Euro-Zone Economic Outlook Remains Weak

The European Central Bank might have to take more action to spur growth in the euro zone after data published Friday suggested that German consumers are beginning to feel the strain of the debt crisis and the ECB’s earlier injections of cash haven’t borne fruit.

And while other data published Friday showed French consumers were more upbeat than their German counterparts and that consumer price inflation in the 17-country euro zone held steady in June from May, the overall economic picture across the bloc remains weak.

“Inflation is not going to be an obstacle for future policy action,” said Annalisa Piazza, economist at Newedge Strategy.

ECB President Mario Draghi has already indicated inflation isn’t a problem, which should mean the bank will make future policy decisions based on their potential to spark growth rather than their impact on prices, she added.

Meanwhile, the French economy, the euro zone’s second largest, ground to a halt in the first quarter of the year at the same time as debt rose sharply, data showed, highlighting the challenges facing Socialist President François Hollande.

Gross domestic product was unchanged in the first quarter from the last quarter of 2011, data released by statistics bureau Insee on Friday showed, confirming the first reading published in May. GDP was 0.3% higher in the first quarter than in the same period last year, Insee said.

In the final quarter of last year, GDP expanded only 0.1% on the quarter, and Insee expects the French economy to eek out only 0.4% growth for the whole of this year, after 1.7% last year.

At the same time, France’s public debt shot up to €1.789 trillion ($2.23 trillion), a rise of more than €72 billion in three months, the highest quarterly increase in debt for France in the history of the euro. Public debt now stands at 89.3% of GDP.

Next week, Mr. Hollande’s government is set to announce measures aimed at raising up to €10 billion, mainly through tax increases, as it battles to stay on track with budget deficit reduction targets. The government has vowed to bring down budget deficit to 3% of GDP in 2013, from an expected level of 4.5% this year.

On Thursday, Prime Minister Jean-Marc Ayrault also announced the framework for budget planning through 2015: a freeze in the number of civil servants, and a freeze in the nominal value of spending, excluding pensions and debt servicing. To offset job creations in education, justice and the police force, other sectors will have to cut staff by 2.5% a year, Mr. Ayrault said.

Some ministries will be asked to cut their operating expenses 7% next year, and 4% a year thereafter, he said.

“Now is the time for reality tests on the French budget,” said BNP Paribas SA economist Dominique Barbet in a research note.

There were some bright spots in the French data releases Friday. Consumer spending rose 0.4% in May from April as shoppers spent more on clothes.

“This increase seems to be due to the new president and his promises of more social redistribution and growth,” said Manuel Maleki at ING. “However, the new austerity plan of €10 billion with more taxes and less redistribution than expected might freeze French consumption, and have a negative impact on growth,” he said.

German retail sales fell 0.3% on a monthly basis in May, while ECB data showed a disappointing drop of €10 billion in business lending in May from April.

Both French and German retail-sales outcomes came as a surprise but probably reflect one-off factors, such as a surge in clothing sales and a likely spike in food prices, economists say. As such, the figures shouldn’t alter the overall disappointing outlook for the economy.

Indeed, details of the money-supply data published by the ECB show that while broad money supply across the region did expand, banks didn’t put the ECB’s injection of cheap money into the real economy, instead of using it to buy euro-zone government bonds to avail of the potentially higher returns on sovereign debt.

The hope had been that much of the €1 trillion of cheap three-year ECB loans would allow firms and consumers to borrow funds at a lower rate and to spend and invest that money, giving a much-needed boost to a region that stagnated in the first quarter of 2012 and is widely expected to have contracted in the second.

ECB data show that the tightening of credit conditions has moderated after the central bank’s cash injections, but demand for loans is still weak across all key sectors, said Ken Wattret, chief euro-zone economist for BNP Paribas. Mr. Wattret said he expects private-sector lending to keep weakening “given the difficult economic and financial backdrop.”

He is forecasting next week’s ECB meeting will produce a rate cut to 0.75% from the current historic low of 1%. While the economic outlook would justify a larger cut to 0.5%, it is less likely after the market’s initial positive reaction to a deal reached by European Union leaders at a summit Thursday night, Mr. Wattret said.

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