Macroeconomic developments in Europe
- We expect economic growth in Europe to accelerate gradually, although the economy has far from fully recovered from the Global Financial Crisis and the Great Recession
- Substantial deterioration in the Greek situation, the conflict in eastern Ukraine and / or instability in the Middle East and North Africa remain downside (tail) risks to the outlook
- The depreciation of the euro will likely have a positive, yet limited impact on net exports
- The current accounts of most European countries improved markedly, though doubts remain as to the sustainability of this development
- The recovery of domestic credit growth is relatively uneven across the continent, partly reflecting the impact of elevated NPL levels in the GIIPS and parts of South Eastern Europe
Europe’s economy has not yet fully recovered from the crisis
Across Europe, economic growth slowed as a result of the Global Financial Crisis (GFC) and the subsequent euro crisis. GDP growth is expected to be highest in Turkey, the Central and Eastern European (CEE) countries, the Baltics and the South-Eastern European (SEE) countries. This is largely catch-up growth. In GDP per capita terms, the gap between these countries and the wealthier Western and Northern parts of Europe remains large (figure 1).
However, the SEE countries and the Baltics, together with the Southern European countries, are also the economies that experienced the sharpest growth slowdown compared to the pre-crisis situation. Before the Global Financial Crisis, these countries experienced large inflows of cheap capital that resulted in overheating economies. Despite their relatively good growth outlook (by European standards), the deleveraging process as well as the loss of productive investments since the GFC will remain a drag on growth in these regions going forward. Another long-term negative effect of the crisis is on the labour market. In almost all European countries the crisis resulted in increased unemployment (figure 2). Youth unemployment is even higher across Europe (figure 3). Especially in Southern Europe and parts of the SEE region, this increases the threat of creating a ‘lost generation’. The longer these people continue to be unemployed, the less positive their labour market prospects will be once the economy starts to recover.
Going forward, we expect Europe to continue its road to recovery. We also expect domestic demand to be an important growth driver. Households’ spending power should be boosted by rising real wages. Nominal wage growth is gradually picking up on the back of slowly improving employment, while inflation has declined thanks to the sharp decline in oil prices (figure 4). However, in countries with elevated levels of household debt or where economic uncertainty is still high, a large part of the additional income will likely be saved or used to pay down debt.
In addition to real wage developments, household consumption and public investment should benefit from moderating fiscal consolidation in various countries. The private investment outlook is still less rosy, however. Across most of Europe (the Baltics excepted), capacity utilisation rates are still below pre-crisis averages. Whether the ECB’s quantitative easing programme and Juncker’s investment plan will help buck this trend is doubtful. Meanwhile, the impact of a markedly weaker EUR/USD exchange rate on net exports will likely be limited, due to the relatively low degree of openness of the euro area economy. Although individual eurozone economies are quite open, most cross-border trade stays within the eurozone. Because of the relatively close economic and monetary integration across most of the continent, the share of exports destined for non-European countries is relatively small. Amid these trends, economic growth in the euro area will likely come in at about 1%-2%, on average, in 2015/16. Economic growth in the UK and the Nordics is expected to be slightly stronger. Yet, given still considerable catch-up potential, at 2%-4% economic growth will be strongest in Turkey and parts of Central and Eastern Europe. Downside risks to the outlook for the whole region remain the Greek situation, the conflict in Eastern Ukraine and the political instability in the Middle East and North Africa.
Economic impact of (geo)political tensions limited so far, but sentiment may worsen markedly
Europe’s moderate economic recovery coincides with a period of political tensions within the euro area, as well as violent conflicts on the continent’s borders, notably in Libya, Syria, and Ukraine . The questions regarding Greece’s future within the euro area and stagnating structural reforms in several eurozone countries are contributing to lingering concerns about the currency union’s survival. On the external front, the EU’s bilateral relations with Russia deteriorated markedly due to the conflict in Ukraine. Moreover, in the aftermath of the Arab Spring, political stability in vast parts of the Middle-East and Northern Africa remains weak at best as the region struggles with Islamist fundamentalism. So far, these conflicts are not having a pronounced negative effect on economic sentiment across the European continent (figure 5). However, sentiment may deteriorate quickly in case of a marked escalation of any of these conflicts, which may hit the domestic demand-driven economic recovery.
The uncertainty surrounding the Greek crisis and potential for contagion to other ailing euro area economies are weighing on economic growth across the continent. The direct effect of both external sources of conflict remains limited, however. Notwithstanding their combined relatively large size or potentially disruptive impact, Europe’s exports to Ukraine and Russia account for a mere 0.5% and 2.5%, respectively, of total exports (figure 6). While export dependency on Russia and Ukraine varies considerably across the continent, it is mainly concentrated among several small economies in North-Eastern Europe and the Balkans. Taking into account that re-exports account for the lion’s share of the Baltic countries’ exports to Russia and Ukraine; Finland, Serbia and Poland remain most exposed to a deterioration in trade with these countries. Consequently, even if relations between the EU and Russia remain tense and trade fails to recover, the direct economic impact on the continent’s economy remains limited. The same holds for the various conflicts across the Middle-East and Africa, to which Turkey is most exposed. Yet, given that country’s focus on the euro area, declining exports to countries like Iraq and Syria do not constitute a major direct threat to Turkish economic performance.
Trade benefits from a weaker euro are distributed unevenly
The depreciation of the euro (figure 7) driven by the quantitative easing programme by the ECB will positively impact eurozone net exports growth in the coming years. The price competiveness of European producers will improve and the costs of importing from non-eurozone products and services will rise. Ireland will likely be the biggest beneficiary of the lower value of the currency given the large share of Irish exports to the US and UK (figure 8). For Southern Europe however, the potential impact is minimal. Compared to the other euro area member states, the value added by exports to their GDP is lower. All in all, this raises the question whether the right countries will benefit from QE (Southern Europe needs it most) and whether the negative impact of the side-effects (bubble formation in financial markets) will outweigh the positive impact (on inflation, inflation expectations and growth). Finally, export growth will probably disappoint in Finland, given that Russia, its largest export partner, is facing a deep economic crisis and might extend its current ban on imports of EU agricultural products.
In contrast, Switzerland and the UK have seen their respective currencies appreciate. Especially in Switzerland, the negative effect on net exports could be profound given the sharp appreciation of the CHF after the abrupt removal of the Swiss floor on the EUR/CHF exchange rate. For other non-eurozone EU countries, the effect of the ECB’s quantitative easing policy is twofold. On the one hand, they stand to benefit from the expected improvement in economic conditions in their main trading partner, the eurozone. This especially applies to the CEE countries, that produce many intermediate products for the German industrial sector. On the other hand, their exchange rates against the euro may appreciate. This would hurt their price competitiveness and lead to deflationary pressure through lower import prices. To avoid such an appreciation, the individual central banks need to further ease monetary policy. This has already resulted in negative policy rates in e.g. Denmark, Switzerland and Sweden.
External imbalances are being reduced
Compared to the pre-crisis situation, current accounts have improved drastically for most European countries (figure 9). Part of this adjustment is due to an improvement in price competitiveness. The current account of the eurozone has become more unbalanced however, because the rebalancing within its member states has been asymmetric. Deficit countries have made the largest adjustments, driving the eurozone current account strongly into positive territory. In countries with a large surplus, such as Germany and the Netherlands, the current account has not adjusted to the downside towards balance. This is a sign of weak domestic demand in these countries.
In countries that experienced a strong deterioration of economic growth, a sizeable part of the current account adjustment is due to lower imports. This has been especially the case in Greece, Cyprus and Montenegro (figure 10). Once these economies start to recover, imports will also recover. It is therefore questionable whether the current account adjustments will be sustainable. On the positive side, of the same group of countries, especially Iceland, but also Portugal, Spain and Croatia have significantly increased their exports. When looking at export growth as an indicator of competitiveness, the Baltics in particular have shown a remarkable improvement.
High levels of non-performing loans weigh on credit provision in various countries
Especially in the SEE, Baltic, Southern European countries and Ireland, non-performing loans as a percentage of total loans (the NPL ratio) increased sharply during the crisis years (figure 11). This has often been the result of a deep economic crisis, a weak legal framework and/or rapid pre-crisis domestic growth (figure 12). Much of this lending financed investments in housing, which suffered a decline in value during the crisis. The economic pain of losses on these loans however extends beyond national borders. In the SEE region, the banking system is dominated by Greek and Austrian banks. Banks from most of the bigger eurozone countries operate in the CEE countries, while a major part of the Baltic banking system is owned by Nordic banks. The current low growth and high unemployment environment is not at all conducive to a rapid improvement in the NPL ratio in the SEE and Southern European countries. The same also holds for oftentimes weak legal frameworks for the settlement of non-performing loans.
Going forward, we do not expect a recovery in credit growth any time soon, particularly in Southern and South-Eastern Europe (with the exception of Turkey). Both demand for and supply of loans will remain low. Demand will be subdued due to ongoing deleveraging efforts and the improving but nevertheless subdued investment outlook. Supply is expected to be restrained by banks’ low interest margins and rising regulatory requirements that are increasing the costs of lending.
 The regions are defined as follows: Nordics (Denmark, Finland, Iceland, Norway, Sweden), Western Europe (Austria, Belgium, France, Germany, Ireland, Luxembourg, Netherlands, UK, Switzerland), Southern Europe (Cyprus, Greece, Italy, Malta, Portugal, Slovenia, Spain), Baltics (Estonia, Latvia, Lithuania), CEE (Czech Republic, Hungary, Poland, Slovakia), SEE (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Kosovo, FYR Macedonia, Moldova, Montenegro, Romania, Serbia), and Turkey.
This study is a publication of Economic Research (KEO) of Rabobank.
The views presented in this publication are based on data from sources we consider to be reliable. Among others, these include Macrobond. The economic growth forecasts are generated from the NiGEM global econometric structure models.
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Abbreviations for sources: AMECO: Annual Macro-Economic Database, BIS: Bank for International Settlements, DOTS: Directions of Trade Statistics, EC: European Commission, ECB: European Central Bank, OECD: Organisation for Economic Co-operation and Development, EIU: Economist Intelligence Unit, IMF: International Monetary Fund, WEO: World Economic Outlook, UN: United Nations
Abbreviations used for countries: AL: Albania, AT: Austria, BE: Belgium, BG: Bulgaria, BA: Bosnia and Herzegovina, CH: Switzerland, CY: Cyprus, CZ: Czech Republic, DE: Germany, DK: Denmark, EE: Estonia, ES: Spain, FI: Finland, GB: Great Britain (UK), GR/EL: Greece IE: HR: Croatia, Ireland, IS: Iceland, HU: Hungary, IT: Italy, LU: LV: Latvia, Luxembourg, LT: Lithuania, MD: Moldova, ME: Montenegro, MK: Macedonia, FYR, MT: Malta, NL: The Netherlands, NO: Norway, PL: Poland, PT: Portugal, RO: Romania, RS: Serbia, SI: Slovenia, SK: Slovakia, TR/TK: Turkey, XK: Kosovo, SE: Sweden, EA17: Euro Area-17, EU27: European Union.
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Allard Bruinshoofd, head of International Research, Economic Research
Graphics: Selma Heijnekamp and Reinier Meijer