A nascent recovery is taking hold across the eurozone but despite positive signs of an uptick in the economy, growth is expected to be slow. The easing of austerity measures and a pickup in world trade will strengthen the recovery towards the end of the year but it will be hampered by unemployment still increasing and widening divergence across the continent, according to the autumn EY Eurozone Forecast (EEF).

The forecast predicts a contraction of 0.5 per cent this year, a slight improvement from last quarter’s forecast, followed by growth of 0.9 per cent in 2014. GDP growth of 1.5 per cent a year is expected in 2015-17.

However, ever increasing differences remain between the core and periphery.

Germany remains the powerhouse of the eurozone, showing 0.6 per cent growth this year. But most troubled peripheral states continue to contract in 2013, although their slide is slowing. The forecast predicts a stabilisation of the economy in Italy and Portugal in 2014 and Greece in 2015.

Eurozone unemployment will continue to rise peaking at 12.6 per cent in the middle of 2014.

Substantial divergence in unemployment rates across the continent will persist with Spain and Greece peaking at 27.6 per cent and 29 per cent, respectively, in 2014 while Germany is only at 5.4 per cent.

The forecast also highlights that the recovery will continue to be constrained by deleveraging in both the public and private sector and the lack of affordable finance.

Both of these issues will have a larger impact on the periphery causing further divergence from the core countries in the eurozone.

Marie Diron, senior economic adviser to the EY Eurozone Forecast, said: “For the first time in eight forecasts we are predicting modest growth for the next quarter and the next year in the eurozone. However, policymakers must not be lulled into complacency. Differences in financing conditions and labour market developments across the continent remain stark. The relative calm in the financial markets must also be used to accelerate restructuring, particularly in the banking sector.”

Mark Otty, EY Area Managing Partner for Europe, Middle East, India and Africa comments, added: “The longest recession in eurozone history came to an end in the second quarter and a slow recovery is now in prospect.

“Corporate confidence has turned a corner but businesses must be nimble and embrace the changes that the new economic environment brings. This cannot be a return to business as usual.”

A stronger recovery is expected in the second half of this year thanks to external factors, including a pick-up in economic activity in the US and encouraging signs in the UK, both key trading partners.

These point to a robust uptick in eurozone export demand. The forecast shows growth in demand for eurozone exports accelerating from 3.8 per cent this year to 5.9 per cent in 2014 and 6.6 per cent in 2015.

A substantial weakening of the euro, which is estimated to currently be overvalued by eight per cent, should also assist eurozone exports.

Given the importance of exports to the recovery, EEF expects manufacturing to enjoy a turnaround in fortunes as well as business services. However, the outlook is weaker for other sectors, particularly those exposed to the consumer and government sectors. Construction is also expected to perform poorly.

Diron commented: “While strong growth in world trade and a weakening euro will assist eurozone exporters, this alone will not be enough to sustain the recovery.

“Recent disappointing performance of emerging markets highlights the risk of relying on an export-driven recovery. Therefore it is important for the domestic economy to gain momentum.”

The chances of a stronger domestic recovery have certainly increased since the authorities softened their rhetoric on fiscal austerity. Current plans imply that the pace of fiscal austerity is set to fall from 0.8 per cent of GDP this year to around 0.5 per cent of GDP in 2014-15. This will substantially reduce the drag on growth from austerity.

For the first time in eight forecasts we are predicting modest growth for the next quarter and the next year in the eurozone.

The domestic recovery will be impacted in the short term by rising unemployment, particularly in the periphery. This will offset some of the benefits from lower inflation, limiting the boost to real household incomes and meaning that consumer spending is expected to grow by just 0.5 per cent in 2014 and 1.1 per cent in 2015.

“The process of deleveraging will continue for some time yet. There is much work still to do over the medium term to limit debt levels – in the periphery in particular. Realistically, this condemns the eurozone to a decade of deleveraging and the long-term negative impact on growth that this will entail. There is a need for a coordinated policy response so that the necessary restructuring of balance sheets does not stifle the economy,” Diron said.

Though there has been much focus on reducing public sector debt, high private sector debt also needs to be addressed before the economy can sustain stronger growth in the eurozone. Unlike the US, and to a lesser extent the UK, eurozone private sector debt ratios have barely fallen.

Within the private sector the thinly capitalised and over-leveraged banking sector is a key concern.

Until banks recapitalise, they will remain under pressure to rein in lending.

A lack of affordable finance, particularly in the periphery, will limit the degree to which business investment recovers and will constrain potential output growth in many economies. Until the problems in the banking sector are resolved, economic disparity between the eurozone’s core and periphery will remain.

Although there is still a degree of uncertainty and risk, the eurozone economy appears to be slowly recovering but policy-makers must continue to push ahead with policies to advance the recovery.

The ECB should be ready to activate the outright monetary transactions (OMT) program should Portugal need to apply for a credit line and it should also be looking to offset tightening monetary conditions emanating from the US.

She concluded: “The ECB should also be looking to intervene to keep monetary conditions very loose, which it could do via more explicit forward guidance, relaxing collateral rules for banks or by trying to talk down the value of the euro.

“Additionally, policymakers could take advantage of the relative calm to accelerate plans for a banking union and further fiscal integration which could boost the recovery.”

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