Developed Europe: Regional Economic Review – Q2 2014

Euro-zone Economy Stalls; Ukraine Crisis Hurts Growth Driver Germany

Europe’s ability to sustain its economic recovery is back in the spotlight. The latest second quarter estimates of statistics agency Eurostat, which were released in mid-August, show that compared to the first quarter, GDP merely inched up 0.2% in the 28-country European Union (EU) but failed to grow at all in the 18-member Euro-zone. Compared with the second quarter of last year, GDP edged up 0.7% in the Euro-zone and 1.2% in the EU. These data appear to substantiate the growing belief that Europe is recovering too slowly to shake off its debt burden and to ignite large-scale investment and job creation.

Amid headwinds from the geopolitical tensions involving Russia, the Euro-zone economy was hit hard by the underperformance of its two largest economies — Germany and France. While France, which has so far failed to adopt structural reforms in a meaningful way, has been a laggard for several quarters now, an unexpected output contraction in regional growth driver Germany likely played the biggest role in keeping the Euro-zone economy stagnant from April to June. Nevertheless, barring Italy, which slipped back into recession again, most of the other economies in developed Europe recorded decent performances. Notably, Spain, the Netherlands, and Portugal posted strong growth.

In other developments, the Euro-zone’s unemployment rate slipped to 11.5% in June from 11.6% in May. What’s more, deflation concerns eased slightly within the single currency bloc as June saw producer prices of goods rising for the first time this year. In tune with an extremely subdued economy, price growth has been painfully slow in the Euro-zone for a long time now, making the region vulnerable to a deflationary spiral or a period of persistent decline in prices that is known to create a vicious cycle of falling profits, wages, and employment. Unfortunately, though, the June increase in producer prices appears to have been offset by setbacks in the current quarter. As such, the Euro-zone’s rate of inflation has remained persistently and significantly below the European Central Bank’s target rate of 2%. In July, the inflation rate declined to 0.4% from 0.5% in June. Moreover, several countries like France, Portugal and Spain have lately seen significant falls in consumer prices.

At a Glance

Germany:The economy contracted 0.2% in the April-June period, recording an output decline for the first time in over a year. New industrial orders dropped 3.2% in June compared with May, the second decline in a row.

U.K.:The economy recorded its sixth consecutive quarter of growth between April and June, expanding 0.8% compared to the previous quarter and 3.1% in annual terms. Home prices in the country, which lately have been rising too quickly amid concerns about a housing bubble, slipped 0.6% in June from May.

France:The economy stalled again in the second quarter, repeating its first-quarter performance of 0.0% growth. The government has revised downward its 2014 growth forecast from 1.0% to 0.5%.

Italy:After shrinking 0.1% in the first quarter, the Euro-zone’s third largest economy contracted 0.2% in the April-June period. Italy’s unemployment rate slipped slightly from 12.6% in May to 12.3% in June.

Spain: Spanish output expanded 0.6% between April and June compared with the first quarter, clocking its fastest pace of growth in six years. The Bank of Spain said that exports remained the key contributor to growth during the period.

GERMANY: ECONOMY CONTRACTS AFTER A YEAR OF ROBUST GROWTH

Germany, Europe’s largest economy and primary growth driver, had an unusually disappointing second quarter. The export-driven economy contracted 0.2% in the April-June period, recording an output decline for the first time in over a year. Most of the data published during the second quarter were in line with the poor GDP figures. For instance, both April and May recorded weaker factory production and construction data compared to the first quarter. New industrial orders dropped 3.2% in June compared with May, the second decline in a row, and the Organization for Economic Cooperation and Development’s leading indicator for economic activity in Germany remained in a downtrend, as of June. Further, reflecting subdued economic activity, the Mannheim-based think tank ZEW’s monthly survey of economic sentiment remained in a downtrend all through the quarter.

Several reasons have been attributed to Germany’s subdued performance in the second quarter. For one, the country lost an uncommonly large number of work days to vacation during the period. Secondly, much of the construction activity that is typically carried out in spring, or the second quarter, took place earlier than usual during the first quarter due to an especially warm winter. Germany’s Economics Ministry though believes that geopolitical tensions, primarily western countries’ sanctions on Russia, were one of the most important reasons for the second-quarter slowdown in Europe’s largest economy. Indeed, Germany’s exports to Russia declined 15% in the period between January and May. The June decline in new orders and the second-quarter downtrend in the ZEW economic sentiment index also suggest that amid the uncertainty triggered by the Ukraine crisis, many German companies likely held back investments, which hurt the economy as a whole.

Nevertheless, as the German Economics Ministry and several commentators have pointed out, the sanctions on Russia are unlikely to have had any direct impact on Germany in the second quarter and it was chiefly loss of business confidence that weighed on the economy. This argument seems valid given that Russia buys only about 3% of German exports. While it remains to be seen how the West’s standoff with Russia might affect Germany in the coming quarters, the overall picture of the German economy remains positive. For example, various monthly indicators, including the purchasing managers’ index, show that the country’s key manufacturing sector is still in robust health, with many orders to deliver. Moreover, Germany continues to boast an enviable employment rate and ultra-low borrowing costs.

THE U.K.: ECONOMY PASSES GROWTH MILESTONE AS GDP EXCEEDS PRE-CRISIS SIZE

The British economy recorded its sixth consecutive quarter of growth between April and June, expanding 0.8% compared to the previous quarter and 3.1% in annual terms. According to the Office for National Statistics (ONS), the dominant services sector, which accounts for close to 80% of economic activity in the country, grew a robust 1.0%, but manufacturing activity merely edged up 0.2% and construction declined 0.5%. What is most notable, however, is the fact that the British economy grew more than its previous peak in early 2008. At the end of June, GDP was 0.2% greater than its pre-crisis size, which means the economy has recouped all of the output it lost during the recession.

The U.K. has been recovering steadily for a while now; so much so that even the International Monetary Fund (IMF), which had chided the British government last year for “being excessively focused on austerity at the cost of growth,” has forecast that in 2014, the U.K. will clock the fastest pace of growth among industrialized nations. In fact, the IMF recently upgraded its U.K. economic outlook for the second time this year, predicting that output in the country would expand 3.2% in 2014. Nevertheless, despite its phenomenal momentum in recent quarters, the British economy has been facing criticism for remaining smaller than its pre-crisis size, especially given that peers Germany and France passed that milestone more than three years ago. So, having finally outgrown its previous peak, the U.K. economy now appears to be on firmer ground.

On another encouraging note, home prices in the country, which have been rising at a rapid pace lately amid concerns about a housing bubble, slipped 0.6% in June from May. However, in the three-month period until June, prices climbed 8.8% on an annual basis following an 8.7% rise in the first quarter. Notably, U.K. authorities have been trying hard to cool down the housing sector. In April, the country’s Financial Conduct Authority made mortgage affordability rules more stringent and not surprisingly, the next month mortgage approvals plunged to their lowest level since June 2013. The Bank of England (central bank), which has declared that the surge in home prices is “the biggest domestic risk to financial stability,” announced tighter mortgage lending norms for banks in June.

FRANCE: GOVERNMENT CUTS 2014 GROWTH FORECAST

The Euro-zone’s second largest economy stalled again in the second quarter, repeating its first-quarter performance of 0.0% growth. France’s statistics agency, INSEE, attributed the underperformance to a repeated decline in manufacturing output. Since the French economy has been swinging between contractions and nominal growth over the past two years, the latest GDP data did not surprise many commentators. However, what was unexpected is the fact that soon after the GDP figures were published, President François Hollande said austerity measures had made it impossible to achieve growth. On a similar note, Finance Minister Michel Sapin has acknowledged that his country is unlikely to meet its budget-deficit reduction target for this year. He has also declared that France has officially revised downward its 2014 growth forecast from 1.0% to 0.5%.

These statements and the outlook revision are significant because the French government had previously expressed optimism about its economy as well as the overall Euro-zone economy. The new stance not just calls into question the Euro-zone’s current focus on austerity but also likely signals a turnaround in the Hollande government’s own approach to dealing with France’s economic problems. In the wake of the financial crisis, France was forced to embrace austerity in order to reduce its debt burden and high budget deficit. As agreed with the EU Commission, the country needs to reduce its budget deficit to 3.8% this year and to 3.0% eventually. Toward this aim, the Hollande government announced last year spending cuts worth 50 billion euros and a series of tax hikes, including for corporates.

Not surprisingly, the moves hurt the economy more, especially because government spending accounts for a large component of French economic activity and businesses in the country had already been losing export competitiveness due to an inflexible labor market. Seemingly to offset the impact of the tax hikes and spending cuts, Paris announced in January new tax breaks for firms that would increase hiring. President Hollande’s latest statement on austerity indicates more such measures will likely be implemented in the future. In fact, the process appears to have started already — the president recently unveiled a new set of stimulus steps, including tax cuts for low-income households.

ITALY: ECONOMY IN RECESSION AGAIN; UNEMPLOYMENT RATE RECORDS A SMALL DECLINE

After shrinking 0.1% in the first quarter, the Euro-zone’s third largest economy contracted 0.2% in the April-June period. Thus, with two consecutive quarters of negative growth, Italy is now technically in recession, again. This is the third time in the last five years the southern European economy has slipped back into recession. Tellingly, the country has recorded growth in only one (the fourth quarter of 2013) of the past 12 quarters. What’s worse, having being stagnant for years, the economy is presently more than 9% smaller than its pre-crisis size. In fact, it is the same size as it was in the year 2000.

Italy holds the second largest sovereign debt in Europe, at 133% of GDP, and persistent underperformance is making it increasingly difficult for the Italian government to start reducing its debt in a sustained manner. But more importantly, the stalled economy reflects the vicious cycle Italy has been seemingly trapped in. Both hiring and investments have dwindled over the years in the face of weak domestic demand while, conversely, the uncertain income outlook and extremely high unemployment, especially among the youth, have played a role in keeping consumer spending subdued.

The only positive aspect of the latest quarterly contraction is that Rome is likely under added pressure now to carry out the structural reforms necessary to kick start the long-awaited recovery in the Italian economy. After taking office early this year, Prime Minister Matteo Renzi unveiled an ambitious agenda to reform Italy’s political system, the labor and product markets, the bureaucracy, and the judicial system. He has taken tentative steps in that direction, but has covered very little distance. Encouragingly, though, one of his key initiatives to streamline political institutions and curb public expenditure has crossed the first milestone in a long and complicated approval process involving both legislative houses. What’s more, the Italian Parliament has approved a package of measures to boost business, including reductions in energy costs and tax exemptions on investments. In another positive development, Italy’s unemployment rate slipped slightly from 12.6% in May to 12.3% in June.

SPAIN: SOARING EXPORTS CONTINUE TO DRIVE RECOVERY

Since emerging from a two-year recession in the latter half of 2013, Spain has been growing with surprising vigor; so much so that it has been widely acknowledged to be one of the best performing economies in the Euro-zone. In the second quarter too, the country was one of the brightest spots in the single-currency bloc. According to Eurostat, Spanish output expanded 0.6% between April and June compared with the first quarter, clocking its fastest pace of growth in six years. This is especially heartening given the muted performance of the other large economies in the Euro-zone, particularly Germany. Quoting preliminary data, the Bank of Spain (central bank) has said that exports remained the key contributor to growth during the period.

Indeed, Spain has come to rely heavily on exports over the past few quarters. After its real estate sector crashed in 2008, the country saw its unemployment rate soaring to near 25%. But on the flip side, as wages declined and companies focused on laying off their least productive workers, production costs in the economy dropped and Spanish goods became increasingly competitive in the global export market. Worryingly though, many observers feel now that Spain’s productivity gains have likely run their course and the country’s export-led recovery may peter out soon, especially since the global economic recovery has been rather inconsistent lately.

Whether the Spanish economy will sustain its current momentum remains to be seen, but clearly there are still hurdles in the country’s path. For one, the debt burdens of both the private sector and the public sector have not fallen enough for investments to pick up momentum. What’s worse, the unemployment rate continues to hover around 24%, crimping household spending. The first quarter did record a spurt in domestic demand, but there is no clear evidence yet that it is a trend. In fact, during the twelve months until July, consumer prices in the country dropped 0.4% — their steepest decline in nearly five years — suggesting that domestic demand is still very weak and Spaniards are extremely cautious about spending freely.

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