- The euro zone is expected to grow 1% in 2014, but unemployment will remain high.
- Tensions are rising in the interbank market as banks pay off liquidity loans.
- Sovereign yields are stable and the euro is strong.
- The recovery will be driven by exports with modest contributions from consumption and investment.
- An escalation of the debt crisis, a slowdown in emerging markets, and deflation pose the biggest risks.
The euro zone's output grew only 0.1% in the third quarter of 2013, down from 0.3% previously. Yet more recent data suggest the region's economic situation is improving, with purchasing managers' surveys for December pointing to expansion.
Despite signs of a short-term output boost, the unemployment rate remains elevated across the currency union. The jobless rate is especially high among younger workers aged 15 to 24. In a recent McKinsey survey, 45% of Greek firms and 47% of Italian firms said they would hire more but had difficulty finding workers with the necessary skills.
Tensions in the euro zone interbank money market are rising as banks repay the European Central Bank for money loaned under its Long Term Refinancing Operation. Under this scheme, the ECB supplied banks with €1 trillion worth of three-year loans in two rounds. The banks have repaid more than half the loans made in the first round and a third of those made in the second. The remaining balance is €570 billion.
Many banks repaid their loans early, concerned that higher leverage ratios might hurt them in stress tests to be conducted by the ECB later this year. As a result, the key euro zone short-term money market rate, called Eonia, increased to 0.16% in January. Rising money-market rates could mean higher borrowing costs for credit-poor countries such as Italy and Spain.
To mitigate this risk, the ECB could cut its main policy rate from 0.25% to slightly above 0%. But this highlights the ECB's recurring dilemma as it tries to apply a single monetary policy to an economically disjointed euro zone. For example, a Taylor rule calculation to inflation and business cycle conditions across the region suggests that the appropriate policy rate for Germany is 5%, while for Spain it would be -13%, an impossible level in practice given the zero bound for nominal rates. The German housing market shows signs of overheating while the Spanish market has not yet recovered from its post-2007 collapse. Even if the ECB wanted to lower its rate to aid the currency union as a whole, it would likely face resistance from Germany.
What drives borrowing costs
Government borrowing costs were driven by two factors in 2013. The first was the U.S. Federal Reserve's signal to markets in June that it would soon begin to slow its purchases of long-term debt securities. Interest rates rose sharply in the U.S., temporarily driving up the value of the dollar. Notably, when the Fed actually announced in December the start of its long-awaited taper, markets had fully priced in the move and there was little impact on euro zone yields.
Meanwhile, the risk of a euro zone breakup appeared to subside; this was the second factor influencing government yields. The ECB's pledge to purchase sovereign debt via so-called Outright Monetary Transactions continues to push down borrowing costs for sovereigns, as has the progress made by countries that were bailed out by the ECB, EU and International Monetary Fund. Ireland exited its bailout program late in 2013 and Portugal hopes to do so by mid-2014. Both countries have recently sold debt in the private capital markets. While a breakup of the euro area is still a risk, the odds are falling, helping lower yields for sovereign debt.
Government borrowing costs remain high in the southern euro zone, in part because of the link between governments and banks. Governments are responsible for bailing out failing banks, whose problems include their large holdings of government debt. The latest agreement on banking union adopted in December did not go far enough to break this link. The proposed union includes no common deposit insurance, and the ECB cannot restructure banks without involving national regulators.
Recently, the Basel Committee changed its rule for calculating bank leverage, excluding some assets to make it easier for banks to meet the 3% target. As a result, many banks will avoid having to raise additional capital. While many banks' balance sheets have strengthened since the 2008-2009 recession, additional capital would make them safer, and the rule change may represent a missed opportunity to push European banks in that direction.
The euro remains surprisingly resilient. The currency's U.S. dollar exchange rate remains above $1.35 and has been between $1.27 and $1.39 over the past year, higher than expected given relative growth prospects. Moody’s Analytics forecasts U.S. GDP will expand 3.2% while the euro zone grows only 1%. Inflation and interest rate differentials may be driving the exchange rate for now: Consumer prices in the euro area were up 0.8% y/y in December compared with 1.5% in the U.S. The ECB’s current monetary policy rate is 0.25%, while the Fed's rate is 0.13%.
The euro has also appreciated against other European currencies. After the Czech National Bank began targeting an exchange rate of CZK27/EUR, the koruna's value fell by more than 10%.
A strong euro may slow export growth in the first half of 2014. Euro area exports grew only 1.2% in 2013 but were the largest contributor to the region’s output, adding 0.6 percentage point. Reliance on exports is risky, as a potential slowdown in emerging markets and in the U.S. would hurt the performance of the euro zone economy. The distribution of exports also raises questions, as Germany has run a strong current account surplus recently, putting further pressure on the euro’s appreciation. On the other hand, exports in Spain and Italy turned positive in 2013, helping trigger the modest recovery. The French current account remains firmly negative, although its deficit is sustainable.
Consumption spending will grow modestly in 2014, restrained by still-large levels of household debt. Private debt is highest in Ireland and Portugal. These are also among the countries with the highest risk of deflation. Inflation was running 0.3% y/y in Spain in December and 0.2% in Portugal, compared with 1.3% in Germany. Deflation could push the fragile euro zone recovery into another recession.
Investment fell 3.2% in 2013, driving the overall output contraction in the euro zone. While we expect investment to grow 2.6% in 2014, this could be reversed should the debt crisis re-escalate. In addition, the cost of borrowing is still higher in southern euro zone countries, and large corporate debt balances may deter businesses from pursuing new projects.
Government spending rose marginally in 2013 and did not contribute to output growth. While the focus on fiscal austerity has subsided, the consolidation of government budgets continues and public spending will not boost growth in 2014. Generally, fiscal positions either improved or did not change. The exception is Spain, which is losing fiscal space, or the amount it can borrow as a proportion of GDP without having to drastically change fiscal policy.
Moody’s Analytics forecasts GDP in the euro area will grow 1% in 2014. The main driver of recovery will be external, while the main risk—a re-escalation of the debt crisis—is internal.
Petr Zemcik is a Director - Economic Research at Moody's Analytics.
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