This Week In The Eurozone: Improving Governance, Still Lacking Growth

Over the last year the EU has significantly strengthened the governance of the eurozone. Thanks to the ECB’s Outright Monetary Transactions, the euro area now has an efficient mechanism to cope with financial crisis. A road map has been created for banking union, coordination of fiscal policy has been enhanced and governments have committed to keep their financial houses in order over the medium term.

Over the week the European Parliament and the EU Council of Ministers have agreed on the details of the “Two-Pack”, which improves coordination and surveillance of budgetary policies, to avoid the possibility of potential spill-over threatening the stability of the eurozone as a whole. In particular, the Two-Pack introduces precise common budgetary timelines and rules for eurozone members. Each year, the Commission will examine draft budgets and issue its opinions before the end of November, that is to say before the following year’s budgets are adopted by national Parliaments. Should the Commission identify a failure by a country to meet its obligations under the Stability and Growth Pact, it will ask the country in question to submit a revised proposal. In the area of surveillance, the Two-Pack strengthens the monitoring of those countries facing serious difficulties regarding their financial stability. If the Commission judges that the financial conditions of a country are threatening the stability of the zone, then it could propose to the Council that the country adopts further corrective measures.

Although there is widespread agreement on the benefit of fiscal consolidation for growth in the medium-term, questions have begun to be asked about the details and timing of corrective measures. The adjustment has probably been excessively frontloaded, especially in the peripheral countries of the zone. Stress and panic in financial markets might have pushed governments and EU institutions to correct fiscal imbalances in too short a period, depressing activity in the short run still further. It seems that EU is now adopting a more flexible approach, based more on structural objectives than on nominal targets. Potential slippages of fiscal targets might, therefore, generate milder market reactions than in the past.

…but growth is still lacking
The eurozone’s commitment to guaranteeing the irreversibility of the single currency boosted confidence in financial markets. Between last summer and the end of February 2013 stress in financial markets fell steadily: equity indices have been trending higher and yields on debt securities have eased. Better financial conditions have helped sustain business confidence. Leading indicators have been on the rise since October 2012. Macroeconomic positions began to improve, as shown by narrowing current account imbalances. Foreign investors have been gradually returning in peripheral countries, signalling renewed confidence in these economies. This trend is also visible in the reduction of the Target 2 deficit position with respect to the eurosystem. Lastly, Portugal and Ireland are progressively regaining access to the market, another sign of renewed confidence.

Political developments in Italy halted this positive trend; however, the relatively mild reaction of financial markets to Italy’s inconclusive general elections probably supports the view that the eurozone is now better equipped to counter shocks. Even so, there is no room for complacency. The eurozone still lacks growth, the key ingredient in rebuilding confidence and stimulating investors’ appetites.

Will the eurozone see a return to growth during 2013? Recently released hard data are not very encouraging. In the last quarter of 2012, the recession deepened, with GDP declining by 0.6% over the quarter, dragged down mainly by the fall of domestic demand, while industrial production contracted by 0.4% m/m in January. Available survey data for Q1 were better oriented, suggesting that the pace of contraction might ease over the quarter. Some positive surprises cannot be ruled out, should the strong reading of German leading indicators be confirmed by hard data. The export-led German economy is benefiting from the recovery of global activity. In addition it can count on fairly favourable domestic fundamentals such as a strong labour market, decent wage growth and corporate profitability.

German GDP will probably increase in 2013 with respect to 2012, while output in the other largest economies of the area will probably contract again or stabilise at best. Credit in peripheral countries is still contracting, particularly in Spain. Lack of credit might continue to squeeze the economy. Italy has done a lot to consolidate its fiscal position and to address the bottlenecks in its economy. The current political instability might affect prospects for the short term (uncertainty and higher interest rates might further constrain domestic demand) and medium term, and the reform process might lose momentum.

To sum up, although the eurozone is better equipped to counter shocks, the uncertainty regarding political developments in Italy and their consequences for the zone have tempered recent optimism and the improvement in financial markets. The recent upturn recorded by leading indicators might, therefore, mark a pause. Against this backdrop, activity may slightly contract over the quarter. Further ahead, the recovery should gain some momentum, benefiting from an accommodating monetary policy, from the improvement in financial conditions which progressively filters down into the real economy and from a more favourable external environment. Over the year, however, GDP is forecast to contract by 0.5%, largely due to base effects. Next year output should grow by almost 1%.

BY Clemente DE LUCIA