DEVELOPED EUROPE:
FOURTH QUARTER 2012 ECONOMIC REVIEW

Stress surrounding weak banks diminishes, but stubbornly high unemployment rate weakens economic outlook

Developed Europe ended 2012 mostly on a positive note, considering the heightened risk perceptions that prevailed earlier in the year. The borrowing costs of debt-ridden Italy and Spain, which had risen to alarming levels in the first half of 2012, stayed in a downtrend during the fourth quarter, largely thanks to the supportive policy announcements of the European Central Bank (ECB) in the previous quarter.

What’s more, the ECB bank-lending survey for the fourth quarter indicated reduced stress around the region’s weak banks as they reported improved access to funding. In fact, several banks in troubled countries like Italy and Portugal, which have had limited access to bond investors all through the debt crisis, managed to sell long-term debt in the final months of 2012, signaling improved confidence in European bond markets.

The steps European leaders have taken over the past year have also added to the improved optimism. While the ECB has promised “to do whatever it takes to save the euro,” several countries like Italy have pushed through politically difficult but important structural reforms. Further, policymakers are in the process of creating a banking union and a European supervisor of the Euro-zone’s big banks. Once such a supervisor is created, distressed banks will be able to seek help directly from the region’s permanent bailout fund or European Stability Mechanism.

Nonetheless, recent economic data and news from Developed Europe suggest there are challenges ahead in 2013. For one, the region’s unemployment rate remains stubbornly high — 11.7% for the Euro-zone (17-nation single currency bloc) and 10.7% for the wider 27-nation European Union (EU) in December, according to EU statistics agency Eurostat. More worryingly, the unemployment rate among youths at the end of 2012 was 24% in the Euro-zone and 23.4% in the EU. The continuing resistance to austerity measures, marked by increasingly violent demonstrations, in several parts of Europe is also a reason for concern. Besides, the International Monetary Fund (IMF) now expects the Euro-zone’s combined GDP to contract again this year.

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Germany: Growth falters on Euro-zone weakness

After resolutely defying the Euro-zone slowdown for several quarters, Germany likely succumbed to the weak economic conditions in the single-currency bloc during the fourth quarter. According to preliminary figures released by the nation’s Federal Statistical Office, German GDP shrank 0.5% in the last quarter of 2012 from the previous quarter, but managed to grow a modest 0.7% in 2012 compared to the 3.0% growth recorded in 2011. Germany has been affected by the slowdown in its neighborhood in two ways. The demand for its exports have been falling steadily in struggling Euro-zone countries like Spain and, worried about their diminished prospects, German businesses have been cutting down their capital investments.

Indeed, CNN Money has reported that German exports expanded only 4% in 2012, while the rate of growth was nearly double that figure during the previous year. According to the publication, Germany’s investment in industrial machinery fell more than 4% last year, after growing in 2010 and 2011. Germany is Europe’s largest economy, accounting for nearly 28% of the region’s economic output. Germany not only exports about 70% of its manufacturing output to the rest of Europe but also buys a similar share of its imports from other European countries. So its economic conditions have significant implications for the rest of Europe.

The outlook for domestic consumption, which has been Germany’s strong point over the past few years, weakened slightly in the fourth quarter as a forward-looking indicator of German consumers’ willingness to buy fell in both November and December. Since 2009, consumer confidence in Germany has remained relatively strong owing to an uptrend in wages, modest inflation, and labor-market policies like shorter working hours as opposed to large-scale layoffs. But even as the country’s dependence on domestic consumption has increased with weakening demand for German exports from the Euro-zone, the buying propensity sub-index of market research group GfK’s consumer climate index fell to 20.1 points in December from 29.4 points in November.

In other developments, the measure of activity in Germany’s all-important manufacturing sector, the seasonally adjusted Markit/BME Germany Manufacturing Purchasing Managers’ Index (PMI), remained well below the level of 50, which separates expansion from contraction, through the quarter. On the bright side though, Germany clocked a budget surplus of 0.1% of GDP for 2012 compared to a deficit of 0.8% of GDP in 2011. This is only the third instance of a surplus for Germany in more than two decades.

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The U.K.: Q4 GDP shrinks; government extends spending cuts until 2018

Britain’s GDP shrank 0.3% in the October-December period compared to the third quarter and was unchanged for the year 2012. According to the U.K.’s Office for National Statistics (ONS), fourth-quarter GDP declined because mining and quarrying output fell 10.2% following maintenance-related delays at the country’s largest North Sea oil field. The ONS data also pointed to subdued services sector activity, which typically accounts for three-quarters of Britain’s economy and had expanded 1.2% in the third quarter owing to a temporary boost from the London Olympics in August. Overall, between the third quarter and the fourth quarter, manufacturing output decreased 1.5%, services output remained unchanged, and construction output inched up 0.3%.

For the year 2012, services output increased 1.2%, total industrial production dropped 2.5%, and construction output dived 9.3%. These figures brought the U.K. government’s austerity measures back into the spotlight. The BBC has reported that in late January, the IMF’s chief economist urged the British government to “consider slowing down austerity measures” in its March budget because of “their effect on growth.” However, responding to the advice, the U.K. Treasury chief George Osborne said his government must continue spending cuts to “retain its credibility.” Incidentally, in a half-yearly economic update presented in early December, Mr. Osborne admitted that Britain’s economic recovery was taking longer than expected but declared that the government would continue spending cuts until 2018, three years longer than initially planned.

Britain is struggling to pick up momentum as household incomes lag inflation, government cost cuts bite, and the demand for its goods weaken in its largest export market, the Euro-zone. Also, sluggish economic growth has weakened the U.K.’s tax revenues, negating the savings from austerity measures and making it harder for the government to cut its large budget deficit. However, on the bright side, there appears to be a notable improvement in Britain’s labor market. The Wall Street Journal reported in late January that the three months to November saw a fall in the number of unemployed Britons and a record number of people in work. Bloomberg reported around the same time that jobless benefit claims in the U.K. stood at an 18-month low.

France: Manufacturing and services sector activity declines further

Most data and news reported from France during the fourth quarter underscored the country’s key structural problem — its diminishing competitiveness in the global export market. For instance, in November, Moody’s became the second credit rating agency after Standard & Poor’s to strip France of its AAA sovereign credit rating. Besides external reasons, Moody’s attributed the downgrade to France’s “rigidities in labor and services markets” and “sustained loss of competitiveness.” Indeed, owing to high wages and social costs as well as rigid labor laws that make layoffs expensive and time-consuming for France-based firms, French products cost more than competing goods from Asia and even neighbors like Germany. Consequently, France’s exports have been falling steadily over many years now, hurting its manufacturing and services sectors.

Reflecting this trend, activity in both the manufacturing and services sectors of France continued to decline in the fourth quarter. Markit’s France Manufacturing PMI and France Services PMI indices remained well below the level that indicates expansion. Not surprisingly, amid this manufacturing and service sector slowdown, hiring and employment generation has also been weakening in France. The country’s unemployment rate increased from 10.4% to 10.6% during the fourth quarter. At the end of December 2011, this seasonally adjusted rate published by Eurostat was 9.9%.

The situation is perceived to be so serious for France that according to a Bloomberg report, the IMF has called for “wage moderation,” labor market reforms, and “more competition in the services sector” in the country. However, the good news is that the government has started taking small steps to improve the competitiveness of French firms. During the fourth quarter, President François Hollande announced tax breaks to the tune of $26 billion for companies to offset their high employee social security costs.

Italy: Poll results to have a bearing on Europe’s debt crisis

Italy plunged into political and economic uncertainty in early December when former Prime Minister Silvio Berlusconi’s center-right PDL party withdrew its support for the technocratic government of Mario Monti. In late 2011, after Berlusconi lost his parliamentary majority amid scandals and a surge in Italy’s borrowing costs, Monti was appointed to lead Italy until scheduled general elections in mid-2013. Now Italy is slated to go to polls on February 24-25 and not just Europe but the entire world is keenly following the election because its results are widely expected to have a bearing on Europe’s debt crisis. Since coming to office, Monti has implemented reforms and austerity focused policies, which are perceived to have improved international confidence in Italy but upset a large number of Italians.

In fact, along with the ECB’s September pledge to buy unlimited amounts of Euro-zone government bonds, Monti’s reforms are believed to have played a role in stabilizing Italy’s borrowing costs in the second half of 2012. Berlusconi has promised to reverse Monti’s austerity measures and implement tax cuts if returned to power. Against this backdrop, the global financial community is concerned that, if a political deadlock is created after February or Italian voters reject austerity and reforms, markets may lose trust in Italy’s capacity to carry out difficult structural reforms and stabilize its fiscal situation.

Italy is the third largest economy in the Euro-zone and its public debt burden is second only to that of Greece. The southern European country is mired in recession, hobbled by austerity measures and loss of export competitiveness, and its unemployment rate is at a record high — 11.2% as of December 2012. As previous quarters have shown, any loss of investor confidence may trigger a sharp spike in Italy’s borrowing costs and put the country at the center stage of the European debt crisis again.

In a positive development though, Italy’s national statistics agency Istat has reported that confidence among the nation’s manufacturers improved for the second consecutive month in December. However, Istat’s broader measure of business confidence, which takes into account the retail, services, and construction sectors, fell from 76.5 in November to 75.4 in December, its lowest level in seven years.

Spain: Borrowing costs stabilize; banking sector sees improvement

Recent news and data released from Spain show that the country’s most pressing worries abated somewhat during the fourth quarter of 2012. Following the ECB’s September promise to buy unlimited amounts of the bonds issued by Euro-zone governments, Spanish sovereign bond yields steadily declined between October and December. In fact, Spain’s 10-year bond yield, which touched a euro-era record of 7.50% in late July 2012 on concerns that some cash-strapped Spanish regions may need a bailout, fell to about 5% at the end of 2012. It is crucial that Spain’s borrowing costs stay within sustainable limits as its federal government needs to continue issuing bonds at regular intervals to finance expenses. Throughout 2012, the global financial community remained concerned that any sharp spike in Spain’s borrowing costs may force the country to seek a bailout.

Spain’s banking sector, which has been hobbled by surging bad loans following a real estate bust in 2008-09, saw visible improvement during the fourth quarter. In mid-January, Bloomberg quoted the Bank of Spain as saying that Spanish banks’ net borrowings from the ECB dropped to €313.1 billion in December from €340.8 billion in November. The same Bloomberg article also mentioned that deposits, which are a source of funding for banks, inched up between October and November. Most encouragingly though, several Spanish banks have managed to issue bonds or raise capital through share sales, signaling that investors’ confidence in Spanish lenders is improving.

Nonetheless, pessimism prevailed in other parts of the Spanish economy during the last quarter of 2012. Owing to banking sector troubles, Spanish firms have been facing a loan crunch, which has hindered their growth. The Telegraph has reported that in December alone, private loans fell €30 billion. The same article said exports, which have been a bright spot for Spain over the past 2-3 years, appear to be weakening due to inadequate capital investment. Car exports dropped 18% in 2012. Similarly, owing to harsh austerity measures, Spain’s retail sales decreased 10.7% in December compared to the year-ago period. The unemployment rate climbed up to 26.02% in the fourth quarter and Spanish GDP for the quarter fell 0.7% from the previous quarter.

Greece: Gets next bailout tranche

At the end of 2012, Greece succeeded in defusing concerns that it may either default on its debt or be forced to exit the Euro-zone. During the fourth quarter, Euro-zone leaders and the IMF asked Greece to cut its outstanding debt further in order to receive the next tranche of its financial aid. Greece complied by launching a debt buyback program through which it managed to purchase its own debt from private bondholders at a steep discount, reducing its outstanding debt by €22 billion. Consequently, Euro-zone ministers and the IMF provided Greece €34.4 billion as the next installment of its bailout package.

Besides sanctioning this tranche, the lenders have promised to take steps to bring down Greece’s debt to less than 110% of its GDP by 2022. Further, they have agreed to help Greece by 1) cutting the interest rate on official loans 2) extending their maturity by 15 years to 30 years, and 3) granting Athens a 10-year interest repayment deferral. The lenders have also decided to return to Greece the ECB’s €11 billion profit from buying distressed Greek government bonds. Meanwhile, Greece’s unemployment rate continued to worsen during the fourth quarter, reaching 26.8% in October, with youth (15-24 age group) unemployment touching 56.6%.

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Other economies

The Netherlands, Europe’s sixth largest economy, sends nearly 60% of its exports to the Euro-zone. So it has been hit hard by the slowdown in the single currency bloc. A housing market slump, which is keeping private consumption and bank lending under pressure, has aggravated the country’s woes. Against this background, the Dutch central bank warned in early December that GDP might shrink 0.6% in 2013. The last quarter of 2012 also saw Mark Rutte, who resigned as prime minister in April 2012 after failing to push through an austerity measure, returning for a second term in office after elections in September. His new coalition government comprising pro-Europe, pro-austerity parties was sworn in November.

Sweden, the largest Nordic economy, exports 50% of its economic output and 70% of the exports go to Europe. So the country continued to struggle to cope with falling demand for its exports, especially within Europe. To boost growth, the Swedish central bank cut its repurchasing rate for the fourth time in 2012, bringing it down to 1%. The government on the other hand trimmed its GDP growth estimate for 2012 to 0.9% from the previously forecasted 1.6%. The government also slashed its growth outlook for 2013, saying Swedish GDP will expand 1.1% in 2013 as opposed to an earlier estimate of 2.7%.

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