A fragile return to confidence in the eurozone

Despite economic growth across the eurozone picking up in the second half of the year, an overall decline of 0.5% in GDP is  expected for 2013, followed by sluggish growth of 1.1% in 2014, according to Ernst & Young’s latest Eurozone Forecast (EEF), Spring edition.  

Ireland has made a lot of progress since the start of the financial crisis; however, short-term growth prospects are still weak. In light of the latest budget, which included further fiscal tightening worth €3.5bn (approximately 2% of GDP), EEF has revised it GDP forecast downwards for Ireland from 1% to 0.1% for 2013, before we start to see sustainable growth of 1.9% in 2014 and accelerating to 2.5% in 2015.

Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast comments, “The success of the 10-year bond issuance by the Irish government is very good news for the economy. It is further evidence of investors’ confidence in the sustainability of public finances and cements Ireland’s restored access to financial markets. Similarly successful bond sales would encourage rating agencies to upgrade Ireland’s credit rating.  Achievements such as this, is one of the main factors behind our forecast of a return to solid growth from 2014 onwards”.

Since 2008, employment in the periphery has fallen by 9% or 5 million people. In the case of Spain, Ireland and Portugal, employment has fallen further than output, thereby providing a boost to productivity. Unemployment levels in Ireland are forecast to remain stagnant in 2013 at 14.9% before we start to see a modest improvement of 13.8% in 2015.

We expect consumer spending in Ireland to fall almost 2% in 2013, with marginal growth in 2014, due to a weak labor market, as well as tax hikes and spending cuts announced in the budget.  Meanwhile, investment in Ireland, already 55% below its 2007 level, is forecast to fall by 9.5% in 2013, before starting to rise in 2014 to 4.1%.  This is due to a combination of tight credit conditions, resulting from ongoing problems in the banking sector, and a lack of appetite among firms to borrow money for investment.

Marie comments, “The return to very modest growth that we expect to see in the peripheral countries in 2014 will initially be driven by business investments and exports and subsequently, once the labor market starts to improve, by consumer spending.”

By 2014, EEF expects the peripheral eurozone countries with the fastest export growth to be Greece, Ireland and Spain – 9.3%, 4.4% and 4.1% respectively. These are the three countries that have seen the largest improvement in their relative unit labor costs, and hence competitiveness, since 2008. This will help these countries exit recession and allow gains in economic activity to accompany job creation.

Mike McKerr, Managing Partner Ernst & Young comments, “Globalisation continues to define our business landscape with increasing levels of cross-border trade.  Ernst & Young’s Globalisation report recently ranked Ireland sixth globally in terms of trade and first on openness and ease of trading.  Encouraging rankings such as these, a rise in investor confidence, increased export competitiveness and improvement in public finances; suggest that Ireland is likely to return to sustainable growth in the medium term”.

Strong euro unlikely to pose threat to growth

Although the economic climate remains difficult, confidence among businesses and consumers should return gradually, as some of last year’s major threats recede. But business investment in the eurozone is still expected to shrink by 2% in 2013, before recovering slowly to post average growth of 3.5% a year in 2014-17. EEF believes that markets have risen too strongly, given that many economic fundamentals remain weak at best and the ongoing political uncertainty in several countries.

EEF has not lowered its growth or export forecasts as it does not expect the rate to stay at its current level for long. EEF estimates that the euro is overvalued by a little under 10% at present. But, as uncertainty about the US fiscal stance clears and the pickup in growth there and in emerging markets becomes more obvious, EEF expects the euro to depreciate again towards US$1.25 by the end of this year.

Marie says, “It is unlikely that the ECB will intervene unless the strength of the euro continues and a significant impact on activity becomes evident. However, if the rise does persist the ECB many need to intervene, perhaps even with an interest rate cut, to stem any further appreciation. A stronger euro does pose a new threat to the eurozone outlook but it is one that businesses are accustomed to so it is unlikely to have a major impact.”

Fiscal tightening to cut 1% off GDP growth

Fiscal tightening is also expected to be a medium-term drag on growth. EEF estimates that fiscal tightening will amount to more than 1% of GDP again this year, which will cut around one percentage point off GDP growth. From 2014 onwards, the pace of fiscal tightening should lessen, but at around 0.5% – 1% of GDP a year, it will continue to dampen growth.

Marie explains, “After several years of austerity, one of the key challenges now facing policy-makers in the eurozone – both in the peripheral countries and most others – is to apply public sector reforms in a way that does not continue to undermine growth.”

Two steps forward, one step back

Marie concludes, “As has often been the case with the eurozone since we began our forecasts in April 2010 recent developments have been two steps forward and one step back. As soon as the outlook improves and volatility declines, fresh concerns appear and new threats rear their heads. If there is to be a recovery later this year – and we believe on balance there will be – it will be a fragile one and policy makers need to keep a close eye on political and economic developments and be prepared to again respond quickly and effectively to deal with any potential crisis.”