Global Insight Perspective | |
Significance | Although the Eurozone achieved robust growth in the third quarter of 2007, the economy appears to have since lost significant momentum in the face of mounting headwinds. |
Implications | The upward revision to quarter-on-quarter third-quarter 2007 Eurozone GDP growth is unlikely to push the European Central Bank into raising interest rates further. |
Outlook | We estimate that Eurozone GDP growth moderated from 2.9% in 2006 to 2.6% in 2007, and we expect a further slowdown to 1.8% in 2008. |
Eurozone GDP growth rebounded to 0.8% quarter-on-quarter (q/q) in the third quarter of 2007, according to a third release from Eurostat. This was revised up from a previous estimate of 0.7% q/q. Growth had previously slowed markedly to 0.3% q/q in the second quarter (the weakest performance since the first quarter of 2005) from 0.8% q/q in the first. The Eurozone economy had earlier expanded by 0.6-1.0% q/q throughout 2006. Meanwhile, the annual Eurozone growth rate edged back up to 2.7% in the third quarter of 2007 (unrevised from the previous estimate), having slowed to 2.5% in the second quarter from 3.2% in the first quarter.
Growth Picks Up in Germany, France, and Italy in Q3
Growth improved in all of the three largest Eurozone economies in the third quarter of 2007. German GDP growth rebounded to 0.7% q/q, having slowed to 0.3% q/q in the second quarter from 0.5% q/q in the first. Nevertheless, annual German growth remained at 2.5% in the third quarter, having dipped to this level in the second quarter from 3.6% in the first. French GDP growth similarly improved to 0.8% q/q in the third quarter after having moderated to 0.3% q/q in the second quarter from 0.6% q/q in the first. Annual French growth picked up to 2.2% in the third quarter from 1.4% in the second. However, the improvement in Italian growth was more limited. Italian GDP grew by 0.4% q/q and 1.9% year-on-year (y/y) in the third quarter, having expanded by just 0.1% q/q in the second quarter and by 0.3% q/q in the first.
Eurozone growth was also pushed up in the third quarter by Dutch GDP, which surged by 1.8% q/q and 4.2% y/y, lifted by substantially higher natural gas production. The Dutch economy had expanded just 0.2% q/q and 2.6% y/y in the second quarter. In addition, Austrian GDP growth improved to 0.8% q/q from 0.7% q/q in the third quarter, resulting in annual growth of 3.4%. Furthermore, Slovenian growth was a robust 1.6% q/q and 6.3% y/y in the third quarter.
However, GDP growth moderated to 0.7% q/q and 3.8% y/y in Spain in the third quarter, from 0.9% q/q and 4.0% y/y in the second. This was the weakest q/q growth since the fourth quarter of 2004 and partly reflected a marked slowdown in the construction sector. Meanwhile, Finnish GDP growth eased back to 0.7% q/q and 4.1% y/y in the third quarter from 1.0% q/q and 4.3% y/y in the second. In addition, Belgian growth moderated to 0.5% q/q and 2.6% y/y in the third quarter from 0.6% q/q and 2.8% y/y in the second. Portuguese GDP was only flat q/q in the third quarter after markedly improved growth of 0.6-0.7% q/q in the first two quarters. Consequently, annual Portuguese growth was limited to 1.8% in the third quarter. Finally, annual Greek GDP growth eased back to 3.8% in the third quarter from 4.1% in the second, while Irish expansion moderated to 3.9% from 5.7%.
Solid Consumer Spending and Firmer Investment Lift Growth
Eurozone GDP growth in the third quarter benefited from solid consumer spending. Specifically, consumer spending expanded by 0.5% q/q, although it was still only up by 1.6% y/y. Consumer spending had previously picked up to grow by 0.6% q/q in the second quarter, after having stagnated in the first quarter when it was dragged down by a sharp fall in German consumption following January's sales-tax hike. Sustained improvement in Eurozone labour markets and modestly higher wage growth in some countries are supporting Eurozone consumer spending, but the upside for consumption has continued to be limited to some extent across the region by overall modest real income growth, higher interest rates, and significant concerns among consumers about their long-term future personal finances in view of potential reforms relating to healthcare, pension, and labour markets.
Third-quarter Eurozone GDP growth was also lifted by a recovery in gross fixed capital formation after it had faltered in the second quarter following robust growth throughout 2006 and the first quarter of 2007. Gross fixed capital formation rose by 1.2% q/q in the third quarter, having been essentially flat in the second quarter. Consequently, y/y growth in investment edged back up to 4.7% in the third quarter, after having dipped to 4.3% in the second quarter from 7.1% in the first. Business investment continued to gain support in the third quarter from relatively elevated corporate confidence across the Eurozone, healthy company balance sheets and profitability, and the need of many companies to boost or upgrade capacity to meet recent extended robust business.
Government spending growth picked up to 0.6% q/q and 2.1% y/y in the third quarter from 0.1% q/q and 2.0% y/y in the second. Nevertheless, Eurozone governments face an ongoing need to contain their spending in order to significantly improve the underlying public finances. Meanwhile, inventories added 0.2 percentage point to overall q/q GDP growth in the third quarter. In contrast, a sharp run-down in inventories had cut second-quarter growth by 0.3 percentage point.
Net trade reduced overall q/q Eurozone GDP growth by 0.1 percentage point in the third quarter of 2007, in contrast to a positive contribution of 0.3 percentage point in the second quarter. Eurozone export growth was actually an impressive 2.2% q/q and 7.1% y/y in the third quarter (up from 0.9% q/q and 5.9% y/y in the second) as relatively strong global growth countered the strength of the euro. However, Eurozone import growth was even higher at 2.6% q/q in the third quarter (up from just 0.3% q/q in the second quarter), reflecting healthy Eurozone domestic demand and the increased competitiveness of many exporters to the Eurozone resulting from the euro's strength. Imports were up 5.9% y/y in the third quarter.
Outlook and Implications
Although Eurozone growth was back above trend in the third quarter of 2007, the latest data and survey evidence nevertheless suggests that economic activity is faltering. Following robust growth since mid-2005, Eurozone economic activity had already seemed set to moderate in the latter months of 2007 and more markedly in 2008, due to the combined impact of higher interest rates, a strong euro, and elevated oil prices. The ongoing credit crunch and financial-market turmoil will make the slowdown more pronounced.
We estimate that Eurozone GDP growth moderated from 2.9% in 2006 to 2.6% in 2007, and we expect it to slow significantly further to 1.8% in 2008. Furthermore, there are significant downside risks to the 2008 forecast. On the positive side, Eurozone economic fundamentals currently still seem relatively favourable overall. Higher employment and some pick-up in real disposable income growth across the region are supportive of consumer spending. Meanwhile, business investment intentions currently remain relatively strong, benefiting from generally healthy corporate finances and recent extended healthy demand. Nevertheless, the financial-market turmoil poses a serious threat to Eurozone growth, particularly as we suspect that it will persist in varying degrees for some time to come. By restricting loans to some consumers and businesses, and by causing market interest rates to rise, the ongoing credit crunch could markedly dampen Eurozone domestic demand.
Indeed, there are clear signs that the turmoil is weighing down markedly on business and consumer sentiment across the Eurozone, which threatens to undermine prospects for investment, employment, and consumer spending. Furthermore, any significant hit to global growth resulting from the financial-market turmoil would be damaging to Eurozone exports, which have made an important contribution to the Eurozone's upturn. The damage would be magnified should the euro appreciate further against the U.S. dollar, having reached a lifetime high of 1 euro:US$1.497 in November. There is also an increased risk that overvalued housing markets in countries such as Spain and Ireland could see a sharp correction, with significant knock-on effects for the rest of the economy.
ECB Set to Leave Interest Rates Unchanged
Despite the upward revision to quarter-on-quarter Eurozone GDP growth in the third quarter, the European Central Bank (ECB) still seems set to keep its key interest rate at 4.00% at its 10 January policy meeting. The bank will almost certainly retain a tightening bias in its policy stance and maintain the hawkish rhetoric. The ECB is likely to stress that current elevated Eurozone consumer price inflation must not feed through to have second-round inflationary effects—in particular through higher pay settlements.
We expect the ECB to keep interest rates at the current level of 4.00% well into 2008. With Eurozone economies currently showing clear signs of slowing, the euro uncomfortably strong, and financial-market turbulence likely to continue for some time to come, any additional tightening of monetary policy by the ECB would exacerbate already significant downside risks to the Eurozone growth outlook. At the same time though, we suspect that the ECB will not countenance cutting interest rates for some time to come, given current well above-target Eurozone inflation of 3.1% and ongoing risks to the medium-term inflation outlook stemming from possible higher wage settlements resulting from tighter labour markets across the Eurozone, increased capacity constraints, still excessively strong money-supply and credit growth, and elevated oil, commodity, and food prices.
Ultimately though, we believe that the ECB's next move will be to trim interest rates as slower Eurozone growth and the strong euro dilute underlying inflationary pressures. However, this is unlikely to occur until at least mid-2008.