Growth builds up steam but pressure increases on the ECB

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May 12th, 2014

The euro area's growth prospects are improving. Indicators published in April have continued to suggest that economic activity is gradually recovering. Strong exports and especially the greater solidity shown by demand within the EU are helping to improve the region's growth prospects. The IMF, for example, has revised upwards its growth forecasts for 2014 and 2015 by 0.1 p.p. (to 1.2% and 1.5% year-on-year, respectively). The institution points out that domestic demand is more solid although it has noted several factors that still make the current recovery particularly delicate. Among the main changes made to the forecasts by country, of note is the case of Germany whose growth has been revised upwards by 0.3 p.p. since the last World Economic Outlook (WEO). The revision carried out for Spain was also considerable, up to 0.9% year-on-year in 2014. Less positive are the changes made for France and Italy, countries where the IMF highlights the fragility of the economic recovery.

Confidence indicators point to growth gaining ground in 2014 Q1. One sign of this is the trend in the Purchasing Managers' Index (PMI), both for manufacturing and services, which are clearly above 50 points, the threshold as from which positive growth rates are usually seen. In fact the composite index rose to 54.0 points in April, its highest level in the last three years. The trend in the European Commission's economic sentiment indicator is also clearly upward in spite of having stood still temporarily in April. The significant improvement in consumer confidence (–8.7 in April compared with –11.2 in 2014 Q1 on average) also seems to augur an improvement in private consumption over the coming months. All this points to economic growth in the first quarter of the year being greater than in 2013 Q4, namely 0.2% quarter-on-quarter, therefore coming close to the region's historical average of between 0.4% and 0.5%.

The figures for business and consumption also show trends that invite optimism. The industrial production index consolidated its growth in February with an increase of 1.7% year-on-year. Particularly significant was the dynamism seen in the production of intermediate and capital goods, presenting a favourable scenario for increased investment. Once more we should point out the divergence between France and Germany; France's industrial activity disappointed again, down by –0.5% year-on-year in February while in Germany this grew by 4.1%. The trend in retail sales is the most similar between countries: almost all recorded growth. For the euro area as a whole, they grew by 0.8% year-on-year in February, boosted particularly by the upswing in the non-food component.

Exports remain healthy and imports start to stabilise. Goods exports, which ended the year with good figures, have accelerated their rate of growth slightly in the early part of 2014. Specifically, in the first two months of the year they posted average annual growth of 2.7%, almost 1 p.p. higher than their increase in 2013 Q4. The change in trend is more pronounced in imports, which have been falling for some time but have started to considerably moderate their rate of decline in the last few months: from –1.7% in 2013 Q4 they have gone to –0.4% year-on-year in January and February. This is largely the result of improved domestic demand, especially household consumption and investment in capital goods which have enjoyed positive growth rates for the last three quarters and are gradually affecting imports.

Inflation remains low, increasing pressure on the ECB. The inflation rate for the whole of the euro area is the lowest it has been since 2009. In April it rose by 0.2 p.p. to 0.7% but an important part of this upswing was due to temporary factors such as the effect of Easter. This makes it difficult to judge to what extent underlying factors such as the recovery in domestic demand will turn this increase into an upward trend. While this question remains unanswered, pressure is building on the ECB to take action. In addition to the list of circumstances justifying more accommodative monetary policy, the last few months have also seen an upswing in money market interest rates and the euro's appreciation, which is gradually nearing 1.40 dollars. For the moment, the ECB has limited itself to verbal action but the tone of its statements has become firmer and more specific in the last few months, to the extent that the ECB has managed to convince agents it will carry out quantitative easing if it deems this necessary, something that was difficult to imagine just a short time ago.

The euro area still suffers from financial fragmentation. According to a study carried out by the ECB (Financial Integration in Europe), in spite of improvements in the last two years the region's financial fragmentation is still excessive. This report stresses that the advances made have been particularly the result of monetary policy actions, of the progress made towards banking union and the structural reforms carried out by countries in the euro area, especially in the periphery. However, the ECB warns of the huge variation in financing costs for non-financial firms and notes the importance of ensuring credit reaches the real economy, especially in the periphery. The ECB states that the materialization of the banking union over the coming months will be crucial to restore financial integration.

Different situations in public accounts. Although the public deficit stood at 3.0% of GDP in 2013 for the euro area as a whole, there are still notable differences between countries. At one end of the scale is Germany, whose public accounts have remained practically balanced for the second year in a row. Also of note are Austria and the Netherlands, both with a public deficit that is also clearly below 3% of GDP. France is far from achieving such figures and ended 2013 with a 4.3% deficit, just 0.6 p.p. lower than in 2012. The biggest adjustments have been seen in the periphery countries which, although still far from the 3% target, are continuing to correct their fiscal balances according to the planned timeline agreed with the EC. Ireland and Portugal particularly stand out in this respect. Ireland's deficit fell by 1 p.p. to 7.2% while in Portugal this drop was 1.5 p.p., down to 4.9%. In Spain, if we do not include the losses due to aid to the banking sector, the reduction in the public deficit was very small but this does not reflect the fiscal effort made as many of the measures employed in 2012 to adjust the deficit were temporary, resulting in the need for additional measures in 2013.

Portugal will successfully complete its programme with the troika. Except for the government crisis last year, the implementation of the programme agreed with the troika has been characterised by commitment and seriousness on the part of Portugal's authorities over the three years it lasted. The good pace of growth shown by Portugal in the last few quarters has surprised most analysts; its firm commitment to fiscal consolidation, to the extent of reducing its public deficit more than originally planned in 2013, and the scope of some of the structural reforms carried out have helped Portugal regain market confidence. The risk premium for Portuguese debt has fallen substantially in the last few months and its Treasury has taken advantage of this fact to pre-finance its needs for this year and start to cover those of 2015. Nevertheless the Portuguese economy is still delicate and it is vital to remain firm on all three fronts mentioned above.

The rate of growth speeds up in the United Kingdom. The country's GDP grew by a substantial 0.8% quarter-on-quarter in 2014 Q1. Until recently there were serious doubts regarding the solidity of the United Kingdom's recovery as it was largely based on a boom in the real estate market and private consumption. However, these signs of improvement have spread to credit conditions, confidence indicators and especially investment in capital goods. Now the uncertainty relates to when the Bank of England will start to tighten its monetary conditions. In fact, in its forward guidance strategy, the authority announced that the turning point will come when unemployment falls below 7%; and it is currently at 6.9%.