No Spring time for the Eurozone as risks abound

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FRANKFURT 4 April 2011: The Eurozone economy is growing at a much slower pace than expected at this stage of a recovery with GDP estimated to increase by only 1.5% this year and 1.7% in 2012, according to EY’s Spring Eurozone Forecast (EEF).

GDP growth this year, as with last, is expected to be mainly accounted for by exports, with world economic performance likely to remain robust, driven by both emerging markets and the US. Assuming that the nuclear situation is brought under control, the recent disasters in Japan are unlikely to have a significant impact. However, rapidly rising inflation is causing concerns, breaking the 2% barrier in December 2010, the first time since late 2008, and increasing further to 2.6% in March.

Unemployment across the area is also likely to remain stubbornly high. Even in 2015 EEF forecast unemployment to be around 14 million, still well above 2007 levels.

Marie Diron, Senior Economic Advisor to the EY Eurozone Forecast says, “Although we still expect a muted recovery for the Eurozone over the next 12 months that could easily be blown off course by global economic events or an escalation of the Eurozone debt crisis.”

Mark Otty, Area Managing Partner for Europe, Middle East, India and Africa, EY says, “Despite a pick up in the global economy, the Eurozone continues to face a challenging combination of concerns over sovereign debt, political instability and rising prices. Such an uncertain economic environment is continuing to put the brakes on business investment by corporates and subsequent job creation.”

Raising interest rates would be a mistake

Despite the rise in inflation, EEF believes an interest rate rise later this week, with subsequent rate rises later this year to try and dampen down the level of inflation, could potentially endanger the fragile economic recovery in the Eurozone. This is despite the fact that energy, raw material and food inflation are likely to remain high for some time. EEF forecast oil prices to only gradually decline from their current levels of around $110-$115/ barrel towards $95/barrel by the end of 2011.

Marie comments, “We do not believe inflation is a medium or long term concern as there is plenty of slack in the Eurozone economy and raising rates as a response to commodity-driven headline inflation is a policy mistake that risks impacting on GDP growth. We see no need for the ECB to make such a move as our forecast assumes that in 2012, as oil prices start to fall back, food prices return closer to fundamental levels and the effect of VAT increases from the beginning of 2011 disappear, inflation will again fall below 2%.”

But significant risks remain with oil prices

There are however significant downside risks to GDP growth and inflation related in particular to further tensions in the Middle East. EEF estimates that if oil prices were to rise and stay at $150/barrel, Eurozone inflation would be raised to around 3% this year and more than 2.5% in 2012. GDP growth would be cut to 1.2% this year and 1.3% next year. With oil prices rising to and staying at $200/barrel, inflation would rise to around 4% this year and remain above 3% in 2012 and GDP growth would remain at 1% for both years. But the negative implications that this would have for growth (in the Eurozone and the world economy) would suggest that non-energy inflation would decline in such scenarios.

Downside risks to growth still dominate

The negative impact of a sustained and deepening Middle East crisis could spread wider as it could trigger a reassessment of risks across financial markets, with share prices falling rapidly and risk premiums rising on a wide range of bonds. For the Eurozone, this could mean very negative developments if it led to renewed escalation of the sovereign bond crisis. While EEF attach a relatively small probability to such a scenario, the latest developments in Portugal are worrying and the consequences would be very serious.

Eurozone countries must also contend with the implementation of fiscal tightening. Marie says, “EEF believes that governments currently underestimate the negative impact of fiscal retrenchment on growth. Fiscal tightening on the current scale in so many countries at the same time has never happened before and even our relatively cautious assumptions about the negative growth impact could prove far too optimistic.”

EEF welcomes the decision to make the European Financial Stability Facility permanent and to increase its effective size. However, its mandate should have been widened to allow it to purchase government bonds under less restrictive conditions. Marie comments, “Short of significant steps towards closer fiscal union, imbalances and crises similar to the ones we have just seen will remain significant. Closer fiscal union would imply a loss of sovereignty that Eurozone governments do not seem ready to accept.”

Is the Eurozone still attractive?

Amidst all the gloom, it is easy to forget that the Eurozone can still remain attractive to potential joiners. On 1 January 2011, Estonia became the zone’s 17th member and the benefits of joining such a large market a large market and a relatively stable currency are already apparent. Marie explains, “Booming exports will push Estonian GDP growth to over 4% this year and there is no doubt that consumer confidence has been bolstered by Estonia’s entry into the Eurozone”.

Risks and uncertainties abound

Although the establishment of the European Stability Mechanism at the recent EU summit has brought some temporary relief, tensions mounted again as a result of the political instability in Portugal after the resignation of Prime Minister Socrates. The economic recovery in the Eurozone remains fragile and the possibility that Portugal appeals for financial assistance is now seen as nearly certain.

Marie adds, “Even if Portugal and the Eurozone muddle through this particular crisis the outlook remains challenging with the likelihood of a two speed or even three speed Europe that we have forecast for the last twelve months becoming even more entrenched.”

 

 

About the EY Eurozone Forecast

The forecasts and analyses presented in the EY Eurozone Forecast are based on the European Central Bank’s model of the Eurozone economy. This model embeds state-of-the-art economic theory and techniques and is used by the ECB to produce its quarterly forecasts of the euro area.