Sovereign debt crisis hits Eurozone economic growth

Years of stagnation in Southern Europe; GDP growth in North dependent on exports
 
Frankfurt, 24 June 2010 ― The imminent threat of default may have passed but the crisis is far from over in the Eurozone, according to Ernst & Young’s quarterly Eurozone Forecast (EEF). The EEF has revised its forecast for the region’s growth down to 0.8% this year and 1.3% for 2011. Furthermore, unless the Eurozone seriously tackles structural reforms that are the root of the massive challenges it faces, the risks of an economic “lost decade” like that of Japan in the 1990s are significant, particularly for countries in Southern Europe.

Marie Diron, Senior Economic Advisor to the Ernst & Young Eurozone Forecast said, “The repercussions of the sovereign debt crisis will mean economic growth in the Eurozone being 1-2.5% lower per annum than in the US over the next five years. The impact on jobs is just as striking. While during 2010-14, the US economy will generate more than 10 million new jobs, employment levels will barely change in the Eurozone.”

Mark Otty, Area Managing Partner, Europe, Middle East, India and Africa for Ernst & Young said, “The sovereign debt crisis has hit an already fragile Eurozone economy very hard. Businesses across Europe will look to their governments and to the pan European institutions for firm leadership and policy coordination. Muddling through is simply not an option if Europe is to be a long term contender on the world economic stage.”

A lost decade for Southern Europe?

Given the more drastic deficit reduction plans in Greece, Spain and Portugal that were announced in May, the two-speed Europe that the EEF highlighted in its April forecast is now expected to be even more marked. While GDP growth in the principal Eurozone countries in Northern Europe (Germany, France, the Netherlands and Belgium) is expected to average 1.7% per year in 2010-12, EEF predicts negative growth of  -0.1% per year in the same period in Southern Europe.

As a result GDP per capita in Greece will fall from 89% of the Eurozone average in 2007 to 83% in 2012. In Spain, it will fall from 93% of the Eurozone to 88%, a relative level last seen in 1998.

Diron said, “The South is heading not for just one or two bad years but for several years of very low, or even negative growth. Although Ireland, which is often included with its Mediterranean neighbors, will bounce back from 2011, Greece, Spain and Portugal are not expected to get back to their pre-crisis levels of activity until 2014.”

With notable divergence from the North

The forecast suggests the outlook in Northern Europe is relatively optimistic for two main reasons. Firstly, countries like Germany and the Netherlands enjoy strong competitiveness levels, after years of robust productivity growth and wage moderation and they are in a good position to reap the benefits of a robust recovery at the global level.

Secondly, while significant, the fiscal adjustment that is needed in the North is manageable and governments can push ahead with deficit reductions without impacting growth substantially.

Euro continues to weaken and interest rates on hold until 2011

EEF expects the euro to fall to US$1.05 by the end of next year, before rising back slightly as Eurozone growth picks up. In effective terms, against a basket of currencies representing the Eurozone trade structure, this means that the euro will depreciate by around 20% from its peak at the turn of the year. 

Diron explained, “Ongoing worries about the fiscal sustainability of some Eurozone countries, and their reluctance to tackle the underlying problems, are weighing heavily on the euro. The euro currently stands at around US$1.20, its lowest value since early 2006 and nearly 20% below its value at the beginning of 2010.”

Given the weaker growth outlook and the absence of inflationary risks, EEF believes that the ECB will keep interest rates on hold until mid-2011.

No rapid recovery in business investment

This will not be a business-led recovery either. EEF is forecasting a further 2.8% drop in business investment in 2010 after a dramatic 14% drop last year. From 2011 onwards the forecast does predict moderate growth in business investment but even by 2014 the level will not recover to pre-crisis figures.

Negative outlook for unemployment and consumer spending

Uncertainty about the economic outlook will encourage companies to postpone new hiring. There will be no fall in the unemployment rate across the Eurozone until 2012 and even with a modest decline to 9.4% by 2014 that is still 2% higher than in 2007. The number of unemployed will rise further, to peak at around 16.8 million in the first half of next year from under 16 million currently.

Together with cuts in benefits and/or tax increases in many countries, these combined factors imply muted income growth. As a result, private consumption is forecast to be broadly flat this year at last year’s depressed levels. Even in 2011, consumption growth is still forecast below 1%, gradually increasing towards 1.8%.

What’s next? 

According to EEF, monumental reforms will be needed to ensure that wide-ranging imbalances and structural weaknesses are addressed. Furthermore, the sovereign debt crisis has exposed fundamental flaws in the Eurozone’s institutions that require policy coordination to achieve a more sustainable monetary union.
Diron concludes, “While restoring sustainable public finances is necessary, the current trend to cut deficits in a very rapid manner, even in countries that do not have any problems to finance their deficits and refinance their debt, risks being counter-productive. In particular, countries that can afford to reduce their deficits more gradually should do so in order to help sustain growth in the Eurozone in general and in the South in particular.”

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