Eurozone Financial Improvements Improve Region’s Competitiveness

Kenneth A. Orchard, CFA
Portfolio Manager, European Fixed Income
July 2013

Eurozone growth has disappointed our expectations of a gradual and shallow recovery in this region. Gross domestic product (GDP) in the eurozone contracted 0.2% in the first quarter year-on-year (YoY), marking the sixth consecutive quarter of decline for the region. Germany reported meager growth at 0.1% YoY, while the eurozone’s second- and third largest economies, France and Italy, are entrenched in recession. The ECB will likely revise down its 2013 GDP forecasts later this year (current estimates suggest average annual real GDP growth at -0.6%).

What has been surprising is how the improvement in the financial markets in the second half of 2012 (including the reduction in sovereign spreads and improvement in bank and corporate funding conditions) has not flowed through into the real economy as of yet. We maintain our view that the fourth quarter in 2012 marked the bottom (or worst point) of the recession and the economy should gradually recover, albeit one that is slow, bumpy and uneven.

The longer-term indicators we monitor (including Purchasing Managers’ Indexes – PMI) data and their correlation to money supply—see Figure 1) show that the eurozone economy in aggregate should return to modest growth in the second half of 2013. That said, we expect growth to be within a concentrated core of countries, namely Germany, Austria, Belgium, Finland, Slovakia and Ireland with the rest remaining in recession until 2014 at least.

Figure 1

In terms of the broader macroeconomic adjustment, probably the greatest untold eurozone story over the past year is the improvement in current account balances.  Ireland holds a surplus of 4.5%. Spain and Italy’s current account deficits have declined from 3% to 4% of GDP 12 months ago to almost zero today. Portugal and Greece’s declines have been greater (see Figure 2). These developments will reduce external debt liabilities and improve competitiveness.

Indeed, labor costs have been declining across most periphery countries vis-à-vis Germany, mainly resulting from productivity gains. The extent of competitive adjustment varies across countries, with Ireland’s adjustment mostly complete. Spain and Portugal have also made significant progress but, due to their worse starting position, still have a way to go.

Figure 2
  Source: Eurostat.
Figure 3








While the periphery countries’ external adjustment exceeded expectations in 2012, their fiscal adjustments have generally lagged expectations. For example, Spain’s 2012 budget deficit was 7.0% of GDP against an initial target of 4.3% of GDP 3. Ireland was the only periphery country to outperform its fiscal target in 2012.

With the potential exception of Ireland, it is likely that periphery governments will miss their deficit targets again in 2013. Worse-than-expected economic performance in the year to date has already caused slippages behind plan. For example, as of April 30, 2013, Italy’s budget deficit was tracking at an annual rate of 4.5% of GDP versus a target of 3.0%. 4  The Spanish central government’s deficit at the end of March was tracking at an annual rate around 4% of GDP, slightly above the government’s target. The macroeconomic assumptions embedded in the regional and social security budgets are too optimistic, so those aspects of the government deficit will also probably be above targets.


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1 European Commission.
2 Excluding the cost of bank recapitalizations.
3 Later revised up to 6.3% in September 2012.
4 Although we expect Italy’s final 2013 deficit to be around 3% of GDP.