The full version of the European outlook, available to subscribers, includes the following sections:
– Is the Worst Over? Clues from Industrial Production and World Trade
– Potential Output, Potential Growth and Output Gap
– Inflation or Deflation?
– Fiscal Policy
– Credit Market Conditions
– The European Banking Sector
– Sovereign Risk Watch: Ireland
– Sovereign Risk Watch: Greece
– Private Consumption and Labor Markets
– Power Shift Back to Nation States?
European Monetary Union
RGE Monitor expects the cyclical recovery in the eurozone–led by Germany and France–to lag recovery in the U.S., the BRICs and non-Central and Eastern Europe (CEE) emerging markets. Among the main factors muting Europe’s recovery in 2010 are a permanent decline in potential output; unwinding pressures of large internal imbalances leading to deflationary pressures; a more restricted monetary and fiscal policy response compared to the U.S. and especially to China; a leveraged financial sector with too-big-to-fail institutions and too-big-to-save features; and a strong reliance on bank funding by the corporate sector subject to a larger financing gap than that seen in the U.S.
In order not to impair the banking sector’s lending ability permanently, a quick disposal of bad assets is warranted. Lending to the private sector is slowing quickly, and for small and medium sized enterprises with no access to capital markets, bank credit lines represent the only recourse for liquidity. Based on IMF and ECB estimates, total bank losses in the eurozone will amount to between $650 billion and $900 billion, implying substantial additional recapitalization costs.
Germany’s specialization in cyclical industrial goods, and its export-led growth model, exposed it heavily to the synchronized global downturn. Going forward, RGE cautions that given the likely reticence of the U.S. consumer in the medium term future, an exclusive reliance on export-led growth is not advisable. France’s more balanced domestic demand-led growth model has served it relatively better. Italy is grappling with a structural and long-term decline in its relative living standard–a situation that requires a radical overhaul of structural impediments in product and labor markets. Spain’s challenge lies in an expected 20% unemployment rate and deflationary pressures to restore relative price competitiveness. Ireland is among the developed countries hit hardest by the crisis and its large banking sector (relative to GDP) represents a contingent liability despite the country’s commendable ‘bad bank’ scheme.
The UK’s mainstay is its financial sector, which has accordingly received substantial government support. The country’s strained fiscal position puts more radical solutions for unviable banking institutions on the table for regulators, who are openly discussing options like splitting banks that are too-big-to-fail. The lending environment is equally important for the housing market, which is fundamental to the British economy.
Central and Eastern Europe
Among emerging market regions, CEE economies are experiencing the steepest roller-coaster ride in terms of growth. After exceeding global growth averages for the last decade, regional growth is plummeting in 2009 and is expected to underperform both emerging Asia and Latin America. All EU newcomers in the region are either in or headed for recession. A dangerous combination of falling exports and slowing capital inflows is behind the bleak growth picture. The hardest-hit economies have tended to be very open, with wide current account deficits in recent years and high levels of foreign currency borrowing.
Not all CEE economies are in the same boat. The Czech Republic and Poland, for example, are considered relatively healthy and are expected to experience relatively mild contractions in 2009. Those in more dire straits–Estonia, Latvia, Lithuania–are facing double-digit contractions. Hungary, Latvia, Romania and Serbia have already turned to the IMF for financial assistance, and more are likely to follow in their wake.
RGE Monitor points to the following as possible downside risks to regional growth:
Given the strong financial and trade linkages with Western Europe, a recovery in Eastern Europewill not come until its western neighbors’ economies improve. That means the region’s recovery will lag behind that of Western Europe. Meanwhile, the downside risks described above could further delay recovery. And even when recovery comes, RGE expects sluggish positive growth in the medium-term, rather than a return to the soaring growth rates seen earlier this decade.
rong growth earlier this decade, all five Nordic economies are now in the midst of recessions. These are small, open economies that have been hit hard by slumping external demand for their exports. Given their strong public finances, Nordic economies, with the exception of Iceland, have resources available to cushion their contractions. Ultimately, however, economic recovery in the region hinges on a global recovery.
Norway’s economy will experience the mildest GDP contraction in the region in 2009, while Iceland will see the sharpest contraction. Norway is the best placed for a quick rebound to positive growth given its sizeable buildup of oil revenues and its large maneuver room on fiscal and monetary policy. Recovery in Finland and Sweden is tied to a revival in demand for their export products. The global production slump has been particularly bad news for Finland and Sweden given the large share of capital goods in the makeup of their exports. Not surprisingly, these economies are facing the region’s sharpest contractions in 2009 behind Iceland. Stress in the Swedish banking sectorcould result in a more protracted recovery there.