A year ago, Europe was being touted as the resilient zone. Inflation was the big worry, not recession. Interest rates were hiked 25 basis points on July 9th, 2008. But the zone’s analysts were wrong. Along with the rest of the world, Europe tumbled. Brighter signs have emerged recently, enough to prompt calls for a scaling-back of government stimulus. Is Europe poised to lead the world back to growth?
It certainly didn’t look that way a few weeks ago. Europeans were shocked enough by the 6.8% annualized drop in output in the final months of 2008, but the 9.1% slump in the January-March period was a stunning blow. Most other big economies also contracted in the quarter, but Europe’s accelerated decline set it apart from all other zones. Economic momentum was clearly in the wrong direction, and led to significant downgrades of the pan-European growth forecast for 2009.
Recent signals are more upbeat. Industrial production posted gains in Germany, France and Italy during May. The trade balance for the Eurozone marched further into the black during the month. Germany also saw a surprising surge in new manufacturing orders in May, and both business and investor confidence are on the upswing, kindling hopes that recovery is imminent.
The signs are encouraging, but in each case, they represent gains from very low levels – the freefall may be over, but restored activity levels are still a long way off. Meanwhile, Europe faces increasingly serious domestic concerns. Those earlier sharp drops in output are still affecting the region’s labour market. The zone-wide unemployment rate has shot up from 7.4% in June 2008 to 9.5% in May of this year, and further deterioration is expected before the year is done. Usually backward-looking, these job stats point to a near-term concern: the marked rise in unemployment is bound to translate into rising defaults in the banking system – defaults on what are currently viewed as good credits.
Is Western Europe’s banking system well-positioned for a wave of defaults? At present, it is difficult to say. While stress-testing of the system is underway, it appears to be well behind the US exercise, and far less transparent. Moreover, there are deeper structural concerns about Europe’s banks. A number of key financial institutions entered the recession with unusually high loan-to-asset ratios. In addition, the IMF has registered concern about the extent of toxic assets still on the books. Furthermore, the region’s banks are more highly exposed to Central and Eastern European economies, which together are particularly hard-pressed in the current downturn. Finally, many European financial firms are large as a share of their home country’s GDP, and as such, a bailout, if needed, would be very onerous.
Will other government policy measures come to the rescue? European economies, like most others, have announced hefty public stimulus plans. Unfortunately, they will be more muted than elsewhere. Interest rate cuts were smaller and came later than in other big economies. To date, announced fiscal measures fall well below the OECD average, and the overall effectiveness of certain key plans is in question. There is no doubt the stimulus will help, but there are lingering doubts about its adequacy.
The bottom line? Western Europe has been slow to accept the severity of the global recession, and it still faces key economic challenges. At this point, it is unlikely that Europe will lead a global recovery, but at the same time, a fulsome world recovery will not occur without Europe’s full participation.