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Eurozone moving away from crisis mode but long-lasting scars will remain

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  • Long-term impact of financial crisis far more severe for eurozone than US and UK
  • Deflation could have a very negative impact on growth by raising real cost of debt

FRANKFURT, 20 DECEMBER 2013 – Despite signs of renewed growth across the Eurozone deep scars of the recession are likely to remain for years to come. While 2014 will be the first year of positive growth since 2011, as a result of an export recovery and easing of austerity measures, growth will remain low for the foreseeable future, according to the winter EY Eurozone Forecast (EEF).

The forecast predicts a contraction of 0.5% in GDP this year followed by growth of 0.9% in 2014. The Eurozone recovery will continue to be weak between 2015 and 2017 at 1.6% a year. However, despite the weak outlook for the region, joining the eurozone remains an attractive prospect for eastern European economies. Latvia will become the eurozone’s 18th member on 1 January 2014 and it is expected that Lithuania will follow suit in 2015.

Marie Diron, senior economic adviser to the EY Eurozone Forecast, comments, “As we head into 2014 conditions in the eurozone should continue to improve. There will be increased domestic demand as unemployment begins to stabilize and inflation continues to fall causing a rise in consumer spending.  However, the recovery must be based on a program of broader reforms aimed at boosting competitiveness.” 

Long-term scars
Comparing data from 1998 to 2007 and from 2008 to 2017 it is evident to see the long-term impact that the Eurozone crisis continues to have on the region. Annual GDP growth between 1998 and 2007 averaged 2.3% while between 2008 and 2017 it is expected to be at 0.4%.

The forecast shows eurozone GDP finally moving 3% above its pre-financial crisis peak by the end of 2017. In contrast, by that date, UK GDP is expected to be more than 8% higher and US activity is forecast to be 20% above its late-2007 level.

The report also highlights stark differences in the number of unemployed which will average over 17m between 2008 and 2017 compared with just over 13m in the previous decade. Investment across the region is also expected to contract by 0.1% per annum in the decade from 2008 to 2017 down from an average of 3.3% growth annually in the previous decade.

Mark Otty, EY Area Managing Partner for Europe, Middle East, India and Africa comments, “The eurozone is on the road to recovery but deep scars will remain from the crisis. Growth will continue to be low and unemployment, although now stabilizing, will remain high. This has significant implications for businesses in the region as they consider their long-term plans.”

Domestic demand to boost growth
The initial phase of the eurozone recovery was driven by net trade and EEF expects export growth to accelerate further, as global growth strengthens and boosts world trade. This is likely to be supplemented by domestic demand, which has been a sizeable drag on growth over recent years, but should improve from 2014. Austerity will also continue to weigh on growth but the drag will be considerably smaller than in previous years.

Conditions for households are also likely to improve. Consumers have endured a prolonged period of falling real wages and rising unemployment which has squeezed spending power. However, with inflation dropping back and unemployment stabilizing, this squeeze will ease and EEF expects to see consumer spending grow by 0.5% in 2014, after falling by an estimated 0.6% in 2013.

In addition, the investment climate is showing signs of improvement. Surveys of business confidence report firmer sentiment on the back of an improving outlook – both at home and abroad – and a reduced level of downside risk.

Marie comments, “These improvements should encourage cash-rich firms to begin committing to investment projects, although the extent to which investment recovers will be limited by credit conditions remaining relatively tight. As a result we expect investment to rise by 1.3% in 2014, after declining in 2012-13, and to accelerate further in 2015-17.”

Threat of deflation looms
Although positive signs are on the horizon risks still remain. Eurozone inflation has been moving worryingly low in recent months, reaching a four-year low of just 0.7% in October. Low inflation rates are not just prevalent in the peripheral economies but also in the core countries.

EEF forecasts inflation at just above 1% in both 2014 and 2015. If this is the case some precautionary easing of monetary policy would be warranted early in 2014 as insurance against deflation and to counter any tightening in credit conditions imported from the US once the Federal Reserve starts tapering.

Marie comments, “The surprise rate cut in November is unlikely to be enough to head off concerns about possible deflation. We believe that deflation would have a very significant negative impact on growth prospects for the eurozone economy by raising the real cost of debt.”

AQR a test for the ECB
he resilience of financial markets in the face of political turmoil in Italy and fiscal issues in the US has been a pleasant surprise. This reflects faith in the ECB as a backstop for eurozone bond markets and greater confidence in the outlook now that the economy has returned to growth. But this resilience cannot be taken for granted. The next big test is the ECB’s asset quality review (AQR) and the subsequent restructuring of the banking sector. Policy-makers must ensure that – at the very minimum – the relatively modest expectations of the markets are met so as not to threaten the current stability of the region.

Unemployment to stabilize
Rising unemployment has been a key concern throughout the eurozone crisis. However, recent data has been encouraging; with the rate having been broadly flat at the eurozone level over the latter part of 2013, and the countries with the highest rates of unemployment, such as Greece and Spain, reporting much smaller increases. However, the forecast confirms the long-term nature of the problem of unemployment in Spain and Greece which is set to remain over 25% even by 2017.

Marie comments, “A relatively weak recovery, combined with businesses trying to improve profitability and productivity, mean that there will be further modest rises in unemployment in 2014. However, this may prove to be unduly pessimistic and a more favorable labor market outcome would offer the possibility of a firmer recovery in consumer spending.”

Latvia joins the eurozone
Latvia will join the eurozone as its 18th member on 1st January 2014 with Lithuania expected to join in 2015. Despite the recent crisis the eurozone is still an attractive prospect for eastern European economies, because many already send a large chunk of their exports to the single currency area, so membership removes the exchange rate risk. There is also a perception that they are more likely to attract foreign direct investment as the cost of doing business with other eurozone countries would fall.

Marie concludes, “The loss of control over monetary policy in joining a currency area is a potential risk to small and open economies. However, taking into account earlier substantial internal devaluation and structural reforms, it is likely that both Latvia and Lithuania are well placed to adapt to eurozone membership.”

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