RaboResearch - Economic Research

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Eurozone: Risk of further north-south divergence

Economic Quarterly Report

  • The Eurozone economy incurred heavy blows in the first quarter. Expectations for the second quarter are even worse
  • We forecast contraction of 9.1% in 2020 for the Eurozone economy. For 2021 we forecast growth of 6.1%. This recovery will be unequally distributed between member states
  • Much of the economic damage can be explained by the stringency of the lockdown
  • Extra investment is important for economic recovery. But southern member states are less equipped to provide large fiscal stimuli. The European Union is willing to offer help
  • Some member states might throw a spanner in the works by demanding strict conditions. It is therefore likely that the European Union will have to water down its current proposal

Economic damage even greater in second quarter

Now that the GDP growth figures for the first quarter have been released, we can start to form an image of the economic damage from the Covid-19 crisis. And the figures that have been published do not paint a pretty picture (Figure 1). Without exemption, Eurozone economies, contracted sharply in the first quarter. And the contraction will be even worse in the second quarter given the fact that lockdowns spanned most of the second quarter (Figure 2).

Another trend is (even more) divergence between the northern and southern member states in the Eurozone. Even though countries such as Germany and the Netherlands have not seen a contraction of this scale for over ten years, the southern member states have fared even worse. We expect to see a similar picture in the second quarter. This divergence can be attributed to a number of factors which we will elaborate below.

Figure 1: Every economy contracted sharply in the first quarter
Figure 1: Every economy contracted sharply in the first quarterSource: Macrobond
Figure 2: The purchase manager index implies an even sharper contraction in the second quarter
Figure 2: The purchase manager index implies an even sharper contraction in the second quarterSource: Macrobond, Markit

Looking forward

There are a number of factors which impact the economic contraction and the subsequent recovery. Because of this, and the potential downside risks (such as a second wave of infections), forecasts are still very uncertain. But what we can say with certainty is that the Eurozone economy will go into recession in the second quarter. Based on the strong contraction in the first quarter, recently published data, and a reconsideration of a number of factors, we have revised our forecasts for the Eurozone member states downwards (Figure 3). For the Eurozone economy as a whole we forecast a contraction of 9.1% for 2020. For 2021 we forecast a recovery of 6.1%.

The contraction is primarily driven by a collapse in consumer spending and business investment (Table 1). Rising unemployment and continuing uncertainty have weakened confidence. Additionally, an implosion in world trade has had a large impact on export and import volumes. We expect that the net effect of trade will be negligible for most countries.

Table 1: Growth forecast for Eurozone economies
Table 1: Growth forecast for Eurozone economiesSource: RaboResearch

It is evident that debt ratios will sky-rocket due to a combined shock of economic contraction and the extra-large fiscal stimulus packages that consist of tax breaks and higher spending (Figure 4).

Figure 3: Growth forecast member states and total Eurozone economy
Figure 3: Growth forecast member states and total Eurozone economySource: RaboResearch
Figure 4: Forecast debt ratios member states
Figure 4: Forecast debt ratios member statesSource: RaboResearch

Structural differences within Europe

The differences in the level of economic contraction within the Eurozone economy can be explained by a number of factors. For starters, Italy, Spain and France experienced worse outbreaks of the virus and consequently imposed a stricter lockdown (Figure 5), resulting in a sharp contraction of economic activity. Additionally, sectors such as hospitality and tourism have experienced a larger economic downturn than other sectors. And these sectors are relatively large in the southern member states.

Figure 5: The lockdown stringency for several member states
Figure 5: The lockdown stringency for several member statesSource: Blavatnik School of Government, RaboResearch

Not every lockdown is the same

Figure 6: The stricter the lockdown, the larger the economic contraction
Figure 6: The stricter the lockdown, the larger the economic contractionSource: Blavatnik School of Government, RaboResearch

The main factor determining the magnitude of the economic contraction is the constraint on the supply side of the economy. The supply-side impact is determined by government-imposed constraints on freedom of movement for consumers and companies. Therefore, it comes as no surprise that countries with stricter lockdowns have had a sharper economic contraction.

Composition of the economy

Next to government-imposed constraints, the composition of the economy is an important determinant for the vulnerability of the economy. Economies in which sectors such as tourism and recreation are relatively large, have been hit harder. This observation is, once again, bad news for the southern member states since the aforementioned sectors are relatively larger in those economies (Figure 7).

Another important determinant is the labor market (Figure 8). Employees with a temporary contract and the self-employed are especially vulnerable to the crisis since it easy for companies to let them go. Additionally, some governments are less equipped to support furloughed workers through unemployment schemes.

Figure 7: Tourism has a larger share in the economy of southern member states
Figure 7: Tourism has a larger share in the economy of southern member statesSource: WTTC, Oxford Economics
Figure 8: Temporary workers and the self-employed are a relatively large part of the labor force in southern member states
Figure 8: Temporary workers and the self-employed are a relatively large part of the labor force in southern member statesSource: Eurostat

Differences in recovery

After the major economic contraction in 2020, we foresee a ‘technical’ recovery in 2021. The simple fact that workers can return to factories, offices and stores will give a boost to economic activity compared to the lockdown period. But the loss of jobs, company bankruptcies and lower consumer confidence will prevent the economy from running at full speed. The shock to the supply side of the economy will be accompanied by a demand-side hit. We also expect some sectors to continue operating below full capacity until mid-2021 due to the constraints imposed by the ‘6-foot economy’. On top of that consumers are likely to shun some services, such as international travel, even if the restrictions are lifted.

Are governments able to kick-start the economy?

Governments can speed up the economic recovery after the lockdown, especially by stimulating the demand side of the economy. Using subsidies, tax cuts and cheap loans, governments can create an environment that spurs businesses to make investments and rehire employees. But not every government has the fiscal space to do this. Even before the corona crisis, southern member states had a debt ratio that was significantly above the threshold of the treaty of Maastricht (Figure 9). And in the past years they have had trouble reducing their debts. France, Spain and Italy received a slap on the wrist from the European Commission because it was unhappy with the progress being made (Figure 10).

For now, the budget rules have been loosened, but it is unlikely that the southern member states will have adequate fiscal space for economic recovery without help from the EU. The interest payments on their existing debt will rise as investors demand a higher risk premium. So there will be less money available for investments that drive structural growth, such as education and infrastructure. This will further heighten the divergence between north and south. This divergence is a risk for the EU and the Eurozone as a whole.

Figure 9: Debt ratios for large member states
Figure 9: Debt ratios for large member statesSource: Macrobond
Figure 10: Primary balance for large member states
Figure 10: Primary balance for large member statesSource: Ameco, Macrobond

Will the European Union save the economy?

Since southern member states are not adequately equipped to spur economic recovery, all hope is directed at Brussels. On May 27, the European Commission presented a proposal for a European recovery fund. Amounting to EUR 750bn, EUR 500bn of the fund will be in grants and EUR 250bn in cheap loans. The money will be raised on capital markets using the EU budget as collateral. To make sure that the repayment of the principal amount is not left to the member states, the EU wants to generate income through a digital service tax and the Green Deal.

This large sum of money should end up in the hardest hit regions to spur economic recovery. But it is not yet a done deal. The ‘Frugal Four’ (Denmark, Netherlands, Sweden and Austria) were quick to announce that they disagree with unconditional gifts. They would rather see cheap loans with strict economic reform conditions. Given that the proposal must be unanimously accepted, it is very likely that the European Commission will have to water down the proposal.

Box 1: Risk for Europe: Unrest regarding the ECB mandate

On May 5 the Bundesverfassungsgericht, the highest judicial entity in Germany, ruled that the ECB is overstepping its mandate with the Public Sector Purchase Programme (PSPP). The ECB has three months to argue why PSPP is within the mandate.

The German judiciary has no authority over European Institutions of course, but the purchase of government debt within the PSPP is done by national central banks. If after three months, the Bundesverfassungsgericht is not convinced of the legitimacy of PSPP, the Bundesbank will be forced to stop its purchase of government debt. This could result in the program coming to a standstill since there is a strict distribution key.

As well as potentially bringing PSPP to a standstill, this verdict also creates a precedent. If it turns out that national legislation prevails over European legislation, other countries (where politics and jurisdiction are not always well separated) could use this verdict to promote their national interests in Europe. This would make it a lot harder for European policymakers to efficiently govern the EU.

Additionally, if the ECB’s leeway is reduced, the weight of economic recovery will shift from the central bank to national government shoulders. Germany and France have already anticipated this shift with the proposal for the European recovery fund.

 Are economies equally able to recover?

Even after lockdown constraints are lifted, some sectors will change temporarily or permanently. Restaurants, tourism and the event sector will not be able to operate at the full capacity they were used to pre-crisis. Governments can prevent them from doing so by putting a cap on the maximum number of persons on a flight or event. But consumers can also choose to stay away because of health hazards.

Figure 11: Not every country is equally digitally advanced
Figure 11: Not every country is equally digitally advancedSource: Eurostat

The composition of the economy therefore determines the number of jobs that still exist in the 6-feet economy. Based on labor force data, we can assess the degree of vulnerability of an economy. We have done this exercise before for the Dutch and American economy (Groenewegen and Hardeman, 2020; Erken et al., 2020). Using the same methodology, we have been able to compute that 87% of German employees and 83% of Italian employees are able to work a safe distance or from home. This difference can have a significant effect on the long-term economic impact of the crisis.

Not every country is equally well equipped to adjust to the new economy where working from home is the standard. This is partially dependent on the digitalization of a society. If digital remote working facilities are inadequate, there could still be reduced economic activity. And the differences within Europe are quite large (Figure 11). Once again, northern member states fare better than southern member states.


Undeniably, the economic impact of the crisis will be enormous. The figures yet to come will be worse than what we have seen already. Some economies are more vulnerable than others due to both their composition and their recovery capabilities. It is vital that national governments have adequate financial means to spur economic recovery. This is not the case for a number of southern states, which are already hard-hit. All hope of help is directed at Brussels. If Brussels cannot deliver, the divergence in Europe will only widen further.


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