Eurozone: A change of view

At the end of last year we envisaged a marked slowing of eurozone GDP growth to 1.6 per cent in 2008 and maintained our long-held view that the European Central Bank (ECB) would resort to cutting interest rates in the second quarter, once the worst of the inflation hump was over and the pace of economic activity had moved undisputedly below trend. In the light of evolving economic developments we need to tweak down our growth forecasts a bit further.

The reasons for this are three-fold: the disappointingly weak recent eurozone consumer spending data; the tightening in banks' lending conditions combined with their expectation of falling corporate loan demand; and the deteriorating external environment.

Eurozone survey data have been in line with expectations of GDP growth slowing below trend - but not dramatically so - in the final quarter of 2007 and first quarter of 2008 but the domestic surprise has been the weakness of the consumer spending data.

The sharp slowdown in Spain was fully expected given the housing exposure: Retail sales of household goods have been particularly weak and a slowdown in construction was reflected in a rise in the unemployment rate. The surprise was the extremely weak German consumer spending (retail sales fell 3 per cent quarter-on-quarter in the fourth quarter of 2007 and we expect overall spending to have been flat at best), which in turn reflects the impact of very high inflation (by German standards) on real wages and consumer confidence. The improved flexibility of the German labour market means that the relative price effect of rising food and energy prices has so far been to squeeze real wages rather than to feed through into higher wage growth which would hit employment. The latest labour market data showed further strong gains in job creation and the unemployment rate falling to a new cycle low.

Since the beginning of the credit crisis last summer we have been arguing that the main vulnerability to the eurozone (outside Germany) was within the debt-dependent non-listed corporate sector which would face reduced availability and higher cost of credit. The latest ECB bank lending survey not only confirmed that credit conditions have tightened further but that demand for corporate loans in the first quarter of this year is expected to fall for the first time since the third quarter of 2003. Admittedly there is little evidence yet in the data, with corporate loan growth having accelerated again to 14.4 per cent year-on-year in December, but we are of the view that the pick-up in net new monthly loans reflects a substitution effect as firms no longer have access to attractive financing in the capital markets. This is likely to prove temporary and we continue to expect a slowdown in corporate loan growth over the coming two years. While the sharpest slowdown in loan demand continues to come through in demand for loans for mergers and acquisitions and debt restructuring, demand for loans for fixed investment has also weakened.

Since December the US data, particularly the labour market, housing data and survey data, have weakened significantly, suggesting a higher probability of a US recession. At the same time, the ongoing downturn in the housing market in the UK (destination for 15 per cent of Economic and Monetary Union exports of goods and a quarter of exports of services) is showing little sign of abating. The other growing, though still much smaller, risk in the eurozone's external backdrop is, of course, in central and eastern Europe, home to countries with more traditional emerging market traits: current account deficits; a heavy reliance on foreign currency borrowing encouraged by a perception of currency stability; and economies where much of the strong credit growth has found its way into property markets. However, they are relatively small as export destinations. The risk should therefore not be overstated as long as growth holds up in the much more important destinations of Poland, Russia and the Czech Republic. For these countries, domestic overheating is still the primary risk and the fear of inflation is still pushing policy rates higher but growth is likely to moderate in late 2008 and 2009.

As a consequence of these three factors we have shaved our eurozone growth forecasts a little further, from 1.6 per cent GDP growth in 2008 to 1.4 per cent. We envisage that the ECB will remain very cautious in easing its policy stance. In fact in its February meeting the ECB kept the benchmark interest rate at 4 per cent. The ECB will likely remain encouraged by the relative strength of the German economy. German consumer spending may be disappointing but the still very high optimism reflected in the likes of the Ifo survey, strong industrial orders data and robust employment growth all suggest that the risk of a eurozone recession is still sufficiently remote to deter the ECB from aggressive pre-emptive rate cuts.

Instead we envisage a scenario whereby eurozone growth remains clearly sub-trend with quarterly growth rates of about 0.3 per cent quarter-on-quarter or less through most of 2008 and a gradual easing of inflation to a little below 2 per cent by end-year, which will allow the ECB to gradually lower its policy interest rate to 3.25 per cent by the turn of the year.

• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.