The outlook for the Euro area has brightened, but economic growth remains sluggish on account of post-crisis legacies and Euro area-specific structural weaknesses. Furthermore, four years into the economic recovery, real GDP still remains some 2.2% below its 2008 pre-crisis level. Uncertainty associated with rising geopolitical tensions and sluggish implementation of reforms, coupled with the private sector’s ongoing deleveraging, unfinished macroeconomic adjustment, and credit rationing, all combine to constrain growth.
The recovery in economic activity has been supported by factors that are at play across the EuroZone: Labour market conditions are improving, household disposable incomes are on the rise and there is significant pent-up demand. Low oil and commodity prices and the European Central Bank's (ECB) ultra-loose monetary policy have also delivered short-term impetus. Other factors are poised to drive growth in the medium-term.
Firstly, fiscal policy is set to remain broadly neutral and monetary policy to remain highly supportive. Secondly, the ECB’s new package of economic measures (expanded quantitative easing, incentives to banks to increase lending, and further interest rate cuts), will keep financing costs low and the euro weak vis-à-vis the other major currencies. In addition, the large number of asylum seekers should lead to higher government spending for shelter and food, adding to aggregate demand. Furthermore, productivity-enhancing structural reforms implemented over the past few years should gradually begin to pay off even for the more vulnerable member states.
The combined strength of these tailwinds should gradually reverse the pattern of weak domestic demand and low investment, causing economic growth to accelerate in the medium term. Nevertheless, the euro area economy still faces significant headwinds. Many euro zone-specific structural weaknesses, which predate the debt crisis, remain unsolved: the poor demographic profile; the lack of a fiscal union; and widespread political reluctance to move toward a deeper economic and political integration, to name but a few. Furthermore, despite the ECB’s efforts to revive credit flows in the Euro zone, bank lending is only gradually picking up as ongoing private sector deleveraging and the high level of non-performing loans act as a break on credit expansion. In addition, lower growth in emerging markets, most notably China, will limit the Euro area’s capacity to export its way out of trouble.
Inflation and the labour market
Against this backdrop, still-weak demand and low oil and commodity prices continue to weigh on inflation and curb inflation expectations. On account of this, we expect inflation to remain below the ECB’s target of “just below 2%” for an extended period of time. At present, we believe that the current period of low inflation will be followed by a gradual increase during 2016. Inflation should reach a level closer to 2% toward the end of 2018 and stabilise at around that level by 2020. Meanwhile, labour market conditions will continue to improve. However, significant differences will persist across member states in terms of unemployment rates and the speed of adjustment: While the unemployment rate in some peripheral countries is unlikely to fall below 20% before 2018 at the earliest under current policies, some core economies, such as Germany and Austria, are already close to full employment. Our baseline scenario assumes the unemployment rate to gradually fall from an average of10% in 2016 to an average of 9% in 2019. The unemployment rate was at 10.9% in 2015, and at 7.2% in early 2008.
What are the four key risks impacting the Eurozone?
Our baseline projections are subject to a number of downside risks. In particular, we have identified four key short-term risks that could push the European economy into a protracted period of low growth and low inflation.
A British exit (or Brexit) from the EU would, among other things, will cause disruptions and encourage disintegrative forces in other member countries. Dun & Bradstreet currently assesses the risk of a Brexit to stand at 35%, but this can go up quickly should, for instance, the migrant crisis in continental Europe escalate.
Even though the bailout agreement in August 2015 has significantly reduced the short-term risk of Greece leaving the euro zone, the threat of a Grexit remains a Damocles sword for the EuroZone. Borrowing costs for large Euro area economies such as Italy and Spain would surge; the viability of the currency union itself might be called into question; the status of the euro as reserve currency would also be challenged. We currently assign a 20% probability to a Grexit in the medium-term.
3. The Refugee Crisis
The increased inflow of migrants into the EU has exposed deep political divides between European countries as to how it should be addressed. From a supply-side perspective, the crisis has only caused minor disruption so far, but we cannot rule out more serious supply-side issues should the inflows lead to a further tightening of border controls.
4. Rising Anti-Austerity Sentiments
Recent elections in Ireland, Spain and Portugal have signaled growing populist, anti-austerity sentiment across Europe. At the same time, elections in Germany and France will take place in 2017 with anti-establishment (and very often anti-EU and anti-immigration) parties polling well in both countries. Regardless of the economic situation among different countries, anti-EU parties have gained popularity across Europe. As these growing political forces encourage widespread distrust of the EU’s institutions, the much-needed movement toward closer European integration and coordination is under increasing threat.
Whether the Eurozone will collapse or survive over the medium term largely depends on politics, as it has primacy over economics. Our core scenario foresees policy makers continuing with a reform agenda, albeit painfully slowly, with any reformist zeal being stymied by the need for frequent consensus and compromise. Several more changes to the Eurozone’s institutional framework are required in the next years and implementation risks are high.
Despite our core belief that the Eurozone will survive (at least) for the next 5-10 years, we recommend monitoring the situation closely. The risk of a break-up might increase again, especially if the four key short-term risks we have identified materialise and their spill-over effects cannot be contained.