Europe: Robust growth amid continued policy challenges

Economic activity in Europe remains robust, with real GDP growth forecast to reach 2.1 per cent in 2018. Household consumption will remain a major contributor to growth, underpinned by rising disposable incomes, falling unemployment, further upward pressure on wages and the continued low level of interest rates. The expansionary monetary policy stance will also continue to underpin business investment and construction activity. Nevertheless, the European Central Bank (ECB) decision to taper the pace of its asset purchases and eventually cease expansion of its balance sheet will have some dampening effect, contributing to a slight downtick in growth to 1.9 per cent in 2019.

This overall solid aggregate growth trajectory encompasses several economies with markedly higher growth rates. For example, Spain is forecast to see growth of 2.6 per cent in 2018 and 2.4 per cent in 2019, driven by private consumption, fixed investment — especially in construction and machinery — and solid external demand, including tourism. A similar combination of solid domestic and external demand will drive growth in Ireland, with a growth forecast of 2.8 per cent and 3.1 per cent for 2018 and 2019, respectively. By contrast, Italy will register the lowest growth in the region, with 1.4 per cent and 1.1 per cent in 2018 and 2019, respectively. Slow employment growth and weak consumer sentiment related to political uncertainty will hinder private consumption growth, while weak public investment and limited access to bank lending will cap fixed investment. In the United Kingdom of Great Britain and Northern Ireland, growth will decelerate to 1.4 per cent in both 2018 and 2019, as the economy will face increasing pressure from the effects of the decision to leave the EU. The weaker pound sterling has contributed to the rise in import cost pressures while taming domestic demand. At the same time, business investment is suffering from significant uncertainty regarding the future framework for the economic relations of the United Kingdom with the EU and the rest of the world. This includes, in particular, the looming loss for businesses located in the United Kingdom of the right to operate in EU member countries under the umbrella of unified EU regulations. The outlook for Europe is subject to several downside risks. Negotiations over the exit of the United Kingdom from the EU remains a major source of uncertainty. Any negative surprises or perceived increase in the probability of a negotiation failure would further crimp business investment in the United Kingdom. In terms of euro area economic policy, the ECB has already shifted its policy stance by reducing the amount of its monthly asset purchases. Implementing the further reduction in its stimulus will be challenging in terms of both its precise design and communication to the public, creating important risks for actual or even perceived policy missteps.

In the area of fiscal policy, the euro area’s lack of a stronger and more coherent institutional underpinning will remain a major weakness. The continued excessive reliance on targets for budget deficits leaves open the problem of enforceability and the risk of renewed tensions between member states, especially if there is a new economic downturn. International trade will remain a major driver of growth for Europe. The overall positive economic trends within the region in terms of falling unemployment rates, rising incomes, stronger consumption and solid consumer and business confidence will lead to a continued strong expansion of trade between EU member states. In addition, steady expansion in other major global export markets such as the United States and China will also underpin solid external demand. Despite this positive baseline forecast, the trade trajectory for Europe will face a number of headwinds.

A major challenge for exporters lies in the appreciation of the euro against the US dollar, which makes European exports more expensive abroad and, thus, less competitive. However, past episodes of currency appreciation showed the capacity of many exporters to absorb the negative effects of a stronger currency by increasing their productivity or by using their pricing power based on quality and the provision of niche products. Second, negotiations over exact procedures for the exit of the United Kingdom from the EU not only create major uncertainties, but could also spark negative economic shocks if negotiations fail. Third, stronger protectionist tendencies in the global arena would kindle significant downside risks, especially for the heavily export-oriented sectors and companies in Europe, including many small and medium-sized enterprises.

Against a backdrop of solid economic growth, unemployment has been on a downward trend across the EU, with the overall unemployment rate declining to 7.5 per cent in September 2017 compared to 8.5 per cent in the previous year. This solid aggregate trend masks significant dispersion among national labour markets. The Czech Republic, Germany and Malta registered the lowest unemployment rates, with 2.7 per cent, 3.6 per cent and 4.1 per cent, respectively. By contrast, unemployment was the highest in Greece, Spain and Italy, with rates of 21.0 per cent (July 2017), 16.7 per cent and 11.1 per cent, respectively, and stood at around 10 per cent in Croatia, Cyprus and France.

Youth unemployment remains a serious challenge. It reached 16.6 per cent EU-wide in 2017, and exceeded 35 per cent in Greece, Italy and Spain. Although employment should be boosted by the robust economic forecast, the spillover effects of this boost will not be fully exploited unless policymakers take action, for example, to reduce skill mismatches. In various European economies with significant automotive sectors such as the Czech Republic, Germany and Slovakia, drastic technology shifts in the automotive industry — tied to electric vehicles and autonomous driving — will cause significant economic and employment impacts. Notably, any meaningful adoption of electric vehicles stands to revolutionize the automotive supply sector, as entire subsystems and components needed for conventional engine technology will not be required anymore. While new technologies, including those linked to battery technology or autonomous driving, will create new opportunities in the automotive supply chain, this would still involve significant structural changes, for example regarding the skill profile of the workforce.

Inflation in Europe has been on an upward trend and has remained solid. This is true even after the one-off effects from lower oil prices fade. The aggregate inflation rate is forecast to increase from 1.6 per cent in 2017 to 1.8 per cent in 2018, with a further acceleration in inflation to 2.1 per cent in 2019. A number of factors are driving this price trajectory. In the United Kingdom, the still lingering effects of the depreciation of the pound sterling in 2016 has pushed up import prices, leading to inflation forecasts of 2.5 per cent and 2.9 per cent for 2018 and 2019, respectively. Unemployment has decreased in numerous economies, with some regions experiencing labour market conditions equivalent to full employment and real wages showing some solid increases, which, in turn, will underpin private consumption. On the other hand, the sharp appreciation of the euro against the dollar during 2017 will exert a moderating effect on inflation on the import side.

Major developed market currencies’ exchange rates against the US dollar
Major developed market currencies’ exchange rates against the US dollar

The ECB monetary policy stance has in large part driven financial market movements in 2017. The ECB reduced the amount of its monthly asset purchases, albeit with an extension of the purchase programme, and adjusted the language in its policy guidance by dropping the reference to possibly lower interest rates. These hints of a reduction in the monetary policy stimulus and some expectations of more pronounced moves by the ECB in this direction helped to support the sharp increase in the value of the euro against the dollar during 2017 (figure III.6) and underpinned higher yields on euro area benchmark bonds. Notably, the yield on the German 10-year bond reached almost 0.60 per cent in July 2017, compared to around -0.19 per cent in the previous year. In view of robust economic growth and inflation trends, the elevated levels of consumer and business confidence indices, as well as the extremely loose current monetary policy stance, the ECB is likely to initiate additional steps to remove some of its stimulus in 2018. This includes further guidance on its path for reducing asset purchases, which are expected to continue until at least September 2018. Guidance regarding interest rate normalization may also be announced, which will begin well past the end of the asset purchase programme. At the same time, the ECB is expected to continue reinvesting maturing asset holdings for an extended period of time, bolstering support for financial markets.

Rising inflation pressure also underpinned an increase in interest rates by the Bank of England in November 2017, with policymakers stating that further interest rate hikes may be required. Fiscal policy will have a less negative impact on growth compared to recent years that have been marked by fiscal consolidation. The implemented fiscal adjustments have led to measurable improvements in fiscal budget positions. In 2016, only France and Spain exceeded the EU limit for budget deficits of 3.0 per cent of GDP by registering a deficit of 3.4 per cent and 4.5 per cent, respectively. A number of countries, like Austria and Germany, will increase fiscal spending to integrate a large number of migrants. However, fiscal policy space will remain limited in the EU as a whole, with the aggregate debt-to-GDP ratio standing at 86 per cent and Belgium, Cyprus, France, Greece, Italy, Spain and Portugal featuring debt-to-GDP ratios around or in excess of 100 per cent. The current low level of interest rates reduces the costs of servicing these debts, but the turn in monetary policy towards a normalization of interest rates points to higher levels of fiscal spending on servicing public debt in the future. In the United Kingdom, the budget deficit will reach around 3.5 per cent of GDP in 2018. Fiscal policy will remain under pressure from the effects created by the decision to leave the EU. In the course of this process, the United Kingdom has to reorganize public support mechanisms and financial flows in a plethora of policy areas, and undertaking this administrative exercise alone already entails a major fiscal cost.

Economic growth in the EU members from Eastern Europe and the Baltic States continues to outpace the EU average, thanks to capital accumulation and productivity gains. The aggregate GDP of the group of EU-13 countries, which also includes Cyprus and Malta, is estimated to expand by 4.2 per cent in 2017, 3.6 per cent in 2018 and 3.5 per cent in 2019. As in 2016, Romania will remain the fastest-growing European economy over the forecast horizon, with GDP growth projected to approach 6 per cent in 2017. The expansion in the EU-13 in 2017 has been largely driven by the robust export performance of the manufacturing sector in Eastern Europe, and also a recovery of investment following the earlier slump (in particular, in construction activity) in 2015–2016 that was related to the interval between EU funding cycles. Private consumption has also contributed notably to growth, supported by a surge in nominal wages amid tight labour market conditions. The Czech Republic in 2017 had the lowest unemployment rate in the EU, and in a number of countries, including Hungary, Poland and Slovakia, the unemployment rate has declined to record low levels. A rapid expansion in private credit, as well as an increase in social transfers also supported growth in some countries. There are signs that some EU-13 economies may be operating above potential, as reflected in the accelerating inflation — from negative or near zero figures in 2015–2016, inflation surged to around 2 per cent in most EU-13 countries and exceeded the target in the Czech Republic by almost 1 percentage point, prompting the central bank to become the first in the EU to start a gradual monetary tightening in 2017. In Lithuania, inflation accelerated to an alarming 4.8 per cent at the end of 2017. Consumption-driven growth and rising private debt may hide numerous risks. The rising housing prices across Eastern Europe, and the increased exposure of the financial sector to housing loans raise concerns about the emergence of another housing bubble similar to the pre-2008 period. Although the positive growth differential between the EU-13 countries and the rest of the EU is expected to remain, the current strong growth may not be sustainable in the medium term. In some countries, the outflow of labour to their richer EU counterparts is constraining further capacity expansion. The projected slowdown in 2018–2019 also reflects expectations of a mild fiscal tightening and weaker private consumption in response to the higher inflation.