets have risen too strongly, given that many economic fundamentals remain weak at best and the ongoing political uncertainty in several countries.


The euro has already surrendered some of its earlier gains, but it is still up by 8% against the US dollar and 8.5% on a trade-weighted basis since mid-2012. In the current climate the impact of the appreciation will be mitigated by the fact that it is accompanied by a more stable environment. However, the export sectors from the periphery may suffer from the appreciation of the euro and if sustained it may undo some of the painful work undertaken to restore competitiveness.

Despite these concerns, EEF has not lowered its growth or export forecasts as it does not expect the rate to stay at its current level for long. EEF estimates that the euro is overvalued by a little under 10% at present. But, as uncertainty about the US fiscal stance clears and the pickup in growth there and in emerging markets becomes more obvious, EEF expects the euro to depreciate again towards US$1.25 by the end of this year.


Marie says, “It is unlikely that the ECB will intervene unless the strength of the euro continues and a significant impact on activity becomes evident. However, if the rise does persist the ECB many need to intervene, perhaps even with an interest rate cut, to stem any further appreciation. A stronger euro does pose a new threat to the eurozone outlook but it is one that businesses are accustomed to so it is unlikely to have a major impact.”


Fiscal tightening to cut 1% off GDP growth
Fiscal tightening is also expected to be a medium-term drag on growth. EEF estimates that fiscal tightening will amount to more than 1% of GDP again this year, which will cut around one percentage point off GDP growth. From 2014 onwards, the pace of fiscal tightening should lessen, but at around 0.5% - 1% of GDP a year, it will continue to dampen growth.


Marie explains, “After several years of austerity, one of the key challenges now facing policy-makers in the eurozone – both in the peripheral countries and most others – is to apply public sector reforms in a way that does not continue to undermine growth.”


In the peripheral countries particularly, a range of measures have been proposed and implemented. This restructuring has involved broadening tax bases, increasing tax rates, improving tax collection, reducing public sector wage bills, and lowering the scale and duration of welfare payments. Competition laws have also been strengthened which have shown signs of reducing bureaucracy and made it easier to start businesses.


Two steps forward, one step back
Marie concludes, “As has often been the case with the eurozone since we began our forecasts in April 2010 recent developments have been two steps forward and one step back. As soon as the outlook improves and volatility declines, fresh concerns appear and new threats rear their heads. If there is to be a recovery later this year – and we believe on balance there will be – it will be a fragile one and policy makers need to keep a close eye on political and economic developments and be prepared to again respond quickly and effectively to deal with any potential crisis.”


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