Macro-economic developments Europe: is Europe becoming the new Japan?
- European growth is expected to remain subdued in the coming years
- Economic growth in most Baltic and CEE countries is expected to outpace the European average, while growth in most Southern and South-Eastern countries is more likely to lag behind
- Negative risks to the outlook have risen; the refugee crisis and a Brexit being the most prominent ones
Short-term tailwinds set to fade, risks have increased
In 2015, the European economy benefited from two substantial tailwind gains. Low commodity prices and inflation boosted real disposable income and household spending. In addition, many exporting firms benefited from the cheap euro vis-à-vis the US dollar and British pound, which bolstered exports, especially during the first half of 2015. Although we expect oil prices to remain low going forward and the ECB to continue its QE program, these are temporary stimuli and appear to be losing effectiveness. This raises the question whether Europe is capable of producing solid economic growth once the tailwinds fade and it has to rely on more structural growth engines. At the same time, risks to the European growth outlook have risen, such as: implications of the refugee crisis, a Brexit, a hard landing in China, renewed Grexit worries and the negative side effects of the current expansionary monetary stance (De Groot, 2016).
How strong are structural sources of economic growth?
There are increasing concerns that low European growth is structural in nature and the continent will go along the same route as Japan (R. Gordon, 2012; C. Teulings and R. Baldwin, 2014), see Figure 1. In any case, Europe is showing similarities to the Japanese case: ultralow interest rates, credit constraints, low labour productivity growth, high government debt levels and an ageing population (Prins and Stegeman, 2014).
Convergence in Europe is slowing
To get a better idea of which countries still have substantial growth capacity, we first need to get a broad idea of income disparities across Europe. Figure 2 shows that differences in GDP per capita are still substantial, with the highest income regions being Northern and Western Europe and the lowest being Southern and Eastern Europe. Inequalities are mostly the result of differences in labour productivity per hour, but activity rates are also important.
In the post-crisis era, GDP per capita growth slowed all over Europe, and even turned negative in Southern Europe (Figure 3). Notably, convergence towards high income regions also slowed, except in Turkey. Depending on the region, declining labour productivity growth and/or activity rates can be marked as the culprit. These developments are at least partly the result of distorted labour markets, weak investment, balance sheet repairs, a distorted credit channel and inadequate policy. Overall, the tide is unlikely to turn drastically any time soon, though for several CEE countries and the Baltics the economic outlook is somewhat more promising.
Distorted labour markets
Unemployment increased significantly during the crisis years in most countries, and especially in the Baltics and Southern and South-Eastern Europe. The Southern European countries in particular still have a large gap to bridge in order to bring unemployment down to equilibrium levels (Figure 4). Substantial government effort and reforms will be needed to lower these more structural levels as well, and there would appear to be little appetite for this at the moment. Against this background, it could take time for activity rates to recover in these countries.
At the same time, current labour market problems potentially have long-lasting negative effects on future productivity growth. There is a substantial risk that parts of the labour force, especially the young, will lose out on crucial working experience and skills due to long spells of unemployment (CPB, 2014; Stegeman, 2014; Arulampalam, 2001). The empirical evidence is quite undisputed and Gregg and Tominey (2005) even find that the damage caused by unemployment at a young age can result in a wage penalty of 13% to 21% 20 years later.
Labour productivity slowdown
It has been several years since the debt crisis hit Europe and productivity is still growing at a snail’s pace compared to the pre-crisis period: see the yellow diamonds in Figure 5, which illustrate the magnitude of this productivity growth gap. Many countries in the Eastern part of Europe are showing large losses on the investment side, while a slowdown in total factor productivity seems to be broad based. Total factor productivity (TFP) indicates efficiency gains, as it represents growth in value added which cannot be attributed to growth of either (quality and quantity of) capital or labour.
A decline in investment explains the larger part of the productivity slowdown in the Eastern part of Europe. Investment in Southern Europe (except Spain) is also weak, it has been flat-lining since 2013 and is far below the levels seen prior to the Great Recession. Before the crisis, investment was driven by excessive lending (from abroad). In the aftermath of the crisis, many companies and households were forced to deleverage their high levels of private debt and shelve (housing) investments. Yet so far, only few countries have been able to bring down private debt to GDP ratios. Accordingly, except for most Baltics and CEE countries, European countries face continuing private deleveraging needs, which will most likely also hinder investment growth going forward. At the same time, credit availability has been and is likely to remain subdued compared to the pre-crisis period due to several reasons, acting as a further brake on investment.
First, many Southern European and SEE countries are still struggling with a high percentage of non-performing loans (NPLs, figure 6), clogging the flow of credit to new growth opportunities (elaborated on below). Second, higher minimum capital requirements for banks from the Basel III Accord are having a substantial impact on the development of the European financial sector. Van Nimwegen and Bruinshoofd (2016) show that the European banking sector has front-loaded activities to meet the Basel III requirements, despite a long phase-in period until 2019. These requirements have been met not only by attracting new capital, but also by de-risking the balance sheet and selling assets. More importantly, they find empirical proof that balance sheet reduction has put a brake on bank credit growth. In addition, Giesbergen (2016) concludes that additional recent initiatives from Basel Committee on Banking Supervision, such as capital floors, could put further downward pressure on banking balance sheets and credit growth.
TFP: inefficiencies are increasing
Figure 5 illustrates that TFP is the main contributor to Europe’s productivity slowdown across the board. In an earlier study, we noted that the deterioration in TFP growth is partly related to reduced business dynamism Erken, De Groot and Koopman (2015), i.e. a lack of weak firms exiting the market and productive (new) firms growing or entering the market (Figure 7). This has hampered competition and slowed down innovative activity. In our view, these developments are partly caused by extremely loose monetary policy. Expansionary monetary policy has kept unprofitable and weak firms alive as extremely low interest rates (and perhaps weak inspections) enable these ‘zombie’ firms to continue to service their debt and get it rolled over. Consequently, zombie firms absorb part of the financing which otherwise would have been allocated to more productive firms and projects. Moreover, zombies create ongoing distortions by blocking the entry of healthy firms (Caballero et al.,2008). As De Groot (2016) expects, monetary policy will remain very expansionary going forward, which will consequently keep hampering productivity growth.
Another reason for the reduction in competition and innovation is that an economic development strategy to foster innovation and long-term growth seems to have slipped off the radar of European policymakers. Instead they have prioritised overcoming short-term problems and imposing austerity measures to live up to the Stability and Growth Pact during and in the direct aftermath of the European debt crisis. Low interest rates and the refugee crisis have lowered the sense of urgency to initiate the policy actions needed to get business dynamics back on track.
Bringing the growth challenges together
Based on fading tailwinds, the potential long-lasting unemployment effect for young people and more structural challenges (see also Briegel en Bruinshoofd, 2015), we foresee rather subdued economic growth in Europe going forward. Many Southern and South-Eastern European countries face the biggest challenges, with the CEE and Baltic countries having the brightest growth prospects.
The risks for the European economy have increased substantially over the past year. Here we list three major risks, although our list is not exhaustive.
The refugee crisis
The EU seems incapable to come up with a joint solution to the refugee crisis. Instead, border controls have been re-imposed, eroding the Schengen treaty for the free movement of people, and support for nationalist parties is rising (Briegel, 2016). The latter could affect economic growth negatively, as many nationalist parties adopt a protectionist and anti-reform stance, adding to the delay in pursuing necessary reforms mentioned earlier. A complete meltdown of Schengen would moreover have a number of negative implications for Europe’s economy (Erken and Wijffelaars, 2016).
First, the reintroduction of border controls would negatively affect trade flows because of longer waiting times (i.e. higher transaction costs). Second, the division of labour would become less efficient, due to decreasing labour mobility. Third, tourism could be affected negatively. Studies show a very wide range of potential structural economic effects (see Table 1). The Bertelsmann Foundation estimates the potential upper bound of the damage to annual EU GDP at 1.1% points. This study is however not undisputed.
On 23 June 2016, the British people will vote whether to remain a member of the European Union. In case of a vote in favour of a Brexit, trade barriers between the UK and the EU and the UK and third parties will come into play after two years, which could hurt British business investments and induce financial institutions and industries to relocate activities to the European continent and/or Ireland (see Prins, 2015). The impact of EU’s GDP is also expected to be negative, ranging between 0.12% to 0.36% (e.g. Dhingra et al., 2016; Aichele and Felbermayr, 2015). As the UK’s is Ireland most important trading partner, the Irish will suffer the largest relative losses from a Brexit.
Europe’s exposure to a China cooldown
From an growth perspective, we have some doubts whether China is capable of fulfilling its role as leader of the pack (see Erken and Blaauw, 2016). Accordingly, we have examined the extent of the damage to the UK and Eurozone economies between now and 2020 from a hypothetical collapse of the Chinese economy in 2016 due to a severe real estate crisis. Scenarios are modelled using NiGEM, a global macro-econometric model used by Rabobank.
In our first scenario, a hard landing of the Chinese economy (0% growth in 2016) would induce world trade to shrink, commodity prices to fall and cause stress in asset markets. In the UK, this would result in a cumulated loss of GDP growth (over 2016 and 2017) compared to our baseline scenario of 2.3% points, but an outright recession would be averted. In the Eurozone the damage would amount to 2.5% points, leading to a mild recession in 2016. The outcomes differ widely between individual Eurozone countries, with Belgium taking the largest hit.
In a second scenario we add global shocks to investor and consumer confidence, comparable to those seen during the Global Financial Crisis in 2008/2009. These negative confidence effects hit GDP growth via significantly lower investment and consumption, and, consequently, export volumes through the trade channel. The latter especially holds for small, trade-dependent economies. In this scenario, both the UK and the Eurozone would be caught in a recession for two successive years. Cumulative GDP losses compared to our baseline scenario would be substantial: -4.7% in the Eurozone and -6.6% in the UK.
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.
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: Ireland, HR: Croatia, IS: Iceland, HU: Hungary, IT: Italy, LU: Luxembourg, LV: Latvia, 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.