Eurozone Economy: A Fragile Recovery

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Summary

ECB is defeating deflation trends in the Euro area.

Recovery has started but looks fragile.

More reforms are needed.

More than a year has passed since ECB started its full-scale QE program in March 2015. ECB assets have increased one and a half times during this time, reaching €3.06 trillion. The bulk of this increase was due to the rise of securities holdings - they have more than doubled and have reached €1.48 trillion. The key target of the QE program is 2% inflation in the Eurozone. In 2015, it was 0.03% and in 2016 it is projected to be 0.36%, according to the IMF. ECB gives approximately the same figures. As for the Eurozone growth rates, both institutions expect them to be around 1.5% in the next two years. Below is the IMF data for several specific Euro area countries. (See Figure 1 and Figure 2)

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(Figure 1:Eurozone countries growth rates, source: IMF)

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(Figure 2:Eurozone countries inflation, source: IMF)

Here we see that ECB is gradually defeating deflationary trends in the Eurozone. Only Spain is expected by the IMF to have lower prices in 2016 than in 2015. Growth rates among the Euro area countries are near 1.5%, except Ireland, Spain, and Greece. Other figures also say that the overall economic activity in the Eurozone is improving. Both Manufacturing and Services PMI indices are much higher than during the 2012-2013 peak of the debt crisis. (See Figure 3 and Figure 4)

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(Figure 3: Eurozone Services PMI, source: tradingeconomics.com)

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(Figure 4: Eurozone Manufacturing PMI, source: tradingeconomics.com)

Another trend that ECB has succeeded in reverting is decreasing loan growth. In January 2015, when the massive expansion of the assets purchasing program was introduced, the annual growth rate of credit extended to the private sector was -0.5%, while in April 2016 it stood at 1.2%. What is remarkable concerning annual credit growth is that credit extended to the general government is growing much faster. In April 2016, it was 10.4%, according to the ECB data. Government bonds are the main assets that ECB is purchasing. That drives yields down, as far as into the negative zone, providing room for indebted EU countries to make new borrowings. However, it doesn't look like a risk. Loans to the general government account for about 15% of the total Euro area banking system assets. Debt-burdened countries' austerity programs prevent unsustainable debt growth. It also makes their bonds eligible for ECB refinancing facilities, so the rapid government credit growth is reflecting current deficit financing needs. Moreover, the gap between private and public sector credit growth rates will begin contracting, as ECB is going to start purchasing corporate bonds in June 2016.

Individual consumption expenditure grew at 1.5% in 2015, which is the highest it's been since 2008. The same is true for gross fixed capital formation, which has grown by 3.4% in 2015. The last year has been the first for capital investments to grow steadily since 2011.

Financial conditions remain very favorable due to accommodative monetary policy and reduced sovereign debt risk. Composite cost-of-borrowing indicator to corporations and households for house purchases was 2.41% and 2.39%, respectively, in January 2015. In April 2016, these indicators decreased to 1.99% and 2.09%, respectively. Money market spreads remain at low, stable levels. (See Figure 5)

(Figure 5: Three-month EURIBOR/OIS spreads, source: ECB)

Thus, after the Greece debt deal in 2015 and expanding assets purchase program by the ECB, negative growth, and deflation trends have been generally overcome. However, there are two main risks for the emerging recovery. The first is its fragility and the second is its sustainability and its rates. The fragility of the recovery means that some external shocks, such as Brexit or sudden oil price rebound or emerging markets slowdown, may require additional stimulus from the ECB and may shift 2% inflation and 1.5% growth rates projections further in the timeline. Such shocks, if realized, will be short-lived and the ECB can deal with them. However, sustainability is a systemic problem. Even if 1.5% growth achieved, it is still less than the average 2% for advanced economies. The unemployment level of 10.2% across the Euro area is still far from the 7.5% pre-crisis level. To achieve steady and sustainable GDP growth, more reforms are needed, including labor flexibility, further financial integration, improving insolvency and foreclosure procedures, and developing capital markets. Moreover, these reforms will make the Euro area economy more resilient to the shocks mentioned above. Flexible prices and labor costs help economies to adjust in case of external shock or sudden demand contraction.

Ireland and Netherlands are good examples. Ireland's growth rates are projected to be above 3% in the next three years, with 5% growth in 2016. Netherlands' growth rates are slightly less than 2% but still more than the Euro area average. Both countries are the only Eurozone members of the Top-10 of the IMD World Competitiveness Yearbook. Not surprisingly, both countries hold the leading positions in the Index of Economic Freedom among the Euro area countries. This index assesses regulatory and business efficiency and reflects, to a large extent, which sustainable and solid economic growth depends on the structure of the economy.

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