Summary: Eurozone growth was surprisingly strong in Q2 2010, but this momentum is likely unsustainable as the economy is now facing strong headwinds.
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Major headwinds to come
Eurozone growth was surprisingly strong in Q2 2010, but this momentum is unlikely to be sustained as the economy is facing headwinds. Investor relief on European bank stress tests lasted only a short while and concerns about the banking sector have re-emerged. Moreover, fiscal retrenchment only became significant in the middle of the year, with the full impact yet to come. Slow US recovery means that exports are unlikely to be as strong a driver of recovery as previously hoped.
Growth in Q2 unlikely to be sustained
Eurozone GDP growth in Q2 2010
Q2 is likely to mark the peak in growth for some time. With a marked slowdown likely in the second half of the year, Eurozone GDP is expected to rise by just 1.5% in 2010 as a whole and 1.4% in 2011. Eurozone unemployment is still expected to continue rising until mid-2011, to more than 16.3 million.
Banking sector still fragile
Banks still tightening credit
The stress tests suggested that the banking sector was in better shape than had been feared. Only a small number of banks failed and the amount of additional capital that European banks had to raise was relatively small. Nevertheless, Eurozone banks have been tightening credit standards further, partly due to their own difficulties in accessing funds and partly due to ongoing uncertainty about the outlook. So, while a collapse of a major Eurozone bank is not anticipated in the near future, tight credit is likely to continue to weigh on growth for some time.
Uncertainty about fiscal plans
The impact of fiscal tightening measures is estimated to amount to around 1% of Eurozone GDP next year, following the neutral fiscal policy this year and a boost of about 1% of GDP in 2009. It is still unclear to what extent governments will be able to deliver on their fiscal plans, which is reflected in still large spreads on government bond yields and financial market volatility. So, while the dire scenarios of sovereign debt default or even an EMU break-up seem more remote than in May, such developments remain risks for the next few years.
Commodity-fuelled rise in inflation
Sticky inflation
The Eurozone economy also needs to deal with a commodity-fuelled rise in inflation. While inflation rates remain relatively low, they are higher than would normally be anticipated in such weak economic conditions, reducing households’ and businesses’ purchasing power.
Companies and consumers remain cautious
Very slow recovery in investment
In this context, Eurozone companies and households are likely to remain cautious. Businesses will probably continue to postpone recruitment and investments, and consumer saving levels are likely to remain high. The European Central Bank (ECB) will therefore continue to face a difficult task balancing its desire to normalize monetary policy with the risk of hampering a fragile recovery. We expect that it will keep interest rates unchanged until mid-2011 and continue providing as much liquidity as banks need until shortly before that date.
Possible scenarios
• 50% chance that EMU continues to “muddle through”
Our baseline forecast is, in many ways, a best case scenario that assumes no significant escalation in financial tensions. The EMU would “muddle through” in its current form without going through a renewed financial crisis.
Default would occur if the fiscal adjustment proved too painful to sustain.
• 15% chance of a default by one country, then spreading to other
Depending on how it is managed, default by one country could lead to the contagion spreading to other countries. In the event of a default case, the negative effects on Eurozone growth would be much larger.
Our baseline forecast therefore represents a best case scenario for the financial environment. In the next best case scenario, default in one country – Greece is still the most likely country to default – is contained via organized discussions with its lenders and EU, ECB and IMF support to other countries in order to avoid contagion.
Even in this “ideal” default scenario, some tensions would emerge, however, pushing risk premia [ 1] up and denting business confidence. This would lead to lower Eurozone growth than in the baseline forecast for the first couple of years.
• 5% chance of disorderly default leading to the break-up of the EMU
A break-up could occur if a “core” group (comprising, perhaps, France, the Benelux countries and a few other smaller states) no longer wishing to be fiscally responsible for the weaker countries and not wanting the euro's reputation damaged by containing defaulting countries, decided to create a narrower monetary union.
Meanwhile, the defaulting countries, tired of fiscal austerity and facing massive problems in their banking sectors and with financing budget deficits, could decide to create new national currencies which are then devalued sharply in an attempt to boost growth.
• 25% chance of orderly default, probably Greece
An orderly default would be difficult to achieve. It would require Greece to achieve significant progress in fiscal restructuring. Even if it were not enough to make public finances sustainable, it would give creditors enough faith in the Greek Government’s ability to put public finances on a sustainable path once debt is restructured. This would and encourage the EU governments, the ECB and the IMF to act quickly and decisively to shore up other countries.
On this basis, if Greece were to default, the risk of contagion would be high. Contagion, and, in particular, the financial panic and risk aversion that it would ensue, would imply a much higher and longer-lasting cost to Eurozone growth.
South lags behind in employment and growth indicators
Employment intentions still low
The employment intentions indicator has improved markedly in the North, and especially in Germany. This is also reflected in trends in unemployment rate.
To take two extreme examples:
• German unemployment rate has been falling over the past year, to 6.9% in July
• Spanish unemployment rate keeps rising, at 20.3% on the latest reading
Especially in the South
In many parts of the Eurozone, productivity remains below pre-crisis levels, which suggests that there is some room to increase activity with only limited rises in staff numbers. Despite a weaker employment outlook now in the US than at the time of our last report, we still expect 8.5 million more jobs to be created in the US over 2010-14 than in the Eurozone.
Eurozone unemployment is still expected to continue rising until mid-2011, peaking at more than 16.3 million.
Employment, total
Slow consumption
Sluggish labor markets continue to undermine employees’ bargaining power and put a lid on wage increases.
Consumption is expected to be particularly weak in the South where unemployment is higher, public sector wages and employment cuts are greatest, and VAT hikes are concentrated.
No consumption growth in the South
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