Eurozone economy improves thanks to big economies

Data released Friday 12 confirmed that the Eurozone, as well as the U.S. (+3.5 % q/q annualized) and China (+8.9% y/y), joined the global recovery in the third quarter. In line with the improvement recorded in industrial production, Eurozone GDP grew 0.4% q/q, only slightly lower than the +0.5% q/q expected by the consensus. German GDP, +0.7%, came in substantially in line with market expectations, while French GDP, up 0.3% q/q, fell short of expectations of +0.6% q/q. This was the second consecutive quarter of growth for both countries, which therefore confirmed that the worst may be behind them. Italian GDP gained 0.6% q/q in Q3, below consensus forecast of +0.8% q/q, but its first increase after five quarters of contraction.

The ongoing recovery is highly likely to persist into the coming quarters. The European Commission has recently revised higher its 2010 economic growth forecasts, with the Eurozone economy seen improving by 0.7% from -0.1% projected in April. The ECB Survey of Professional Forecasters is even more optimistic, with an expected growth rate of 1% in 2010. According to the European Commission and other major international organizations, economic growth rates will differ from one country to another. In particular there is a clear divergence between the recovery expected for the Euro area’s leading countries (Germany and France are seen improving by 1.2% and Italy by 0.7%) and the so-called peripheral countries (Ireland -1.4 %, Greece -0.3%, Spain -0.8% and Portugal +0.3%). These projections offer clear evidence that the countries that, more than others, benefited from the housing and credit market bubbles have still a long way to go before they pull themselves out of recession and that a return to growth, albeit below the average for the whole Eurozone, should not materialise before 2011. Therefore, the -0.3% q/q in Spain’s Q3 GDP did not come as a surprise. With the unemployment rate seen exceeding 20% in 2010, the chances of a quick upturn in the Spanish economy look slim. Indeed several factors may continue to penalize the peripheral countries over the coming years. First, the sharp growth posted in the last few years, due to a higher increase in the labour cost per unit of manufacturing output than in other countries, has lowered the peripheral countries’ competitiveness against the Eurozone countries through a devaluation of the real exchange rate. Second, given the bursting of the housing bubble, which slackened consumer spending and therefore inflation, real interest rates in these countries are higher than in the rest of the Euro area. Hence, while the housing bubble was being inflated, the ECB monetary policy was over-expansionary for the peripheral countries but excessively restrictive for the biggest countries in the region. Now the situation could paradoxically reverse.

For these reasons, the task of pulling the Eurozone economy out of recession is in the hands of its major countries. Specifically, Germany appears to be the leading candidate to act as the driving force – not only for its big size. Unlike other countries such as Italy, Germany might still implement a large fiscal stimulus to revive its domestic economy, with the deficit/GDP ratio that could mark the 3% threshold in 2010 (without falling back to this level until 2013) and the debt to GDP ratio that could reach 80% in 2011. In this direction goes the new fiscal stimulus announced by the Merkel’s administration aimed at boosting consumption and investment to rebalance an economy excessively skewed towards exports. Thanks to the efforts to contain labour costs, Germany has enhanced its own competitiveness and boosted exports (as proven by its huge current account surplus) in the last few years but has seen the investment/GDP ratio decline from 21% in 2000 to 18% in 2009, while the household consumption/GDP ratio has hovered around 55% over the course of the past 15 years. Nevertheless, given the sharp decline in consumption in Germany’s major export markets, the country’s export-driven growth model may be put at risk in the medium term. Policies aimed to stimulate domestic demand and investments, would be necessary at a time when they could shrink further in the face of the global downturn. Indeed, the Office for National Statistics’ announcement that Q3 growth was driven by a recovery in exports and by an increase in business investment comes as a very positive indication. Personal spending which weakened in Q3, may improve slightly in the coming quarters in spite of the negative trend shown by the labour market should German families decide to reduce their savings rate (over 11% of disposable income in 2008). Another boost to German domestic demand could also be provided by a continuation of an expansionary monetary policy by the ECB. Due to a rising Euro against major international currencies, in fact, the Monetary Conditions Index (MCI) is well above its historical average. Furthermore, considering that inflation might stay below 2% throughout 2011, the Taylor rule does not seem to require a rate hike until late 2010.

The medium term outlook for France and Italy looks rosy. France, which the European Commission expects to grow as much as Germany in 2009 (1.2%), will likely continue to be led higher by private consumption, while investment should stay stagnant. In Italy, a major positive came from OECD leading indicator, the highest within a panel of European countries in September. Notwithstanding the well-known structural problems facing the Italian economy and highlighted by the sharp increase in the real exchange rate in the past few years, and the country’s huge public debt, the Italian economy could surprise to the upside going forward.

How long will the Eurozone (and the ECB) cohabit with an overvalued Euro? Why the euro’s fall is key for the Eurozone economy...

According to all major international agencies, 2009 and 2010 economic growth is likely to be more subdued in the Euro area than in the US. In their latest Reports, both the IMF and OECD have predicted a contraction above 4% for the Eurozone in 2009 with a slightly negative growth rate also expected in 2010. By contrast, the two agencies have estimated flat US growth in 2010 in the face of a less severe downturn in 2009 (-2.8% and -4% for the IMF and OECD respectively). In the recently published Global Development Finance report, the World Bank has been more positive on the Eurozone’s outlook for 2010, assuming a 0.5% growth rate. Nevertheless, this is well below the 1.8% rate forecast for the US.
All European countries have been hit hard by the global turmoil, even though for different reasons. Indeed, while countries such as Ireland and Spain have borne the brunt of the bursting of the housing bubble, Germany, Europe’s largest country, has suffered the consequences of a slowing international demand due to the manufacturing sector’s strong dependence on exports. France has weathered the crisis relatively well so far, while Italy has felt the pain of the credit crunch without the possibility of taking effective countermeasures as the high public debt level is a big constraint for the Italian government.
Notwithstanding the monetary and fiscal stimulus packages launched in the last few months, the outlook for the Eurozone remains gloomy. No economic factors are likely to provide any boost to economic growth.
The countries that have reaped the benefits of the house prices bubble in the last few years (i.e. Spain and Ireland), which increased consumer spending and broadened the current account deficit, are now paying for past excesses and should post modest growth (if not negative) in the years to come.
On the other hand, the countries that are highly dependent on exports (i.e. Germany) should not be favoured by an upswing in global demand, which should to remain sluggish for a long time. Indeed, demand in emerging markets is highly unlikely to offset a weakening demand trend in the US, at least in the near term. The real challenge facing these countries will be building a stronger domestic demand going forward.
With the Refi rate at 1% and the ECB unwilling to carry out a sweeping quantitative easing programme following the EUR60bn package established to fix the covered bond market, the only boost for the European economy could come from the Euro’s devaluation. A study presented in 2001 by some OECD’s economists (“Standard shocks in the OECD interlink model” by Dalsgaard, Andrè and Richardson) indicated in +0.6% both in the first and second year of estimate the increase in Eurozone GDP due to a 10% depreciation of the Euro. The projected rise in the inflation rate (+0.4% in the following two years) should not be cause for concern in this current scenario as the yearly inflation rate was flat in May and negative readings are expected in coming months.
Moreover, researches conducted by the INSEE and Morgan Stanley in the last few years have highlighted that Eurozone GDP would react to a currency shock with almost no lag, while a rate cut in short-term interest rates would take much longer to feed through the economy.
In spite of the decline against the US Dollar from the record level hit in 2008 (slightly above 1.60), the Euro remains overvalued against the greenback: according to the Purchasing Power Parities estimate of the OECD, for example, a fair Euro/Dollar exchange rate should be 1.20, implying depreciation potential of above 15% for the single currency. The nominal effective exchange rate relative to the 12 major international countries calculated by the ECB suggested that the Euro is 10% above the long-term average and various measures of real effective exchange rates painted a similar picture.
Based on the above-mentioned researches, it is easy to understand that the overvaluation of the Euro is heavily weighing on the economic prospects for the Euro area. A fall in the Euro to a level more in line with the long-term average and with the PPP should help lessen the uncertainty over the Eurozone outlook...