DEVELOPED EUROPE: ECONOMIC REVIEW AUGUST 2011

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Germany: Labor market stable despite growth slowdown

In a step that reflects Germany’s resolve to tackle the Euro-zone debt crisis decisively, Chancellor Angela Merkel’s cabinet has approved the draft of planned legislation to expand the country’s role in the EFSF. The draft legislation envisages raising Germany’s share of EFSF loan guarantees to €211 billion from €123 billion. However, the initiative states that future bailouts must be unanimously approved by all Euro-zone member nations, and that tougher conditions must be imposed for future bailouts. More importantly, the draft bill gives Bundestag, the German parliament, the right to approve future bailouts. Bundestag will vote on the proposed changes to the EFSF on September 29.

Meanwhile, business confidence in the country waned to its lowest level in more than a year amid the global slowdown and a worsening outlook for economic growth in Europe. The Munich-based Ifo Institute's business climate index, which is compiled on the basis of a survey of 7,000 executives, fell to 108.7 in August from 112.9 in July, the lowest level since June 2010. A level of 111 had been forecasted for August. The index had jumped to a record high of 115.4 in February.

German consumer confidence too remained in a downtrend. The GfK research institute's index of household confidence declined from a revised 5.3 points in August to 5.2 points in September, its lowest figure since November 2010.

In sharp contrast to most other data released from Germany, the country's unemployment rate fell for the 26th consecutive month in August, indicating that hiring there has held up despite the perceived slowdown. The number of jobless people declined by 8,000 to 2.95 million on a seasonally adjusted basis, according to the Nuremberg-based Federal Labor Agency. Nonetheless, the rate was expected to fall by 10,000. At the end of August, the unemployment rate stood at 7%, the lowest level since the reunification of Germany.

U.K.: Consumer sentiment continues to weaken

In a month that saw the U.K.’s worst case of rioting since the 1980s, consumer confidence in the country dipped for the third month in a row in August. A report from the London-based research group GfK NOP Ltd. showed that a measure of consumer sentiment fell 1 point to minus 31 between July and August. Further, in a sign that Britons today are growing increasingly pessimistic about future economic conditions in their country, an index of households’ expectations for the economy over the next one year slipped 4 points to minus 31, the lowest point in six months.

Among other indications of a loss of momentum in the U.K.’s economic recovery, the Office for National Statistics (ONS) confirmed in its revised estimate that the nation’s second-quarter GDP, which was first reported in July, had indeed expanded just 0.2%. In the January-March period, GDP had grown 0.5% on a quarterly basis. The ONS added in its report that production industries shrunk 1.6% in the second quarter to record the sharpest contraction since the first quarter of 2009. The construction and total services sectors both expanded 0.5%, the ONS said. Further, the Confederation of British Industry reported that the U.K.’s retail sales data for August showed the quickest pace of decline in over a year. Adding to the pessimism, the confederation said retailers expected sales to decrease again in September.

A Bank of England report released toward the end of August indicated weak borrowing by businesses in Europe’s second largest economy. The report states that on the whole, the volume of loan repayments by U.K. companies was more than the volume of new loans, a signal that businesses may be wary of taking new loans for expansion amid the slowdown. However, the central bank added an encouraging note for the housing industry in its report, saying that the approvals for new mortgages increased to 49,239 in July from 48,500 in June.

France: Flat second-quarter GDP growth a concern

With French household consumption slipping 0.7% in the second quarter compared to the first, GDP growth in the country remained flat in the April-June period on a quarterly basis, according to the national statistics agency Insee. The data have raised doubts about the ability of France, which has so far played a key role in backing bailout programs in the Euro-zone, to support future bailouts, if necessary, as well as to meet its own budget-deficit targets.

The French government’s goal is to narrow down its budget deficit to 5.7% of GDP this year, 4.6% in 2012, and 3.0% in 2013. However, slower-than-desired growth could decrease tax collections and increase spending on unemployment benefits, making it more difficult for the government to meet these targets. Given investor concerns about its ability to hold on to its AAA credit rating and the resilience of its large banks, France is trying hard to prove that it is capable of reining in its budget deficit appreciably. Notably, large French banks are in the spotlight because they reportedly hold significant quantities of Greek debt.

Meanwhile, the French Prime Minister, Francois Fillon, has declared that the government would cut spending by €500 million this year and by €1 billion in 2012 to achieve deficit targets. He has said that the government will also take revenue-generating steps, including a 3% surcharge on those earning more than €500,000 a year as well as higher taxes on capital gains, alcohol, tobacco, and some non-alcoholic beverages.

In an encouraging development, France's unemployment rate dipped to 9.1% in the second quarter from 9.2% in the first. The Sarkozy government has made reducing unemployment its key priority, and it is aiming to trim the unemployment rate below 9% by the end of this year.

Italy: ECB bond purchase arrests rise in yields

To reassure bond investors and convince markets that its finances were in order, Prime Minister Silvio Berlusconi declared in early August that a constitutional amendment would be instituted to make it binding on the government to balance the budget by 2013 instead of 2014, as planned initially. He is widely expected to announce further reform moves.

Barely a month after unveiling a €40 billion austerity package, the Berlusconi government introduced another such plan worth €45 billion around mid-August. The latest package was put together quickly and approved by the Cabinet as the ECB demanded additional austerity measures before stepping in to buy Italian sovereign bonds. The government gave in to this demand because the yields of its 10-year bonds had crossed 6% and had significantly increased the country’s borrowing costs. Among other things, the new austerity plan advocated delayed retirement for some Italians. Notably, though, a key coalition partner of the government opposed sections of this package. In response, Prime Minister Berlusconi agreed to certain changes in the plan’s clauses, including dropping a proposed tax on the country’s rich and lesser cuts in the funding for regional governments.

Fortunately, the ECB’s move to buy Italian bonds under its Securities Market Program (SMP) turned out to be successful. Within 15 days of ECB bond purchases, Italy’s funding costs fell substantially. In fact, toward the end of August, the country managed to auction nearly €8 billion of bonds. However, the auction saw weaker-than-expected demand from private-sector investors, a sign that a section of the investor community continues to be wary of buying Italian bonds.

Spain: New labor laws to facilitate temporary hiring

Much like the Italian government’s move, two of Spain’s largest political parties have promised a constitutional amendment to impose specific limits on budget deficits. The pledge is in line with the suggestions made by Germany and France to bring about greater integration in the fiscal policies of Euro-zone member nations. In a parliamentary meeting during August, Spain’s Prime Minister Jose Luis Rodriguez Zapatero and opposition leader Mariano Rajoy backed changes to limit public borrowing and spending.

In order to give a boost to its moribund housing and real estate industry, which is yet to begin recovering significantly from a property bust, the Spanish government has proposed a temporary reduction from 8% to 4% in the value-added tax on newly built houses. The measure is expected to clear the stock of unsold homes in the country to a certain extent. Having announced this at a media briefing, Finance Minister Elena Salgado also declared a reduction in tax credits.

Desperate to reduce the unemployment rate, which at 21% is currently the highest in the Euro-zone, the Spanish government has approved several steps to help firms hire workers on cheaper temporary contracts. The provisions include permission for companies until 2013 to keep employees on temporary contracts for an indefinite period. Most of the steps are aimed at improving youth employment.

Notably, the Spanish government, which had recently hinted at a plan to reintroduce a wealth tax on the country's rich, has decided to drop the idea. The tax, which the current government abolished in 2008, had reportedly collected €2.1 billion in 2007.

Greece: Second bailout package hits hurdle

The Greek economy continues to be in recession. During the second quarter, its GDP shrunk 6.9% on an annualized basis compared with a contraction of 8.1% in the first quarter. However, the GDP figures, which were not seasonally adjusted, turned out to be better than economists had projected. Nonetheless, Greece has started implementing most of the austerity measures it has pledged to adopt in exchange for the two bailout packages from the international community. It is believed that these measures are likely restraining consumer spending, which in turn is making it more difficult for the country to emerge from recession.

The €109 billion second bailout package for Greece, which the IMF and EU leaders sanctioned recently, hit an unexpected hurdle in August. The bailout still needs to be ratified by the respective parliaments of the Euro-zone countries. Therefore, reports that Finland had demanded and then received from Greece collateral for its share of bailout loan guarantees hurt market sentiment. Investors worried that Finland’s deal with Greece might not be acceptable to all Euro-zone member countries. Amid these concerns, Greek 10-year bond yields soared above 18% and two-year bond yields exceeded 45%. The cost of insuring Greek debt also jumped.

Portugal: Bailout implementation approved

The manner in which Portugal is implementing the key measures it is obliged to take as a part of its €78 billion bailout program has been approved by a delegation of officials from the EU, the IMF, and the ECB. Giving a positive first review, the delegation has expressed confidence that Portugal will be able to meet its budget-deficit targets for this year, even if the debt crisis deepens in the Euro-zone. However, members of the delegation have cautioned that the country must carry out structural reforms quickly, because the much-needed growth and employment generation are tied to reforms.

The Portuguese government is preparing to launch an extensive deficit-reduction and economic growth strategy as a part of its budget proposals for 2012. The proposals are scheduled to be submitted in mid-October. However, in a sign of things to come, Prime Minister Pedro Passos Coelho has signaled that the expenditure on the national health service will likely be cut by 15% in 2011 and 2012. The government is also believed to be considering a 2% yearly reduction in the number of public-sector workers over the next three years. Keen to set Portugal apart from Greece, the Coelho government has pledged to narrow down its budget deficit to “close to zero” by 2015.