What's New in the EU: Early signs of improvement in euro-zone economy

Most financial markets are showing encouraging signs of stabilization.

By ARI SYRQUIN
eu flag 88 (photo credit: )
eu flag 88
(photo credit: )
The euro-zone economy is still deep in recession territory, but new data may indicate that the financial markets have started to send some tentative signs of improvement, the Quarterly Report on the Euro Area shows. The QREA provides a preliminary assessment of the effectiveness of banking-support measures implemented by Member States and discusses challenges ahead, particularly in terms of debt sustainability. A first focus section assesses the impact of the economic and financial crisis on potential growth. A second focus section discusses the economic and budgetary challenges posed by population aging in times of crisis. According to the EU publication, most financial markets are showing encouraging signs of stabilization, although conditions remain fragile. Spreads on money and bond markets have narrowed on the back of improved economic sentiment and lower risk aversion. Financing conditions in the euro area have also improved as the cost of bank loans, equity capital and market debt have all declined. However, money and credit growth have slowed further in recent months, mainly reflecting very weak economic activity but also some supply constraints. Euro-zone GDP dropped by 2.5 percent in the first quarter of 2009, according to Eurostat's June 3 report, driven mostly by an inventory adjustment and a continued sharp fall in investment. On the positive side, the fall in private consumption was contained by the deceleration of consumer price inflation and comparatively supportive developments in nominal disposable income. While hard data have so far remained depressed, survey data have begun to show a pick up in confidence in most euro-zone countries. World trade growth has also shown signs of improvement but remains depressed. The substantial banking-support measures implemented by Member States since autumn 2008 have arguably helped to avert financial meltdown. Developments in price indicators of financial distress suggest that the functioning of interbank markets has improved. However, the convergence process toward more-normal conditions has only been partial, and the situation remains fragile. In particular, further significant asset write-downs are still to be expected, as confirmed by a recent ECB study. Budgetary policy is putting pressure on public finances, which are increasing. From its low in 2007, the euro-zone average debt ratio is projected to increase by 18 percentage points to reach 84% of GDP in 2010 and will rise further in the years beyond because of high government deficits. Coupled with an expected increase in age-related expenditure and an adverse impact on potential output, this raises sustainability concerns and calls for robust exit strategies. The economic and financial crisis is also likely to result in a lower growth potential in the years ahead, due to lower employment and productivity levels, as research and development and capital investment are likely to decrease or stagnate. Euro-zone potential growth averaged 1.8% in the period 2000-2006, but is estimated to have fallen to 1.3% in 2008 and to be only 0.7% this year and next. Historical evidence shows that financial crises tend to have a deeper and more lasting impact than recessions caused by other factors and can be followed by lower productivity growth. A return to pre-crisis potential growth is also likely to be much slower. Therefore it is also important to avoid the policy mistakes of the past (e.g. protectionist policies undermining the free market). Excessive public spending will have a negative impact on potential growth as well as on budgetary conditions. The EU's priority should be now to concentrate the efforts in quickly resolving the crisis and to swiftly return to sound public finances. Structural reforms required by demographic change should be pursued vigorously. In particular, these should aim at raising employment rates substantially and at encouraging the aging baby-boomers to stay in the labor market rather than retire early. syrquin@013.net Ari Syrquin is the head of the International Department at GSCB Law Firm.