Renewed struggles in the eurozone

November 2014  |  COVER STORY  |  ECONOMIC TRENDS

Financier Worldwide Magazine

Following years of uncertainty and stagnation, the global economic outlook has improved. Favourable economic conditions in emerging markets across Africa, Asia and Latin America have boosted talk of the nascent global recovery truly taking hold. Additionally, the uptick in the United States appears solid. Both China and India have seen their economies strengthen recently.

Yet for all the optimism and growth elsewhere, in the eurozone the recovery has failed to gain real traction. Many of the bloc’s largest economies have underperformed in recent years. While the UK and other non-eurozone European nations showed signs of encouraging growth, lacklustre figures from Germany and France, the eurozone’s two biggest economies, have combined to prolong the region’s economic slump throughout the last 12 months. Germany suffered a 0.2 percent fall in GDP in Q2 2014, capital investment dropped 2.3 percent and construction declined 4.2 percent. In light of Germany’s economic difficulties and the worsening political tensions in Ukraine and the Middle East, earlier this year the Association of German Banks (BdB) was forced to cut growth forecasts for the country. The BdB reduced its growth forecast by 0.3 percentage points to 1.5 percent for 2014 and 0.4 percent for 2015. The BdB expects the German economy to grow by just 1.6 percent next year. Although the Ukrainian crisis has had a detrimental effect on the continent’s wider economic outlook, reciprocal Russian sanctions are likely to heavily impact manufacturing output across Germany in the coming months.

France too has endured a difficult 2014. According to finance minister Michel Sapin, the French government will miss the EU’s 3 percent budget deficit target this year. The French government has also confirmed that it will miss its budget deficit reduction target for the year, which was set by the EU. France will end 2014 with a deficit of 4.4 percent of GDP, falling only slightly in 2015 to 4.3 percent. Growth in 2014 will be around 0.4 percent, missing the estimated 1 percent. The European Stability and Growth Pact requires countries to have budget deficits below 3 percent of GDP and debt below 60 percent.

With Germany and other major European economies in recession, growth in the eurozone will remain elusive for the foreseeable future. Italy, the currency bloc’s third-largest economy, announced in August that on the basis of Q2 2014 data, it too had fallen back into recession for the third time since 2008. In Q2 the Italian economy contracted by 0.2 percent. As a result of the country’s perilous financial position, pressure on Prime Minister Matteo Renzi has intensified. There are increasing calls for Mr Renzi to fully implement structural reforms to resurrect the national economy.

Against the backdrop of this poor economic outlook for the region, serious questions are being asked about the future of the eurozone. Individual countries have undoubtedly underperformed in recent years, growth seems unlikely and unemployment remains high. In light of these struggles, the Organisation for Economic Cooperation and Development (OECD) has cut its 2014 GDP growth forecast for the eurozone by a third. The OECD now predicts growth of 0.8 percent, down from 1.2 percent.

For some observers, including the OECD, pessimism and declining growth rates have once again become the norm across much of the eurozone. Although bloc-wide recession is by no means certain, it is extremely likely that the eurozone will continue to flounder unless changes are made. “Such an anaemic growth rate is insufficient to put the eurozone economy back on its pre-crisis track, and to reduce the high level of unemployment in the area,” says Gennaro Zezza, a research scholar at the Levy Economics Institute of Bard College and an associate professor of economics at the University of Cassino. “As some commentators have pointed out, the growth strategy of the eurozone seems to rely increasingly on foreign markets for an expansion in sales, while keeping real wages down to enhance competitiveness, and persevering in fiscal austerity to drive down government debts, especially in peripheral countries. It is difficult to believe that this strategy will generate a sufficient increase in output in the eurozone, unless other high-growth countries outside the area are willing to increase their current account deficit against the eurozone.”

However, other analysts are not convinced that further recession can be avoided. With the German economy, which provides a third of the eurozone’s total GDP, suffering its first contraction since 2012 and the ongoing travails in a number of the zone’s largest economies, the outlook appears bleak. In some respects, the eurozone’s economy has never truly recovered from the first two periods of recession endured between 2008 and 2010. This time, however, potential recession is being driven by the region’s historic economic powerhouses. Where the weaker economies in the south and to the eastern edge of the zone were at the vanguard of the previous eurozone recessions, we appear to be entering a new paradigm of economic troubles in Europe.

Austerity

The bulk of the sluggish eurozone economies, most notably Germany, have been proponents of European austerity for a number of years. Although the tactic has been championed by key political figures both inside and out of the eurozone, austerity has been a divisive issue. Since the onset of the financial crisis, governments in both Germany and the UK have preached the importance and the benefits of austerity. While there has been some degree of recovery in the UK, critics have doubted the viability of austerity as an economic tool and questioned its ability to deliver growth to stalling economies. Moreover, they suggest that the aggressive pursuit of austerity and the repression of employee wages have helped to exacerbate the eurozone’s economic troubles. The relentless and uncompromising nature of austerity has been viewed by some as disastrous for the eurozone, drawing comparisons with Japan’s so-called ‘lost two decades’.

Too much austerity and not enough fiscal stimulus have arguably combined to help drive down growth since the financial crisis first hit. There are genuine fears within the European community that the eurozone’s current economic plight could threaten both the future of the euro as well as the European Union itself. As a result, the rigid application of European austerity programs appears to have softened. Both the German coalition government and the European Central Bank (ECB) have hinted that they may be willing to move away from austerity programs and embrace greater monetary stimulus going forward. For the underperforming eurozone economies, this change of approach will undoubtedly be welcome, according to Mr Zezza, although more must be done to reinforce the bloc’s financial markets. “The austerity policies put forward so far in the eurozone have contributed to reducing the exposure of the financial sector in core countries. However, in my view, the financial fragility which became evident in the 2007-08 recession has not been addressed, and further policies to strengthen financial markets at the expense of the European taxpayer may not be politically feasible in the near future. A possible remedy for the eurozone’s stagnating economy could come from coordinated expansionary fiscal and monetary policies, with substantial transfers from richer, surplus countries to the periphery. However, such transfers have been clearly ruled out by policymakers in the eurozone,” he adds.

Quantitative easing

In Berlin there has been a shift in focus in the latter half of 2014, away from rigid austerity toward ‘growth-friendly consolidation’. Although the German government has continued to encourage its eurozone neighbours to reduce their deficits and restore balance to budgets, there is an acknowledgement that more needs to be done to promote growth and generate jobs. Discussions include the introduction of quantitative easing (QE) across the eurozone. The potential introduction of QE would help to ease the threat of deflation across the bloc. For the vulnerable eurozone economy, deflation could prove to be disastrous. The prospect of lower prices in the future causes consumers to delay significant purchases, in turn leading firms to scale back production and postpone investments of their own. This can diminish labour demand and further curtail consumer spending power.

However, rather than adopting QE measures, in early September Mario Draghi, president of the ECB, announced the beginning of a new program of acquiring asset-backed securities (ABS). While ABS purchases are not the measure many analysts expected the bank to introduce, they can perhaps be seen as a derivative of QE, or perhaps a precursor. It is hoped that the stimulus package will add liquidity to the financial system and revive lending over time.

In addition to the ABS purchases, the ECB also announced reductions to its benchmark interest rate in September, to 0.05 percent. The ECB had already cut its rate from 0.25 to 0.15 percent in June. As result of the latest cut, the ECB became the first major central bank to introduce negative interest rates.

Mr Draghi’s comments at the annual Jackson Hole conference of central bankers in August also made it clear that although the ECB “will use all the available instruments needed to ensure price stability in the medium-term” it would not be willing to allow the eurozone to be reliant purely on a program of QE. In the past the bank has been reluctant to engage in QE, unlike a number of other central banks. Although there is room for the ECB to alter its stance on QE further down the line, it is unlikely to initiate a full program of financial stimulation any time soon.

The OECD has become the latest group to call on the ECB to embark upon a program of QE as soon as possible. In its September interim economic assessment, the organisation noted that “a moderate expansion is underway in most major advanced and emerging economies, but growth remains weak in the euro area, which runs the risk of prolonged stagnation if further steps are not taken to boost demand”. Despite the swelling chorus, Mr Draghi and his colleagues appear unwilling to make a push for QE, instead putting their faith in both the ABS purchases and the sort of structural reforms which have been successful in Spain. “The ECB has already tested non-conventional monetary stimulus, with little effect,” says Mr Zezza. “I believe that Mr Draghi has recently made it clear that monetary policy will not be sufficient, without coordinated efforts of fiscal policy at both the eurozone and individual country level.”

Structural reforms have certainly had a positive impact on productivity in Spain. Product-market overhauls have allowed the Spanish government to increase competition between firms, drive job creation and turn around the national economy to some extent.

Structural reform would certainly make an impact in a number of struggling eurozone countries. At the time of writing, inflation is at just 0.3 percent in the eurozone and unemployment levels have reached 11.5 percent. More needs to be done to help raise inflation throughout the bloc if the eurozone is to stave off deflation.

PE and M&A

Despite ongoing concerns, there is some good news within the eurozone. The private equity (PE) industry has remained relatively optimistic about the region over the last two years. In June, Permira closed a €5.3bn European focused buyout fund, and is not alone. According to data compiled by Preqin, European buyout funds garnered $64.3bn in 2013, nearly double the amount raised in 2012.

Some observers believe that the eurozone is due to see a marked increase in corporate M&A activity in 2015. Part of this growth will be driven by funds with an overabundance of capital to invest, as well as an increasing appetite of banks to lend. Furthermore, the threat of deflation may be a catalyst for some eurozone companies to pursue deals, since consolidation can help stronger companies to regain pricing power by taking out competitors.

Conclusion

Generating growth remains one of the toughest tasks facing politicians and economies. Although unpopular in some circles, austerity programs have helped to steady economies both inside and outside the eurozone. However, the time has come for economies to move away from the restrictive effects of austerity and to focus on boosting GDP. The ECB’s ABS program will go some way to redressing the balance, as will attempts to carry out structural reforms in both labour and product markets.

The spectre of deflation is too great for the eurozone and the ECB to ignore. The sooner the bank introduces QE, its supporters argue, the better the zone’s chances of economic recovery, or even prosperity.

© Financier Worldwide

BY

Richard Summerfield