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Eurozone’s Fragile Recovery Depends on Continued Adjustment

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Eurozone’s Fragile Recovery Depends on Continued Adjustment

  1. 1. Page of Economic Commentary QNB Economics economics@qnb.com.qa May Eurozone’s Fragile Recovery Depends on Continued Adjustment The Eurozone’s recovery is slowly underway. Data for the first quarter of 2014 published last week confirmed that real GDP growth is on an upward trend in Germany and Spain while France and Italy continue to lag behind. This two-speed growth performance is mainly driven by the extent to which each Eurozone country has managed to gain competitiveness in the last few years by reducing its unit labor costs relative to Germany. Unless this internal adjustment process continues, the growth performance in the single currency area will diverge further, with important implications for the stability of the Eurozone. Data for the first quarter of 2014 indicate a two-speed Eurozone recovery. While Germany grew faster than expected (0.8% quarter-on- quarter), other countries lagged behind. Spain’s growth ( . %) continued to accelerate on a positive trend for the third consecutive quarter. Growth in Ireland has not yet been released, but the consensus estimate is for a similar growth rate (0.5%). On the other hand, France (0.0%) and Italy (-0.1%) continue to lag behind, while growth in Greece (-1.1%) and Portugal (- . %) remains depressed by the fiscal austerity measures contained in the ongoing IMF-supported adjustment programs. Overall, this two-speed economic recovery has resulted in a worse-than-expected Eurozone expansion in the first quarter of 2014 of only . %. What explains this two-speed expansion in the Eurozone? The answer is competitiveness measured by unit labor costs – the cost of labor for one unit of production. What drives growth is the ability of businesses to compete in the global economy, which largely depends on their labor costs, particularly in advanced economies. As unit labor costs rise without a corresponding rise in labor productivity, businesses lose competitiveness. A sufficiently large loss of competitiveness can force businesses to reduce their activities or even shut down. At an economy-wide level, a loss of competitiveness means lower growth and higher unemployment as both external and domestic demand for the country’s goods and services weaken. This is even more evident in countries with a common currency like the Eurozone where the option to regain competitiveness by weakening the currency is unavailable. Unit Labor Costs (Index, 2000 Q1 = 100) Sources: Eurostat and IMF estimates and projections for Greece after 2011Q1 The economic story of the Eurozone for the last 15 years is very much one driven by unit labor costs. Starting in early 2003, Germany implemented a series of labor market reforms aimed at reducing unit labor costs in order to increase the competitiveness of German businesses and reduce unemployment. These reforms— named after Peter Hartz, the head of 90 100 110 120 130 140 150 160 2000Q1 2002Q4 2005Q3 2008Q2 2011Q1 2013Q4 Ireland Germany Greece Italy France Portugal Spain
  2. 2. Page of Economic Commentary QNB Economics economics@qnb.com.qa May the commission that recommended them— have managed to keep unit labor costs well below the Eurozone average for the last 12 years, resulting in higher German economic growth and one of the lowest unemployment rates in Europe. Other countries in the Eurozone did not follow the German example right away. As unit labor costs rose rapidly during the last decade in the Eurozone periphery (Greece, Ireland, Portugal and Spain), their economies became uncompetitive and turned inwards to domestic sectors (e.g., the real estate sector) to maintain the growth momentum. Eventually, the rising gap in unit labor costs between Germany and the Eurozone periphery became so large that it forced an abrupt outflow of capital as the economy could no longer generate the required returns, thus unleashing the Eurozone crisis. Since then, it has been a painful road for Greece, Ireland, Portugal and Spain to adjust unit labor costs down by reducing government spending and thus repressing domestic demand in order to regain competitiveness. The first dividends of this painful adjustment are starting to pay off in Ireland and Spain, while more is still needed in Greece and Portugal. Unit labor costs, however, continue to rise in France and Italy. Notwithstanding the painful lessons of the Eurozone crisis, the second and third largest economy in the Eurozone have not yet mustered the political will to implement the necessary reforms and thus unit labor costs are now the highest in the Eurozone. As a result, France and Italy continued to lag behind the Eurozone recovery in the first quarter of 2014 and registered record-high unemployment rates. Overall, the Eurozone recovery remains fragile and predicated on continued adjustment in unit labor costs. What is worrisome is the continued divergence in growth performance between Germany and Spain on the one hand and France and Italy on the other, reflecting the necessary adjustment in unit labor costs still needed in the latter two economies. Without such adjustment, the economic recovery could unravel, calling into question the stability of Eurozone once again. Contacts Joannes Mongardini Head of Economics Tel. (+974) 4453- Rory Fyfe Senior Economist Tel. ( ) - Ehsan Khoman Economist Tel. (+974) 4453- Hamda Al-Thani Economist Tel. (+974) 4453- Ziad Daoud Economist Tel. (+974) 4453- Disclaimer and Copyright Notice: QNB Group accepts no liability whatsoever for any direct or indirect losses arising from use of this report. Where an opinion is expressed, unless otherwise provided, it is that of the analyst or author only. Any investment decision should depend on the individual circumstances of the investor and be based on specifically engaged investment advice. The report is distributed on a complimentary basis. It may not be reproduced in whole or in part without permission from QNB Group.