The eurozone economy ground to a halt in the second quarter. GDP was literally flat compared to the previous quarter, which marked a slowdown compared to the meagre 0.2% growth rate seen in the first quarter. The outcome was even weaker than economists’ lowered expectations. The report has once again shun a critical spotlight on Europe’s economic performance. In this week’s Big Picture we try to answer some of the big questions that arise.
The eurozone’s recovery remains disappointing, and policymakers should do more to strengthen economic growth.
Nick Kounis Head of Macro Research
We conclude that the weak Q2 number likely overstates the weakness of the eurozone economy. In addition, fundamentals point to resumption of growth in the second half, despite risks related to the Ukraine crisis. Still, the eurozone’s recovery remains disappointing, and policymakers should do more to strengthen economic growth.
What explains the weak Q2 number?
The full details of the GDP report have not yet been published. The industrial sector looks to have been particularly weak, which could be down to soft external demand. Earlier in the year, the two other giants of the global economy, the US and China, were going through a period of weakness. The US economy contracted in Q1 due to the particularly harsh winter weather, while the Chinese economy slowed down. It is possible that this has affected eurozone industry with a lag. Perhaps more importantly, the negative impact on exports of the past strength of the euro is likely still feeding through. The other area of weakness is construction output. In contrast to the US, the eurozone benefited from a particularly mild winter, which led to a surge in construction in Q1. Q2 was payback time. On the other side of the spectrum, data on retail trade and car sales suggest consumer demand continued to gradually recover.
How does the eurozone recovery compare?
The short answer is not very well. This recovery compares unfavourably both in terms of the eurozone economy’s own history, but also internationally. Over the last year, the economy has grown by just 0.7%. The peaks in annual GDP growth that we saw in 2000 and 2006 were around the 4%-mark. Following the recovery from the financial crisis in 2008/09, annual GDP growth reached 2.6% in Q1 2011. Looking at other advanced economies around the world, the US economy grew by 2.4% in the year to the second quarter and the UK by 3.2%. Granted, Japan’s economy was flat over that period but that partly reflects the effects of a major hike in its sales tax. Even top performers in the eurozone – such as Germany – do not get close by the US and UK growth rates. While the bottom performers, such as Italy, actually did worse than Japan. While the level of GDP in the US and UK is now higher than the peak before the global financial crisis in 2006, in the case of the eurozone it is significantly lower. The unemployment rate is at 6.2% in the US, 6.5% in the UK and 11.6% in the eurozone. Of course, this is not a strictly fair comparison, as the eurozone has had to deal with two back-to-back crises. Indeed, where we are today is far from the worst case scenarios we were worried about in 2011 and 2012, during the height of the eurozone’s sovereign debt problems. However, it is difficult to imagine that there are many Europeans that can look at the performance of the economy and labour market with any kind of satisfaction.
Is the economy now set for a new slowdown?
Before the tone becomes too depressing, it is probably time to discuss some good news. It seems unlikely that the slowdown in GDP growth in Q2 marks a new trend for the coming quarters. Granted, the recovery is not very impressive, but it does still looks to be on the rails. For instance, business and consumer surveys through to July are at levels consistent with stronger growth than we saw in the second quarter. Both the PMI and the European Commission’s economic sentiment indicator are consistent with growth rates in the 0.3-0.4% region. That is not spectacular, but it is likely consistent with trend growth in the eurozone and in line with the scenario of an ongoing moderate recovery. In addition, employment is growing modestly, and unemployment is on a slow downward trend, which is also not consistent with a stagnating economy. Fundamentals also point in the direction of moderate recovery. Global growth has been picking up in recent months, with the US rebounding strongly and China’s economy regaining some traction. Although the US often leads the eurozone, the two economies do not often move in different directions. It looks likely that stronger global demand will lead to a recovery in eurozone exports, which should provide support the economy as a whole. The weakening of the euro should help this process. Developments on the domestic side of the economy also look better. Financial conditions have been improving and the ECB’s recent bank lending survey suggests that demand for loans is rising and credit standards are easing.
What about the risks stemming from the Ukraine crisis?
Financial markets have been fretting about the possible fall-out from the Ukraine crisis for the eurozone economy over recent weeks. The direct trade and financial linkages between the eurozone and Russia are not very impressive. For instance, exports to Russia make up only around 4% of the eurozone total. The exports impacted by sanctions are of course only a small subset of that. However, the risks stemming from the Ukraine crisis cannot be dismissed completely. There is a possibility that confidence among businesses and consumers is negatively impacted, which can then have real economic effects as they adjust their investment and spending decisions. We do not expect such effects to be significant or long last lasting, but it is important to watch the upcoming survey data for August. Another risk is that the Ukraine crisis becomes much worse, which could then have bigger effects. The worst case scenario is that there is a disruption in energy supply, though fortunately the chances of that look small.
Who is to blame for the weak economic recovery?
After the GDP data were published, policymakers were quick to blame each other. France’s finance minister Michel Sapin reduced the government’s economic growth forecast for this year, while also abandoning its deficit target. The budget deficit target will now exceed the 4% level agreed early this year with the European Commission. He seemed to place the blame for this at the door of the ECB saying that the central bank needed to respond to an ‘exceptional situation of weak growth and inflation’ across the eurozone. It seems that France sees answer to the weakness in growth as being looser fiscal and monetary policies. Italian Prime Minister Matteo Renzi has also been making the case for ‘fiscal flexibility’. However, the ECB has been throwing the ball right back at the governments. In the central bank’s press conference earlier this month, President Mario Draghi responding to a question about Italy’s weak economic performance said bluntly that the ‘lack of structural reforms produces a very powerful factor that discourages investment’. Mr. Draghi certainly has a point. Spain has significantly outperformed both France and Italy in the first half of this year, even though of course it is subject to the same monetary policy regime. Spain – joined by Portugal and Greece – has been more active in terms of structural reform, while labour costs have fallen sharply, which has helped competitiveness. So there can be little doubt that the Italian and French governments need to play their role and finally get serious about structural reforms. Over recent months, the respective governments have started to make the right noises, but real action is necessary. On the other hand, the dramatic undershoot in inflation does suggest that the ECB has been too conservative with its monetary policy stance over recent years. Fortunately, it finally announced a monetary easing package in June, which it is still rolling out. In particular, the first two 4-year cheap loans to commercial banks (the so-called TLTROs) are scheduled for September and December, which could provide a significant stimulus. If these policies fail to gain traction, or if growth and inflation look to be falling further, the central bank should stand ready to put in place even more aggressive easing.
Is the Netherlands joining the top performers?
Unfortunately not. Dutch GDP rose by 0.5% (qoq in Q2), placing it close to the top of the growth performance league last quarter. However, that followed a 0.4% contraction in Q1. Unseasonably warm weather hurt gas exports and consumption at the start of the year, followed by a normalisation thereafter. Taking the two quarters together, growth still was a little less than the eurozone average. This looks likely to remain the case over the next few quarters. The most important factor is that households are still adjusting to the past correction in the housing market by paying down mortgage debt. This process is likely to hold back consumer spending. On the other hand, the Netherlands is well placed to benefit from the global economic upswing. The recent performance of exports (outside of gas) has been encouraging. Once the adjustment of household balance sheets is complete, we expect the Netherlands to move back up the growth league.