Eurozone Economy: Outlook (Near-Term), Problems and Solutions

May 19, 2016Europe/Middle Eastby Sher Mehta

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The Eurozone's economy faces many challenges, but the solutions are there.

This is an abridged version of this article.  For the full article please see here.

I was in Belgium in 2011-2012, when I witnessed the escalating ferocity with which the sovereign debt crisis undermined confidence and economic activity across the Eurozone. Four years later, in 2016, economic recovery from the crisis continues to remain fragile - with highly lackluster or tepid growth having become endemic in the Eurozone.

For a perspective, according to Eurostat data, the Eurozone grew by only 0.9% and 1.6% in 2014 and 2015 respectively. Further, according to projections by the European Commission, the Eurozone is expected to grow by only 1.6% in 2016 and 1.8% in 2017 (which is not surprising).

Essentially, ECB’s massive unconventional monetary stimulus has been keeping the Eurozone afloat and is likely to ensure that it continues to grow. However, monetary policy alone cannot pull the Eurozone out of its persistently torpid or sluggish growth.

Eurozone Economy - made a strong start to 2016

After growth moderated in the second half of 2015, the Eurozone economy regained momentum and made a strong start to this year - growing more rapidly than expected in the first quarter of 2016. This possibly indicates that despite a distressing backdrop of turmoil in global financial markets and weakness in demand for Eurozone exports from China.

Other emerging economies and large developed economies such as the US (which is Eurozone’s largest trading partner among non-EU countries and, according to ECB Statistics Bulletin, accounted for 13.7% of Eurozone’s exports (of goods) as of March 2016), ECB’s unconventional monetary policies are having some positive effect on domestic demand in the Eurozone

According to latest Eurostat data, Eurozone grew by 0.5% quarter-on-quarter (and 1.5% year-on-year) in the first quarter of 2016 - a marked pick up from the 0.3% growth in both the third and fourth quarters of 2015.

Notably, the Eurozone grew more rapidly than UK in the first quarter. Further, Germany, Eurozone’s largest economy, witnessed its strongest expansion for two years in the first quarter of 2016 (thanks to continued strength of domestic demand); it grew, according to Eurostat data, by 0.7% quarter-on-quarter (and 1.6% year-on-year), which was more than double the 0.3% growth rate recorded in the fourth quarter of 2015.

Moreover, growth firmed up in France (Eurozone’s second largest economy), economic recovery continued at a steady pace in Spain and the Eurozone witnessed continuation of the trend of falling unemployment (from 10.4% in December to 10.2% in March - according to Eurostat data).

Growth likely to moderate in the second quarter (somewhat significantly)

Unfortunately, certain economic data (March and April) seem to suggest that the spurt in economic activity witnessed in the first quarter of 2016 is unlikely to be maintained in the second quarter i.e. growth is likely to moderate (somewhat significantly) in the second quarter.

Economic Data (March): the Eurozone economy lost some momentum towards the end of the first quarter, possibly suggesting a softer economic outlook, moderation in demand and that economic recovery remains fragile; according to Eurostat data, Eurozone industrial production fell more than expected and sharply - by 0.8% (month-on-month) in March — after declining by 1.2% in February.

Further, among Eurozone’s five largest economies (Germany, France, Italy, Spain and Netherlands), industrial output, according to Eurostat data, fell month-on-month in Germany (by - 1.0% - the second consecutive month of decline), France (by - 0.3% - second consecutive month of decline) and Netherlands (by -1.2%) and stagnated in Italy (0.0%) in March.

Only Spain registered growth (1.3%) for the first time in four months. The outlook for industrial production does not seem promising. This is because strengthening of the euro and weakness in global economic growth are likely to weigh on the same in the second quarter. 

According to Eurostat data, Eurozone retail sales fell more than expected in March (by 0.5% month-on-month, after growing strongly in January and February) - registering the sharpest fall since July 2014 - indicating decelerating consumer demand. Further, disconcertingly, retail sales in Eurozone’s two largest economies, Germany and France, dropped (sharply) by 1.1% and 0.7% respectively in March - according to Eurostat data.

Economic Data (April): the start to the second quarter has not been too promising and economic data seems to suggest that though economic recovery continues, it is slowing.  Further, according to this survey, prices charged by business continued to fall - which will disappoint the ECB, who has been trying to boost inflation in the Eurozone.

What is particularly distressing is that manufacturing activity remains consistently subdued in the Eurozone, as weakness in global demand has been weighing on this sector. Further, the aggressive monetary stimulus by the ECB seems to be having little effect on the manufacturing sector.

Markit’s Eurozone manufacturing PMI for April edged up slightly to 51.7 in April, from 51.6 in March - despite deep discounting - and most Eurozone economies reported expansion in manufacturing activity (though manufacturing activity contracted in France).

The PMI reading for April was one of the weakest in the last one year with the index improving only marginally from a low base. This suggests that the manufacturing sector is struggling for momentum and acting as a drag on the wider euro area. 

Business confidence in Germany, Eurozone’s largest economy, dropped slightly in April - suggesting that economic momentum is slowing in Germany; according to the monthly Ifo Business Survey, the Ifo Business Climate Index dropped from 106.7 points in March to 106.6 points in April.

Further, reinforcing my view that the German economy might slowdown in the second quarter, after growth picked up strongly in the first quarter, is Markit’s April final composite PMI survey (manufacturing and services sector) reading for Germany.

It came in at 53.6 in April, when compared to 54.0 in March (i.e. private sector business activity cooled in April in Germany, though it remained well in expansionary territory).

Euro area annual inflation dipped into negative territory (-0.2%) in April (as energy prices dropped) - down from 0.0% in March - according to Eurostat data. Clearly, this underlines the threat of deflation hovering over the Eurozone economy and that aggressive monetary easing by the ECB is not having the desired effect on inflation.

The fall in oil prices and slowing growth in China and other emerging economies have been putting downward pressure on Eurozone inflation. Worryingly, core inflation, according to Eurostat data, eased from 1% year-on-year in March, to 0.7% in April.

I expect retail sales growth to have been disappointing in April (official data is yet awaited) and also likely to disappoint in the remaining months of the second quarter, due to subdued consumer confidence, muted wage growth prospects (despite improving labour market) and higher oil prices weighing on consumer demand.

This in effect means that economic recovery will moderate in the second quarter and is far from durable. For a perspective, for most of the past six quarters or so, Eurozone’s economic recovery (though lackluster) has been mainly due to higher consumer spending because of falling unemployment and rising real incomes (supported by low energy prices and incredibly low inflation).

Unless consumer demand proves to be strong enough to counter the impact of weakness in other parts of the Eurozone economy (for example, weakness in manufacturing, corporate investment and exports), economic recovery is likely to remain rather fragile.

Eurozone economic sentiment, which has weakened in the first quarter of 2016, picked up in April, it remains at subdued levels.  This indicates that though economic recovery will continue, it will be lackluster, according to the European Commission (EC).

The Monthly Economic Sentiment Indicator (ESI), a sound indicator of the Eurozone business cycle, picked up from 103.0 in March (lowest level since February 2015)  to 103.9 in April (the first rise in four months), yet it remained well below December’s reading of 106.6 (which was the highest for 2015) and January’s reading of 105. The ESI had fallen in every successive month between January and March - reflecting weakening economic sentiment in the first quarter.

Rise in economic sentiment in April was broad based i.e. it rose in industry, services and construction sectors, expect retail trade. Further, consumer confidence, according to European Commission’s survey, increased slightly in April (-9.3) from a 15-month low in March (-9.7) and after having fallen consecutively in every successive month of the first quarter.

Further, according to data from the European Commission, inflation expectations among firms and consumers also rose in April - The ECB tends to closely monitor inflation expectations for monetary policy decision-making.

While rise in economic sentiment and consumer confidence (and inflation expectations) in April is something to be positive about and indicates that economic recovery is on track, yet subdued readings on the same seem to be consistent with modest GDP growth in the second quarter at time when weakness in external demand is preventing a firm economic recovery.

Factors that will support Eurozone growth - particularly in the second half of 2016

Growth is likely to pick up gradually in the second half of 2016 (after it is expected to moderate in the second quarter), due to various factors stated below:

* improving labour market, gradual improvement or pick-up in private investment spending (as capacity utilization rises and due to very low borrowing rates coupled with easing of credit standards by banks on loans to firms which will be supportive of credit growth) - though investment growth is likely to be lower than the previous year due to the uncertain economic outlook

* a gradual rise in consumer spending (which is expected to be the key driver of growth)

* further policy easing by the ECB in March (i.e. expanded asset purchases and negative interest rates) to spur inflation and growth in the Eurozone

* fiscal policy, which is likely to be supportive of growth, mainly reflecting public expenditure (largely in Germany) related to the influx of refugees

However, overall growth (on an annual basis) will continue to remain subdued or lackluster in 2016, as suggested by European Commission’s Forecast.

Eurozone Economy - confronting several (11) formidable problems

The Eurozone economy is confronting several (11) formidable problems that pose a significant challenge for its policy makers:

Pace of Recovery: the pace of economic recovery is yet too slow and growth very moderate, uneven and fragile (very low interest rates and bond yields attest to the fragility of the Eurozone economy). Headline inflation has again fallen into negative territory (-0.2% in April), despite the massive monetary stimulus by the ECB - with growth too weak to raise it sufficiently and back to ECB’s inflation target of close to but below 2% anytime soon.

Fixed investment: seems to have slowed down a bit in the first quarter (official data is yet awaited) and is likely to pick up gradually only the second half of 2016.

According to ECB’s Bank Lending Survey for Q1, credit standards for loans to non-financial companies eased further in the first quarter of 2016.  A rise in net demand for loans was less pronounced when compared to the previous quarter due to fixed investment being a smaller contributing factor for loan demand than the previous quarter and when compared to other factors in the first quarter. This implies that fixed investment growth slowed down a bit in the first quarter of 2016 (official data on the same is yet awaited), when compared to the previous quarter.

For a perspective, according to Eurostat data, investment had jumped by 1.3% quarter-on-quarter (and 3.4% year-on-year - highest since March 2011) in the fourth quarter of 2015, after growing by a paltry 0.4% and 0.1% in the third and second quarter of 2015 respectively.

Without a firm recovery in investment, the Eurozone economy will just plod along. Essentially, corporate investment remains very weak in the Eurozone.

Economic Data: suggests that the Eurozone economy seems to have lost some momentum towards the end of the first quarter and that the start to the second quarter has not been too promising (as already stated above). Essentially, the Eurozone economy is again struggling to regain momentum.  

Easy Money and Real Economic Activity: easy money in the Eurozone (because of continuation of ECB’s unconventional monetary policies) is being used to boost asset prices (such as stock and real estate prices), rather than finance consumption or investment (that has been particularly weak since the global financial crisis of 2008-2009). As a result, growth remains subdued.

Liquidity Trap: the Eurozone is caught in a liquidity trap, which indicates that quantitative easing by the ECB is unlikely to stimulate aggregate demand, growth and inflation on its own.

Core Inflation: the possibility of the already weak core inflation (a more accurate indicator of demand in the Eurozone), which slowed from 1% year-on-year in March to 0.7% in April, could slide back over the next few months.

This is due to impact of the strength of the euro feeding through and because of increase in oil prices (which had earlier collapsed to below US$30 in mid-February and are currently around US$48-49 a barrel) which could lower demand for goods. Muted wage pressures and large output gap are already preventing any pick up in core inflation.

Public Investment and Structural Reforms: reluctance by some credit-worthy Eurozone governments, particularly Germany, to use public investment to spur short-term growth (both in the domestic and wider Eurozone area), put upward pressure on inflation, stimulate private investment and enhance long-term growth potential.

This, along with lack of sufficient resolve in the Eurozone to carry out badly needed structural reforms is severely constricting economic recovery and expansion.

The substantial unconventional monetary stimulus is leading to lack of incentives to carry out such reforms (that will enhance investment, competitiveness, productivity and growth) because countries in the Eurozone know that cost of borrowing will not rise even if they don’t reform or do not reduce their debt.

Debt, Productivity Growth and Aging Population: Eurozone debt levels (i.e. government, non-financial corporate sector and household debt as a percentage (%) of GDP) yet remain elevated and are restraining demand.

This results in continuation of sluggish growth in the Eurozone. For example, with reference to Eurozone government debt - consolidated  - (as a percentage (%) of GDP), the same, according to ECB data, rose sharply from 68.5% of GDP in 2008 to 90.7% in 2015 (and reached an all-time high of 92% in 2014) primarily as a result of fall in real GDP and rising bond yields. Further, lack of productivity growth and aging populations are also constraining growth in the Eurozone.

Negative Interest Rates: introduction of negative interest rates in March 2016 (along with expanded asset purchase program) by the ECB, in order to stave of deflation (amid a backdrop of lingering lackluster growth).

Inflation is likely to undershoot ECB’s target for a long time despite easing of financial conditions in the Eurozone, has led to erosion of profitability of Eurozone’s already fragile banks.

If interest rates go further into negative territory, it could incentivize banks to shrink lending (which in turn will dampen demand and overall growth), widely hurt profitability of the already fragile Eurozone banks (as they lower net interest income) and pose a threat to financial stability.

Existence of negative interest rates could create more pessimism about the Eurozone economic outlook among consumers and firms. This in turn could result in higher savings, particularly by those people who don’t hold financial assets such as stocks, and make firms more hesitant to undertake capital investment (at a time when they are already not investing enough and are highly risk averse) - thereby ensuring that subdued growth lingers on in this region.

Array of Challenges and Global Headwinds: existence of significant array of challenges and global headwinds are likely to continue to undermine confidence and growth in the Eurozone:

* the threat of Brexit (which has been undermining business confidence in the Eurozone in particular)

* the migrant crisis

* uncertainty regarding the Greek debt crisis

* Germany (Eurozone’s largest economy) likely to grow a shade lower this year than the tepid rate of growth (1.7% - according to Eurostat data) last year

* possibility of slower growth in China (which is Eurozone’s second largest trading partner among non-EU countries and, according to ECB Statistics Bulletin, accounted for 6.4% of Eurozone’s exports (of goods) as of March 2016)

* a stronger euro - that could lead to uncertain export growth prospects or falling export orders and adversely affect investment spending and hiring in the Eurozone, particularly in Germany

Existence of higher geo-political tensions and oil price volatility, improvement in emerging market currencies, assets and conditions in the last three months is fragile and likely to be temporary, possibility of resurgence of global financial market volatility in the second half of this year.

This could lead to falling stock markets, tighter credit conditions, lower business and consumer confidence and lower household wealth.

It could also see the likelihood of a continuation of headline inflation severely undershooting ECB’s inflation target (as underlying inflationary pressures remain very weak given the large output gap and muted wage growth prospects in the Eurozone) - though I expect headline inflation to somewhat recover and be moderately positive later this year, as energy prices rebound.

Italy - Worrisome Prospects: Italy, Eurozone’s third largest economy, faces gargantuan challenges that could result in a downward economic spiral in this economy - with serious negative consequences for confidence and economic activity in the wider euro area.

Italy is witnessing perilously high public debt, low potential growth, political instability, economic stagnation, huge negative output gap, high unemployment, debt-deflation mix and is badly in need of structural reforms. It is also grappling with stupendously high bad debts and non-performing loans in the banking sector and cuts in public investment. 

Structural Reforms and Public Investment - a compelling imperative for durable economic recovery of the Eurozone

Substantial or aggressive monetary easing by the ECB must be supplemented with structural reforms and enhancement of public investment, in order to take the Eurozone economy out of its prolonged economic torpor or rut.

Structural Reforms: these reforms are critically required to remove obstacles to investment demand, productivity, competitiveness and usher in more durable or sustainable and higher growth in the Eurozone.

Some examples of structural reforms that are critically needed are:

* lowering of minimum wages

* making labour markets more flexible

* liberalizing product and service markets and promoting competition

* undertaking tax and fiscal reforms

* putting in place a full or comprehensive banking union

* deepening capital markets to lower the substantial reliance of Eurozone firms on bank lending

* fixing the non-performing loans problem of the fragile Eurozone banks and restructuring them

* reduction of red tape and making it easier to start a business and encouraging entrepreneurship

* having a more suitable corporate insolvency framework.

Public Investment: despite several rounds of ECB’s unconventional monetary policies, Eurozone economic recovery remains fragile and the unemployment rate is high (above 10%). Monetary policy alone cannot accelerate economic recovery and shift growth into higher trajectory in a highly demand-deficient Eurozone with insufficient investment demand.

Fiscal stimulus is sorely needed to boost aggregate demand, short-term growth and raise potential output.

It also lowers debt levels in the Eurozone. Public investment should be raised collectively (on infrastructure projects) in the Eurozone, so that fiscal multiplier effects are higher or larger.

Advantage should be taken of the fact that bond yields of Northern economies of the Eurozone are historically low - which essentially means that long term interest rates are very low.

Consequently, money can be borrowed very cheaply (almost for free) to fund public investment. Such investment would probably be particularly effective in an environment of very low borrowing costs and have stronger knock-on effects on overall growth.  It will also stimulate private investment by enhancing business confidence in the economic outlook.

Further, since the cost of borrowing long term is currently so low and virtually free, it makes sense to undertake investment in projects with a rate of return that is far above zero.

This will have the beneficial effect of boosting economic growth and enabling faster repayment of debt (which is crucial, given that elevated debt levels are restraining economic expansion of the Eurozone economies in a big way).

It might be noted that public investment in the Eurozone has witnessed a dramatic reduction after the sovereign debt crisis. According to ECB Economic Bulletin, Issue 2 / 2016 – Articles, public investment in the euro area, which was stable at around 3% of GDP for more than a decade, started to rise in 2005 - reaching 3.6% of GDP in 2009.

However, according to this bulletin, in the aftermath of the crisis, public investment in the euro area has fallen to a ratio of below the pre-crisis average of 3% of GDP.  Further, the 315 billion euro European investment initiative – ‘Juncker plan’ – aimed at unlocking public and private investment to strengthen demand and revive ailing Eurozone economies - is unlikely to have much impact on growth. Much more needs to be done.

Unfortunately, stringent fiscal rules which are meant to prevent excessive budget deficits and build up of excess public debt (as a percentage (%) of GDP), are hindering public investment in the Eurozone. Therefore, they need to be made more flexible.

Eurozone economies are required to limit annual budget deficits to 3% of GDP and public debt to 60% of GDP (not all Eurozone economies have succeeded in achieving such rigorous fiscal discipline).

These rules are essentially restricting budget deficits and debt levels at a time when credit-worthy Eurozone economies in particular should be allowed to run larger budget deficits, in order to undertake public investment.

Further, given the compelling imperative for undertaking public investment, in areas such as infrastructure, in the Eurozone, it is critical to distinguish between borrowing for investment (that enhances productive assets and capacity) and borrowing for consumption (all government expenditure cannot be treated equally).

Equally important, public investment spending should not be taken into account in budget deficit calculations.

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