Outlook 2014 - Eurozone
The eurozone economy seems to have entered a phase of modest recovery. But, worrisome public finances, limited investment demand and tight credit conditions continue to hamper growth. Current problems are unlikely to be solved by a banking union.
In 13Q2, the eurozone climbed out of recession, with GDP growth amounting to 0.3% q-o-q. There are several signs that the recovery is set to continue in the coming quarters. In the past four months, the composite PMI figure has been consistent with growth (51.5 in October, figure 1), despite a minor fall back in October which indicates the recovery is still fragile. Furthermore, the Economic Sentiment Indicator (ESI) is slowly heading towards its long-term average (figure 2). Sub-indices show that sentiment is improving in all sectors, although several sectors experienced a minor setback in October compared to September. Especially the level of industrial confidence is encouraging and bodes well for industrial production. Rising producer confidence is, amongst other things, driven by export order books and improving production expectations. All are likely to be influenced by growing demand from the US and the UK as their economic recovery is gathering pace.
In addition to the positive impact of higher producer and consumer confidence on domestic demand, private spending can be supported via wealth effects on account of the rising European stock indices since July 2013. Moreover, systemic stress in capital markets is still falling and back at pre-crisis levels, according to the composite indicator of systemic stress by the ECB (CISS). This could support economic growth via both improving confidence and restoring the credit channel.
In short, we expect the recent upturn in eurozone GDP growth to continue modestly in 2014 (¾%), on the back of net exports. However, we do not expect this growth to be strong enough to bring down the unemployment rate (12.2% in September) significantly. We do believe employment creation will slowly recover next year, but the labour force is bound to grow as well. On top of an encouraged worker effect, the number of people searching for a job will likely increase owing to an increasing minimum retirement age in several Member States.
Risks of tapering muted
A downside risk to the euro area growth outlook could stem from the reduction in monthly bond purchases by the American Central Bank (Fed), of which the start and pace will depend on the strength of the US recovery. A probable implication of this so-called ‘tapering’ is a rise in long-term interest rates in both the US and the euro area. If higher rates in the US were to hamper the country’s economic recovery, eurozone export growth could slow. In our base-case scenario, the Fed will not start ‘tapering’, however, before it regards fundamentals as strong enough. Accordingly, the US economic improvement made so far will not be undermined (Rabobank, 2013). That said, higher capital market rates in the euro area may, at the current phase of recovery, hamper growth via lower domestic demand and, especially in peripheral countries, endanger debt sustainability. On a positive note, we expect the euro-dollar exchange rate to depreciate in the course of next year on account of an increased interest rate differential between the US and the eurozone (Rabobank, 2013). A cheaper euro will support eurozone exports. Note, though, that the actual benefits for individual Member States depend upon the share of exports in their total value added and on the extent to which they compete on prices instead of quality (figure 3). The upshot is that while acknowledging the pains and gains are not equally divided among the euro area countries, the overall damage caused to the eurozone by ‘tapering’ should be only moderate.
Public finances remain a drag
Despite improving sentiment and our baseline expectation of a limited impact of US tapering, we stress that there remain several factors that will put firm pressure on eurozone’s domestic demand in 2014. Public finances in several Member States are still worrisome, which results in both the need of a continued harsh consolidation effort and the risk that worries about debt sustainability will hurt still fragile economic sentiment.
For 2014, the European Commission (EC) requires several large Member States under the excessive deficit procedure to implement a robust structural effort. Having said that, based on the recent EC’s Autumn Forecast 2013 this effort will be slightly smaller than that realised in previous years. Based on several budgets, like in France, Italy and Spain, it furthermore turns out that the focus on tax hikes, when compared to lower government expenditures, will be smaller next year, which might reduce the negative economic impact of the consolidation measures relative to previous years.
As far as debt sustainability is concerned, interest rates on government bonds of peripheral Member States are clearly below their levels seen during the summer of 2012. Although positive, investors’ confidence remains dependent on both general market developments –like US ‘tapering’ or details from the ECB regarding its Outright Monetary Transactions programme- and country specific developments. Disappointing growth, political instability or delays in the implementation of the austerity and reform programs remain important risks to these bond markets. Besides that, in the first half of 2014 talks will start on a modest third aid package for Greece, whereby the IMF will push for a further restructuring of Greece’s unsustainable level of government debt. The bailout programs of both Ireland and Portugal will terminate by the end of 2013 and mid-2014 respectively. Current market conditions suggest that Portugal and maybe even Ireland will need further financial assistance, probably via a credit line from the European Stability Mechanism (ESM). Finally, it cannot be excluded that disappointing Spanish banking figures and the Italian political gridlock will heat up worries about their debt sustainability. Therefore, a deterioration of economic sentiment owing to peripheral tensions remains an important downward risk to our forecast.
Investment growth remains subdued
While the robust budgetary effort remains drag on growth, the gradual improvement of the economic climate might be a tailwind for private spending in 2014. This mainly holds for private investment as, compared to household consumption, this tends to be less dependent on austerity efforts. Consequently, investment will pick up more quickly when the outlook improves. For 2014, we expect total private investment of the eurozone to return to growth (+1¼%), but this recovery is only modest compared to the fact that the level of private investment by mid-2013 was still 22% below its pre-crisis peak. Note that the differences within the eurozone remain large: for next year, we expect private investment to contract in Italy and Spain, and to grow solidly in Germany (figure 4). The subdued investment growth for the eurozone as a whole is a result of both limited investment demand and limited possibilities to finance investments.
Investment demand is set to increase along with the improved economic outlook, but note that the economic recovery will not be robust next year and that uncertainty remains relatively high. In addition, investments with the aim of expanding current production capacity will only pick up when the capacity utilisation rate increases. A survey among entrepreneurs in the manufacturing sector shows that the average capacity utilisation rate in the eurozone is slowly increasing, but still remains far below its long-term average (figure 5). As a result of limited domestic demand, an improvement of the investment climate is bound to mainly hold for export-oriented sectors. Furthermore, we stress that residential investment –which accounts for almost 30% of eurozone’s total investment- will remain depressed in some Member States on account of a large supply overhang. Our expectation that investment demand will recover only modestly is supported by the ECB’s credit conditions survey. The survey shows that the demand for credit still decreased in 13Q3, albeit at a slower pace than in previous quarters.
In addition to subdued investment demand, next year’s investment growth will be hampered by tight credit conditions. Doubts on the solvency of some banks and the need for higher capital buffers under Basel 3 have resulted in higher funding costs and deleveraging of banks’ balance sheets, especially in the periphery. Accordingly, the difference between interest rates charged to firms in Northern and Southern Member States remains large, although this difference has reduced somewhat in recent months, especially for Italians firms (figure 6). If the decrease of peripheral government bond yields continues, this might feed through into lower bank funding costs, which might in turn lead to lower corporate lending rates. Meanwhile, the possibility to finance investment by own means remains hampered by the process of corporate deleveraging. This holds especially for the periphery, since the balance sheets of e.g. German and French non-financial corporations have in fact seen robust growth of liquidity positions (cash and deposits) in recent years.
Banking union not for the short term
As tight credit conditions play an important role in the modest investment outlook, the focus is currently on a European banking union as a solution to these problems. Indeed, a common deposit guarantee system can e.g. help reduce the deposit outflow from the periphery (figure 7), but a banking union should not be seen as a solution for the current problems in the European banking sector. First, political agreement on the several aspects of a banking union proves to be a lengthy process. Second, the establishment of these new institutions requires a large effort regarding infrastructure and the employment of highly educated professionals. Third, the political discussion is being delayed by the existence of ‘legacy assets’: differences between the current situation of Member States’ banking sectors and more specifically the large losses in the Spanish and Irish banking sector that are not effected yet and which might require substantial future recapitalisations.
To deal with this situation, the ECB has announced an Asset Quality Review (AQR): an admission test which must ensure that a common fund can only be used for institutions that were healthy at the time of admission. The AQR is a political condition for setting up a common resolution fund, but can also help increase the transparency of the European banking sector. However, we stress that such a test requires clear guidelines on how to deal with banks with a substantial capital shortfall. The extent to which financial help can be expected from own governments and if necessary the European Stability Mechanism (ESM) – of which a maximum of €60bn is earmarked for direct recapitalisations- is limited by weak public finances of several Member States and political constraints on tapping the ESM. A lack of credible solutions for possibly substantial capital shortfalls might not only increase worries on European banks’ solvency but might also question the reliability of the AQR. From a political perspective, a common resolution fund will only be established if the likelihood that the fund will be used is acceptably small or the amount necessary limited in size. An implication of this is that the capital needs of several peripheral banks will not be met in the short term, as a result of which a quick improvement of credit conditions is not realistic and not included in our baseline forecast.
Rabobank (2013), Outlook 2014: Recovery on a shaky footing, 13 November 2013