However the European Commission recently released its growth forecasts for the coming year and unexpectedly reduced its expectations for the coming year slightly from 1.2 per cent to 1.1 per cent. The data from the region has mostly been positive of late, but it seems an opportune time to take stock of the good, the bad and the ugly in the eurozone.
The good. The European Central Bank’s bank lending survey for the third quarter provided the clearest message of improvement in eurozone credit for some time. Although the overall picture was one of a continued tightening of credit standards, the pace of that tightening is slowing. One of the more striking aspects of the survey, however, was that banks expect the situation to improve. Banks had been concerned about the strength of the economy and ability of borrowers to repay loans, but the latest survey showed that these concerns were receding. For the rest of this year the expectation is for easier credit availability to businesses, both small and large – the first sign of a genuine easing in credit since the end of 2009. Could this perhaps be the start of a turn in the credit cycle? A pick-up in both supply and demand for credit would clearly add to the building of economic momentum in the region. The survey was another encouraging sign in the single currency bloc’s path to recovery.
The bad. The initial estimate of eurozone inflation for October was 0.7 per cent year-on-year. Low levels of inflation leave the region open to shocks that could see weak inflation quickly become deflation, and commentators have made parallels with the years of lost growth and deflation in Japan. Japan and the eurozone do share some common problems: sustainability of government debt and the need for economic reform to increase competitiveness.
The deflation threat is more prominent in the southern countries than the northern and it can be argued that the policies of the northern countries, which are relying on export-led growth, are actually depressing domestic demand in the region and creating the current disinflationary environment. Crisis countries are attempting to increase competitiveness through cheaper labour but weak inflation makes it more difficult to reduce wages in real terms, as nominal wages would also need to decrease. The ECB should act quickly to address the current rate of inflation and avoid the potential for a Japan-style deflationary spiral. The ECB has an obligation to set monetary policy to keep inflation at its 2 per cent target and so far it has not fulfilled this obligation.
The ugly. The banking union falls into the ugly category not because it is an undesirable notion, but because the current proposal is a poor version of what it should be. The debate on a European-wide banking union moved out of focus earlier in the year but is regaining attention. A banking union would reduce fears among investors and depositors of a repeat of the downward spiral of failing banks leading to failing countries – or vice versa. The progress so far is heartening and the ECB will assume the role of single banking supervisor in November next year. However the proposals on the other two components of the union – a mechanism to wind-up failing banks and a deposit guarantee scheme – are lacking the necessary teeth to provide the reassurance that investors or depositors are looking for. The establishment of a banking union is a slow burn, however, and will take many rounds of negotiations. In the meantime investors can take some comfort from the fact that the European banks are looking much stronger, with improved balance sheets and capital reserves.
The latest batch of economic data out of the eurozone suggests that the headwinds faced by the region continue to fade but have not yet completely gone. The improving credit situation is very encouraging and supportive of longer-term economic growth for the region. Meanwhile steps towards a banking union, even the weak version currently proposed, are steps in the right direction for avoiding future crisis. The persistent disinflation in the economy, however, just highlights that while the region is turning the corner it has some way to go and faces challenges ahead.
Kerry Craig is global market strategist for JP Morgan Asset Management