Euro area to swim against global tide
Business confidence in the US, Japan and the UK has fallen, but the Euro area is upbeat
Monday 24 August 1998
The Euro area, those eleven European countries set to form EMU at the start of next year, looked set to be a region of growth in an otherwise gloomy world. While business confidence in the United States, Japan, and the United Kingdom has already fallen to recession-like levels, Euro area businesses have remained remarkably upbeat, with confidence close to all- time highs. But can the Euro area continue to swim against an increasingly adverse global tide? Most likely it can, but being the only region of growth in a depressed world will be an uphill struggle.
Although the Euro is a relatively closed economy, with only 10per cent of the region's GDP coming from exports to the rest of the world, it is not immune to developments elsewhere. Over the coming year, the region will be severely buffeted by global headwinds. Perhaps the biggest shock will be the end of the US spending spree. Although the US economy has been cruising nicely for a while, over the past year it has climbed significantly higher, as individuals have spent some of their stock market gains. But this fuel is rapidly running out, and the economy will lose a lot of altitude in the second half of the year. Since Euro area exports to the US have been growing at a close-on 25 per cent pace, the end of the US spending spree will have significant impact on Euro area firms.
The nature of the Asian headwinds will change. After contracting by around 15 per cent in the first half of the year, Euro area exports to Asia are likely to stabilise in the coming months. While a recovery in Asian demand is still some way off, the worst appears to be over. But although Euro area exporters to Asia will feel a little better, firms competing with imports from Asia face a tough time ahead. Asian firms are only now responding to last year's dramatic improvement in their competitiveness, the result of their sharp currency depreciations. Over the coming quarters, Asian producers will make significant inroads into Euro area markets. Expect to see a lot more Japanese and Korean cars on Europe's highways.
Nearer to home, Euro area exports to the UK have already begun to slow and a further deterioration is in store. At best, the UK economy will have a bumpy landing, with GDP growth not much above zero next year. At worst, it could slip into a mild recession. This is probably necessary to unwind the domestic inflation pressures that have built over the past two years , and ensure that the inflation target is hit. But it represents a significant turnaround in an important market for Euro area firms. After slowing to a 5 per cent pace by the middle of this year, Euro area exports to the UK are likely to contract next year.
It is clear that the Russian crisis is only the most recent headwind to buffet the Euro area economy. Over the coming year, Russia is likely to experience a deep recession and a sharply lower currency. In fact, the recession has already begun. In July, Russian GDP was 4.5 per cent lower than a year ago, and industrial activity plunged over 9 per cent. The recent financial turmoil will drive the economy even lower. What impact will this have on the Euro area? The direct trade links between Russia and the Euro area are quite small: Only 3 per cent of Euro area exports go to Russia. Far more important are the financial linkages. Euro area banks have considerable loan exposure to Russia, worth almost $50 billion. German banks are by far the most heavily exposed, accounting for around 60 per cent of the total. Clearly, a significant build-up of bad debts would act as a drag on Euro area activity, as banks retrenched in domestic markets. The other risk from Russia is a spillover into Eastern and Central European countries, which have been an important export market for Euro area firms. While Russia's problems are specific to Russia, contagion is always a risk.
If the Euro area economy is to continue growing over the coming year, it will need to stand on its own two feet. This would be a significant change in the region's performance. Over the past few years, Euro area activity has relied heavily on exports to the rest of the world. This option is no longer available. For Euro area GDP to expand at the 2.5 to 3 per cent pace seen over the past 18 months, domestic demand, which accounts for 90 per cent of activity in the region, needs to step up to the plate.
So, can domestic demand pull the Euro area economy against the global tide? Most likely, it can. For almost the first time this decade, central banks and governments are both working to promote growth. The average short-term interest rate in the Euro area is 3.75 per cent. This stance of monetary policy looks very stimulative, at least judging by the acceleration in credit across the region and the sharp pick-up in construcion activity. And after dampening demand growth for several years, government fiscal policy has turned neutral this year. And next year, lower taxes and higher public spending look set to boost demand.
This turnaround in the policy environment has been reflected in household and business confidence. Consumer confidence in the Euro is now at the highest level since 1990. And individuals are more optimistic about employment prospects than at any time since 1989. This confidence is fully justified by recent developments in the labour market, with rising vacancies and falling unemployment across the region. With real incomes growing, thanks to lower inflation and higher employment, and confidence at a buoyant level, the ingredients for a strong recovery in household spending are in place.
The prospects for business spending are less clear. Business confidence has held up at the high levels reached last year. But global economic weakness means that there is plenty of spare capacity, so Euro area firms have little incentive to buy new plant and machinery. But there is plenty of room to update the capital stock, as has happened in the United States this decade. Since the start of 1994, capital spending in the United States has increased by almost 40 per cent, while in the Euro area it has risen by only 10 per cent. Much of the increase in the US has involved firms incorporating the latest technology to improve their competitiveness. To prosper in an increasingly global marketplace, Euro area firms need to do likewise.
So, the 10 per cent of Euro area GDP driven by exports will feel significant global headwinds in the coming year. But the 90 per cent of Euro area GPD due to domestic spending looks set to pick up strongly. If it does, then the global weakness will simply restrain Euro area growth, rather than derail it. This will ensure that the Euro area swims against the global tide.
David Mackie is an economist at JP Morgan.
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