Despite cautious optimism Eurozone to lag rest of the world during recovery
19 March 2014
- Unemployment to remain at 11% until at least 2018 is major drag on growth
- Divergence now within core countries rather than periphery
Although the Eurozone is now growing it is still expected to lag well behind other major economies during the recovery, according to the spring EY Eurozone Forecast (EEF). The forecast shows that Eurozone GDP in 2018 will be only about 5% above its pre-financial crisis peak in Q1 2008. In contrast, EEF expects UK and US GDP to be 12% and 23 % respectively higher over the same period.
After two years of decline, the forecast predicts growth of 1% in the Eurozone 2014, followed by a pickup to 1.4% in 2015, which is still weak, particularly compared to the growth seen in the first half of the last decade, and then only slightly faster growth of about 1.6% a year in 2016-18. However, there are reasons for cautious optimism as there will be a gradual recovery in consumer spending and business investment.
The return to modest growth and stabilization in debt burdens should mean the possibility of a Eurozone breakup recedes further The accession of Latvia earlier this year and the probable accession of Lithuania next year have given a welcome boost to faith in the single-currency zone.
Tom Rogers, senior economic adviser to the EY Eurozone Forecast comments, “The Eurozone recovery is likely to gather momentum this year but risks to the forecast do remain. While the risks of a breakup have diminished and some of the peripheral countries have surprised on the upside, deflation and unemployment will remain ongoing concerns.”
Mark Otty, EY Area Managing Partner for Europe, Middle East, India and Africa comments, “Although the overall outlook remains patchy, there is finally some more positive news to report in this forecast, particularly in the peripheral countries in the Eurozone. As their economies continue to rebalance and their labor forces become more competitive, businesses from the rest of the Eurozone and other parts of the world could gain a competitive advantage by expanding or moving operations into these countries.
Divergence extending to core countries
The forecast predicts a variable pace of recovery across different member states. Divergence is nothing new, but the divide is no longer simply between the core and peripheral countries. Some of the peripheral countries that have implemented painful reforms in recent years, notably Spain and Ireland, are benefiting as world trade picks up. EEF now expects Irish GDP growth of 1.8% this year, while Spain is set to return to growth of 0.8%.The fastest growth in the Eurozone is expected to be seen in the newest member, Latvia, which is projected to grow by over 4%, followed by Estonia at 2.5%.
By contrast, GDP growth in France is forecast at only 0.7%, below the Eurozone average. Other core countries, including Belgium, the Netherlands and Finland, are also set to experience very subdued growth, adding to concerns about their medium term prospects.
Deflation still a threat to growth
Tom comments, “As a result of the ongoing deflationary threat, the need for the ECB to be prepared to loosen monetary policy further remains high. Latest inflation data show that the danger of deflation is very real and even assuming a steady recovery unfolds we expect inflation to remain well below the ECB’s target for some time.”
EEF forecasts Eurozone inflation of just 1.1% on average in 2014, with a modest uptick to 1.5% in 2015. But with an output gap estimated at around 4% of GDP in 2014, the risks to EEF’s inflation projections are on the downside. Deflation would increase the real value of the debt stock, while at the same time depressing the tax revenues that service it. As a result, deleveraging would need to happen via further austerity, and in a worst case scenario, debt restructuring.
One source of upside risk to growth is on the government side. With less pressure from financial markets and the European Commission, governments may allow some easing of fiscal targets, particularly if accompanied by further reform efforts that improve longer-term debt sustainability. The possibility of higher spending could mean that the drag on growth from fiscal austerity will be lower than we currently expect. In turn, this would enable stronger private sector demand to emerge, resulting in a virtuous circle.
As well as the possibility of less fiscal austerity than currently expected, it seems likely that the Eurozone’s monetary stance will start to diverge from US policy in 2014. This should help the euro to start to weaken against the US dollar, and perhaps give an even larger boost to exports than is currently expected. EEF estimates that the euro is currently overvalued by around 10%, so a weaker euro would certainly be welcome news.
Unemployment to remain high
As well as tight credit conditions, a key factor in the forecast of subdued consumer demand in the coming years is the high level of unemployment. The unemployment rate at the Eurozone level has flattened out at about 12% in recent months and the countries with the highest rates of unemployment, such as Greece and Spain, are reporting much smaller rises. But the weak recovery that EEF predicts for the Eurozone, combined with businesses trying to improve profitability and productivity in the face of tight credit conditions, means that unemployment will fall only very slowly in the next two years.
The forecast shows unemployment in the Eurozone averaging 12% in 2014, slightly lower than 2013, before edging down gradually to 11% in 2018. But, as with GDP growth rates, wide labor market divergence among member countries will persist. The jobless rate in Greece is projected to climb to 28% this year, before falling slowly to just under 25% in 2018, while the Spanish rate is expected to fall to 25% this year, and then to 23% in 2018. In contrast, Austria and Germany will continue to have the lowest unemployment rates, at about 4.5% and 5.3% respectively, over the 2014-18 period.
While current levels of unemployment in some Eurozone countries are worryingly high, youth unemployment is an even greater concern, especially in the periphery. Spain and Greece have youth unemployment rates of over 50%, while Slovakia, Italy and Portugal have rates of above 30%.
Tom concludes, “The Eurozone has come a long way in the last 12 months and the risk of a breakup of the currency union now seems to have subsided. However, risks such as deflation, growing divergence in the core countries, and the social costs of high unemployment persist, and the outlook for medium to long term growth remains weak by historical standards”
Read the spring EY Eurozone Forecast (EEF) for more information.