Is the best already behind us?
Q2 brought surprisingly good news for the Eurozone but the pain is only just beginning Frankfurt, 30 September 2010 – Eurozone growth was surprisingly strong in Q2 of 2010 but this momentum is unlikely to be sustained as the economy faces up to strong headwinds, according to Ernst & Young’s latest quarterly Eurozone Forecast (EEF). As a result the EEF has revised its forecast for the region’s growth up to 1.5% this year, primarily based on a remarkable performance by the German economy in Q2, but still predicts a below trend growth of 1.4% for 2011. Eurozone unemployment is still expected to continue rising until mid-2011, peaking at more than 16.3 million.
Marie Diron, Senior Economic Advisor to the Ernst & Young Eurozone Forecast says “Q2 is likely to mark the peak in growth for some time. The full impact of the announced spending cuts and tax increases across Europe are yet to come. And signs that the US recovery is slowing mean that exports are unlikely to be as strong a driver of recovery as had been previously hoped.”
Even a robust German economy is unlikely to shield the Eurozone from the combination of negative factors it now faces. The EEF predicts growth to fall back sharply in the second half of 2010 and remain weak for the foreseeable future.
As a result Eurozone companies and households are likely to remain cautious. Businesses will probably continue to postpone recruitment and investment decisions, particularly in Southern Europe, and precautionary saving by consumers is likely to remain high. Mark Otty, Area Managing Partner, Europe, Middle East, India and Africa for Ernst & Young says, “Despite the more positive news in Q2 2010 businesses across many parts of Europe remain pessimistic about the short to medium term outlook and are still reluctant to invest and recruit new staff. It could be 2015 before pre-recessionary levels of business activity are reached.”
A stressed banking sector
The stress tests published in late July suggested that the banking sector was in better shape than had been feared. Only a small number of banks failed and the amount of additional capital that European banks were required to raise was relatively small. Nevertheless, Eurozone banks have been tightening credit standards further, partly because of their own difficulties in accessing funds and partly because of to ongoing uncertainty about the outlook. This has serious implications for any sustained recovery in business investment in the Eurozone given how dependent companies remain on bank loans.
Marie comments, “While the intense pressure the Eurozone was under last May has passed and a collapse of a major Eurozone bank is unlikely to happen in the near future, tight credit is likely to continue to weigh on growth across Europe for some time.”
The pain is only just beginning
The swing from expansionary to contractionary fiscal policy is creating a further obstacle to growth. Governments across the Eurozone are proceeding with the implementation of spending cuts and, in some cases, tax increases. The EEF predicts that the fiscal measures will reduce GDP growth in the Eurozone by 1% next year compared with a neutral contribution this year and a 1% positive boost in 2009.
As Marie explains, “Fiscal retrenchment in the first half of 2010 had a limited impact. The full effect of these measures will only be significantly felt in the second half of this year and then further in 2011. The pain is only just beginning. ”
It is still unclear to what extent governments will be able to deliver on their fiscal plans, and that uncertainty is reflected in still very large spreads on government bond yields and financial market volatility. So, while the dire scenarios of sovereign debt default or even an European Monetary Union break-up seem more remote than in May, such developments remain risks within the next few years.
Inflation adding to caution for households and business
The Eurozone economy also needs to deal with a commodity-fuelled rise in inflation. While inflation rates remain relatively low, they are higher than would be normally anticipated in such weak economic conditions, reducing households’ and businesses’ purchasing power.
A difficult path ahead for the European Central Bank
The ECB will continue to face a difficult task balancing its desire to normalize monetary policy as quickly as possible and the risk of hampering a very fragile recovery. EEF expects that the ECB will keep interest rates unchanged until mid-2011 and continue providing as much liquidity as banks need until shortly before that date.
Marie concludes, “The forecast for the Eurozone economy is a prolonged period of weak growth. Modest recovery in some of the countries in Northern Europe will be dragged down by the south of the Eurozone embarking on a painful fiscal restructuring. If anything, our forecast predicts a widening between the two regions.”
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About the Ernst & Young 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.
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