The outlook for Europe has brightened, but economic growth remains sluggish in the region due to postcrisis legacies and eurozone-specific structural weaknesses. Uncertainty associated with rising geopolitical tensions and sluggish implementation of reforms, coupled with the private sector’s ongoing deleveraging, unfinished macroeconomic adjustment, and credit rationing — all combine to constrain growth.
The recovery in economic activity has been supported by factors that are at play across the eurozone: Labor market conditions are improving and household disposable incomes are on the rise, along with significant pent-up demand. Low oil and commodity prices and the European Central Bank’s (ECB) ultraloose monetary policy have also delivered short-term impetus.
Other factors are poised to drive growth in the medium term. First, fiscal policy is set to remain broadly neutral and monetary policy is to remain highly supportive. Second, the ECB’s new package of economic measures will keep financing costs low. Furthermore, productivity-enhancing structural reforms implemented over the past few years should gradually begin to pay off even for the more vulnerable member states.
The combined strength of these tailwinds should gradually reverse the pattern of weak domestic demand and low investment, accelerating economic growth in the medium term. Nevertheless, the euro-area economy still faces significant headwinds. Many eurozone-specific structural weaknesses, which predate the debt crisis, remain unsolved.
They include a poor demographic profile, lack of a fiscal union, and a widespread political reluctance to move towards a deeper economic and political integration, to name but a few. Furthermore, despite the ECB’s efforts to revive credit flows in the eurozone, bank lending is only gradually picking up as ongoing private sector deleveraging and the high level of nonperforming loans act as a break on credit expansion.
In addition, lower growth in emerging markets, most notably China, will limit the euro area’s capacity to export its way out of trouble. As for the euro, despite the differential in the monetary policy stance between the ECB and the US Federal Reserve, the receding likelihood of a eurozone breakup will lead to an appreciation of the single currency against the US dollar in the quarters ahead.
Key Short-term Risks
Dun & Bradstreet’s baseline projections are subject to a number of downside risks. In particular, we have identified four key short-term risks that could push the euro-area economy into a protracted period of low growth and low inflation.
Brexit: A British exit (or Brexit) from the EU would, among other things, cause disruptions and encourage disintegrative forces in other member countries. Dun & Bradstreet currently assesses the risk of a Brexit to stand at 35%, but this could go up quickly, should, for instance, the migrant crisis in continental Europe escalate.
Grexit: Even though the bailout agreement in August 2015 has significantly reduced the short-term risk of Greece leaving the eurozone, the threat of a Grexit remains a Damocles’ sword for the eurozone. Borrowing costs for large euro-area economies such Italy and Spain would surge; the viability of the currency union itself might be called into question; the status of the euro as reserve currency would also be challenged. On a more positive note, the Greek parliament has recently approved a long-awaited reform of the country’s pension and income tax systems. We currently assign a 20% probability to a Grexit in the medium term.
The Refugee Crisis: The increased inflow of migrants into the EU has exposed deep political divides between European countries as to how it should be addressed. From a supply-side perspective, the crisis has only caused minor disruption so far, but we cannot rule out more serious supply-side issues should the inflows lead to a further tightening of borders controls.
Rising Antiausterity Sentiments: Recent elections in Ireland, Spain, and Portugal have signaled growing populist, antiausterity sentiment across Europe. At the same time, elections in Germany and France will take place in 2017 with antiestablishment (and very often anti-EU and anti-immigration) parties polling well in both countries. Regardless of the economic situation among different countries, anti-EU parties have gained popularity across Europe. As these growing political forces encourage widespread distrust of the EU’s institutions, the much-needed movement towards closer European integration and coordination is under increasing threat.
Daniele Fraietta has been a D&B economist for more than two years. He currently covers some Western European countries, notably Italy, Greece, Spain, and Ireland. For D&B, Daniele has also developed the new econometric framework for commodity prices and exchange rates forecasting. He has an MSc in Economics from the University of Rome Tor Vergata, a Master in Business Administration from The Polytechnic University of Milan, and a Master in International Business from the Chapman College of Business.