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How Is Europe Doing Amidst All This Chaos?

BLOG - 19 February 2019

In the two previous articles of this series, we analysed the factors that are expected to shape the US economy - robust, but less so than in 2018 - and the Chinese, hit by tighter credit conditions at the end of 2018, and where growth is contingent on stimulus measures. We will now turn to the European Union, where political tensions and risks are rising, but whose economy may ultimately turn out to be surprisingly resilient.

Many red flags rose these past months. Almost a year ago, German industrialists surveyed by the CESifo Institute were celebrating the excellent economic situation they were enjoying, but were already concerned by the possibility of a slowdown, probably because of the abrasiveness of the new US trade policy. The slowdown has indeed occurred, and today, the same manufacturers now see their order intakes decreasing, and are even more worried about the coming months, even though they still consider their current situation to be comfortable. German prospective pessimism is mainly due to external causes: the slowdown in world trade is, not surprisingly, bad news for the world's leading exporter. Moreover, this slowdown, which is partly caused by the increases in US customs duties, also mainly comes from the market on which German industrialists have been banking on most in the past 20 years, i.e. China. We must therefore return to China, but this time approach it from a German perspective.

China seen from Germany: it could be worse

The cold snap that seized the Chinese economy is worrying, as she has become the world's third largest trade engine with 14% of global imports, just behind the European Union (15%) and not far from the United States (17.5%). The risk does not so much result from domestic demand - which will react positively to the inevitable stimulus measures decided in Beijing - as from threats to the distribution of value-added chains, an avatar of the late international division of labour, which Huawei’s tribulations perfectly illustrate.

China has become the world's third largest trade engine with 14% of global imports, just behind the European Union (15%) and not far from the United States (17.5%).

The good news - if one may say so - for European manufacturers, especially the Germans, is that they are less involved than their American, Korean or Taiwanese counterparts in the value chains of the electronics industry, from components to smartphones to infrastructures. However, American threats to increase tariffs on car imports are taken very seriously in Stuttgart or Munich, because the German industry is essentially centred around the automobile and machine tools, two activities that are also closely intertwined. But, for the time being, these are just threats.

If the structural threats to world trade are serious, but not to the point of jeopardizing growth in the European Union, what about domestic demand, which represents 83% of the final demand addressed to its producers? Although mixed, news on this side are not so bad.

In continental Europe, demand is supported by German wages…

As previously mentioned in this blog, the German economy is at full employment, if not beyond, and the impact on wages is clearly visible. In sectors where manpower shortage is most acute, such as that of construction, wage costs are rising by 4% per year. In services, the rate is around 3% and, even in the industry, wages are rising faster than in the rest of the eurozone. Despite what is often said on this side of the Rhine, the excellent health of the German labour market is a boon for its neighbours, because it benefits consumption, and reduces the competitiveness gap, provided, of course, that domestic wages remain under control. The Macron-Philippe team is well-aware of this, since it resisted the sirens’ call for an increase of the minimum wage.

... and the stimulating policies of the ECB, France and Italy

Second, economic policies are - generally - in favour of growth. Even if the European Central Bank has stopped adding, month after month, further stimulus in the form of purchases of government and corporate bonds, it continues to step on the gas by leaving its rates and balance sheet unchanged. The best evidence for this is that narrow money supply (M1), often considered to be a coincident cyclical indicator, grew at an annualized quarterly rate of 7.1% at the end of 2018. Also, its broadest version, M3, was at a rate of 5.1%, which is higher than current GDP growth, and is thus signalling an abundance of liquidity. Furthermore, since wages are rising faster in Germany than in other countries of the Eurozone, the common monetary policy is more stimulating there, because inflation-adjusted interest rates are what matters most to the economy.

On the fiscal side, France and Italy finally opted for similar macroeconomic policies, with income support measures approximating 0.5% of GDP on both sides of the Alps, judging by the announced increase in structural deficits. Even if their economic policies differ substantially - reforms in France, redistribution and reassessment of past reforms in Italy - the second and third largest economies of the Eurozone are both also stepping on the gas.

Even if their economic policies differ substantially [...] the second and third largest economies of the Eurozone are both also stepping on the gas.  

Unless there is a major supply shock (competitiveness) or demand shock (confidence), the European economy should be - in theory at least - less sensitive to the global slowdown than China or the United States, thanks to the good performance of its domestic demand. The probability that the economic outlook will not follow this reasonable and rather optimistic scenario is unfortunately significant, due to two internal EU risks.

Two risk factors: Brexit and Italy

We have talked about the first risk so extensively that we might end up underestimating it. If, on 1 April, the United Kingdom left the EU without any further ado, the supply shock caused by the temporary fall in trade and the disruption of production chains could be considerable. Of course, it would be much more important for the United Kingdom than for the EU-27. Of course, continental economies are more deeply intertwined than with the UK, at least for the production of goods. Yet the fact remains that the shock would be negative, and that its magnitude cannot be quantified precisely in advance, because network effects are too difficult to assess, particularly in finance.
 
The second risk is the path of the Italian economy. Although it is known in Brussels that Italy poses a systemic risk, and in Rome that the Italian population values the economic stability provided by the Euro, the fact is that the economy has been stagnating over the past six months due to the tightening of monetary conditions, particularly in credit to SMEs. The tightening was caused by investors’ distrust (i.e. mainly Italian savers) towards the extravagance of the agenda of the Lega-Five Star coalition. Fiscal stimulus should revive the economy, but it will also rekindle the doubts that the markets and eurozone partners of Italy which guarantee its monetary credibility - Germany above all -, already have about the sustainability of Italy's public debt, and the soundness of its banking system. The latter’s balance sheets are far from being cleaned up from the bad loans accumulated over the last ten years. Yet, experience has shown that the Italian economy is resilient, that its public debt, while not sustainable in the long term, is well managed, and that companies, which are often operating via networks in Northern Italy, are innovative and highly adaptable. In the short term, the risk thus seems to be more political than financial or economic.

In France, manufacturers are rather optimistic

To conclude, a word on France. If 2018 was a disappointing year, ending with a stagnant domestic demand, prospects for 2019 could be more promising. Let us start with the bad news. In January, the National Institute of Statistics and Economic Studies’ (INSEE) monthly survey of real estate developers showed a further deterioration in the demand for new housing. Forecasters pay attention to this survey, because it has often warned of turning points in advance in the past. However, an exogenous factor, i.e. the replacement of a broad-based wealth tax (ISF) by a narrower one, focused on real estate (IFI)the ISF is likely responsible for this fall, illustrated by the sharp deterioration in upfront payments reported by developers.

In 2019, the French economy could paradoxically do well in a general context of slowdown and political risks.

On the other hand, the INSEE quarterly survey on investment plans by industrial companies, published in early February, is very positive. As usual, industrialists have upgraded their very first investment forecasts for 2019, announced last October, but they did so even more than usual. Indeed, they are now betting on a 10% increase in spending, and they mention profitability and demand, both domestic and foreign, to justify their enthusiasm. Profitability has been boosted by changes in tax policy in favour of companies (reduction in the corporate income tax rate and perpetuation of the tax credit for employment and competitiveness (CICE) in the form of lower payroll charges).

Industrialists thus cite the creation of new capacities as their investments’ main target, with a confidence unseen since the boom of 1999-2001. As for the good performance of demand reported by companies, which is a good surprise, it illustrates the fact that, on the whole, the French industry is less sensitive to fluctuations in world trade than its German counterpart and, on the other hand, is sensitive to both domestic and German demand.
 
In 2019, the French economy could paradoxically do well in a general context of slowdown and political risks. An excellent reason to keep the reforms going!

 

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