Challenges Ahead for Eurozone Recovery
Last year was a good one for the eurozone. GDP growth almost doubled after a very poor performance in 2005, and the euro has risen to new highs against other major currencies. But recovery is precarious and unlikely to be sustained at its current pace. Lower predicted growth in 2007 reflects global trends, but there are clear risks that policy actions could accelerate the eurozone’s slowdown. More seriously, persistent structural impediments, and the absence of effective reforms aimed at removing them, could hinder the eurozone’s medium-term growth prospects.
The improvement in growth comes after a long period of persistent underperformance. Although the eurozone is a large, rich and stable economy, it lacks dynamism. As Figure 1 shows, the eurozone’s annual GDP growth has been an average of 1% lower than that of the US between 1995 and 2006.
The UK has also outperformed the eurozone in that time and even Japan has overtaken it in the past six years. Even more important is the eurozone’s very mediocre outlook. It has been at the bottom of the global growth league table in every year since 2003, and most forecasts suggest that the eurozone’s relative underperformance will persist in 2007 and 2008 (see Table 1).
Eurozone GDP growth fell sharply in 2005 to a dismal 1.3% – well below the growth in potential output (that is, the maximum growth rate the economy can sustain without stoking inflationary pressures), which is estimated at about 2.1% a year. Between 2001 and 2005, eurozone growth did not reach its potential.
|
2003
|
2004
|
2005
|
2006
Estimate |
2007
Forecast |
2008
Forecast |
|
|---|---|---|---|---|---|---|
|
Japan
|
1.8% | 2.3% | 2.6% | 2.8% | 2.2% | 2.4% |
|
UK
|
2.7% | 3.3% | 1.9% | 2.6% | 2.3% | 2.4% |
|
US
|
2.5% | 3.9% | 3.2% | 3.3% | 2.1% | 2.7% |
|
Eurozone
|
0.8% | 2.0% | 1.3% | 2.5% | 1.8% | 2.0% |
|
China
|
10.0% | 10.1% | 10.2% | 10.5% | 9.5% | 9.0% |
|
India
|
7.2% | 8.0% | 8.5% | 8.5% | 7.4% | 7.5% |
Given this disappointing background, the recovery in 2006, to an above-trend pace of 2.5%, is very welcome. Unfortunately, the renewal of hope in the eurozone’s prospects is premature. The upturn is still on course, but it seems highly likely that 2007 will see eurozone GDP growth slow to 1.8% – reasonable if compared with the pre-2006 record, but still below potential. There could be a modest upturn in 2008, but only to 2%.
The lack of sufficient structural reform is generally seen as a key cause of the sluggish rate of economic growth in the eurozone. More ominously, there are serious risks that potential output is likely to fall over the next few decades, as a result of an ageing population and a declining labour force.
Projections from the European Commission suggest that potential eurozone output growth could fall to around 1.25% a year by 2040, if structural reforms to boost productivity and enterprise are not carried out at a more determined pace.
At the end of last year, the US dollar plummeted while the euro and sterling surged to multi-year highs. The sharp currency appreciation entails serious risks for the eurozone, given its reliance on exports and the 2007 slowdown expected in global economic growth.
Figure 2 shows the longer-term context – and demonstrates that the popular impression of a weak currency is wrong, if the relative strength of currencies is examined on an effective, or trade-weighted, basis.
Following a period of initial weakness, after its establishment as a single currency early in 1999, the euro has been strong overall since mid-2001. It is now about 20% above its mid-2001 effective level and there are serious risks that it will appreciate further in the next few months.
One key reason is that the euro is set to remain a major recipient of capital flows out of the US dollar, at a time when the major Asian players with huge external surpluses are practising capital controls.
Central bank reserve diversification away from the US dollar, and realistic expectations that the European Central Bank (ECB) will raise interest rates further, could put further upward pressure on the euro and seriously damage eurozone economic growth. There are no good objective reasons for the euro to strengthen significantly in 2007, since the eurozone’s current account is no longer in surplus but rather in small deficit.
The ECB has raised its official interest rate at a brisk pace since December 2005, after keeping it unchanged at 2% for more than two and a half years.
There are strong arguments for the ECB to adopt a more relaxed stance and not raise interest rates above their present level:
The markets still believe on balance that the ECB rate will be raised once more in the next few months to a peak of 3.75%.
Table 2 shows recent trends and summarises our forecasts for likely movements in the main official interest rates of the major central banks.
|
Actual
|
Forecast
|
|||||||
|---|---|---|---|---|---|---|---|---|
| end-04 | end-05 | 07.12.06 | 3mnth | 6mnth | 12mnth | 18mnth | 24mnth | |
| US Fed Funds Rate | 1.00% | 2.25% | 4.00% | 4.50% | 4.75% | 4.75% | 4.50% | 4.25% |
| ECB Refi Rate | 2.00% | 2.00% | 2.25% | 2.25% | 2.50% | 2.75% | 2.75% | 3.00% |
| Japan Overnight Rate | 0.00% | 0.00% | 0.00% | 0.00% | 0.25% | 0.75% | 1.00% | 1.00% |
| UK Repo Rate | 3.75% | 4.75% | 4.50% | 4.25% | 4.50% | 4.75% | 4.75% | 4.50% |
| US less ECB Rate | 0.25% | 2.00% | 1.75% | 1.50% | 1.25% | 1.00% | 1.00% | 1.25% |
| UK less US Rate | 2.50% | 0.25% | -0.25% | -0.25% | 0.00% | 0.25% | 0.25% | 0.25% |
There is widespread agreement that a sustained eurozone recovery still faces major obstacles:
It is important not to exaggerate the predicaments, given the eurozone’s affluence and weight in the global economy. Though fragile, its current recovery should not be dismissed, although it would be unwise to disregard the serious obstacles it faces, particularly the need to persevere with reforms and move towards a more competitive economy.
Europeans do not need to adopt all the features of the more dynamic US economic model, but painful changes cannot be avoided without serious long-term costs.