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Economic Research: Disorderly Appreciation Of The Euro Might Inflict Longer-Lasting Economic Harm Than COVID-19

Economic Research: Disorderly Appreciation Of The Euro Might Inflict Longer-Lasting Economic Harm Than COVID-19

The European economy is undergoing multiple shocks, and the risk of recession is increasing. S&P Global Ratings Research believes that for the time being, the main shock is the currently still exponential spread of the coronavirus among the European population--mostly the effects of containment measures on demand--but the rapid appreciation of the currency is fast becoming another concern. Bearish equity markets and stark fluctuations in oil prices add to this picture, which increasingly looks like the perfect storm for the European economy.

The demand shock is severe, but short term in nature

One issue is that these multiple shocks are not concurrent: They will affect European growth over different timespans. The coronavirus will depress economic activity over the months of March and April. Should COVID-19 spread among the European population according to the same bell curve as in China or South Korea, activity will start to resume in Europe before the end of the second quarter, and a U-shaped recovery in GDP would be the most likely scenario. However, uncertainty remains sizable. We see two areas of uncertainty:

  • First, the depth of the loss in demand over the coming months, as containment measures become stricter. Nonessential consumption--in businesses and sectors such as hotels, restaurants, recreation and culture, transportation, and clothes and footwear--accounts for 40% of total consumer spending, with consumer spending representing 54% of GDP.
  • Second, the pace of recovery in demand and potential second-round effects on the creditworthiness of households and small and midsize enterprises (SMEs).

If persistent, euro appreciation might dent eurozone exports from the second half of this year and our GDP growth outlook for 2021 even more. On the more positive side, the drop in oil prices is beneficial for business input costs and for households' purchasing power, but the money saved is unlikely to be spent immediately.

For now, Italy remains the most exposed to the shock of the pandemic, given the number of virus cases reported in the country and the extent of economic activity shut down as a consequence of Italian authorities' containment measures. For example, real-time data indicate traffic congestion in Milan was about 50% below average over the past seven days, while it was about average in other large European metropoles. However, the virus is now spreading rapidly in other European countries such as France, Germany, and Spain, and national authorities are scaling up their responses, for instance by restricting large gatherings, closing schools, and even closing off regions of the country particularly hit by the virus. Moreover, the recent U.S. decision to restrict travel from Europe for 30 days might be costly, but we understand that for now exports of goods are not affected.

Chart 1


Disinflation will be one of the results of the numerous shocks mentioned above. A temporary fall in demand due to COVID-19 delay and containment measures, appreciation of the euro, and the drop in commodities prices are all driving down consumer prices. We estimate the stronger euro, combined with the recent drop in oil prices to $35 a barrel, will reduce inflation up to 40 basis points this year, to about 0.8%. This will boost consumer spending by 0.2%, not immediately, but when measures are lifted. We are likely to see higher savings initially, but they will pave the way for a rebound in consumer spending once social and economic life normalize, probably toward the end of the second quarter, still assuming the epi curve for COVID-19 cases follows the same bell curve as in China or South Korea.

Chart 2


Chart 3


Regarding the currency, the euro exchange rate is at present close to its long-term average in real effective terms, compared with a 1.9 standard deviation above the long-term average at time of its highest value in 2008-2009. However, the speed of its appreciation (4.8% in the past three weeks) might be destabilizing for global financial markets and a major challenge for the export-oriented European economy. The reason behind the euro's current appreciation is the unwinding of carry trades triggered by elevated volatility and a shrinking differential between the European Central Bank (ECB) and U.S. Federal Reserve policy rates.

At the end of the 1990s, when the Japanese yen was still the world's favorite funding currency, carry trades demonstrated the destabilizing force they can exert on financial markets and economies when they suddenly unwind. When this happened in the second half of 1998 amid market turmoil (the LTCM, Russian, and Asian financial crises), it led to a sharp appreciation of the yen, which aggravated the crises and pushed Japan deeper into recession. In the second half of 1998, the yen appreciated 11% in effective terms, but by the end of 2000 stood 32% higher.

It is worth noting that the eurozone economy is much more reliant on external trade than Japan was at the end of the 1990s--and still is today. That means it is also more vulnerable to an appreciation of its exchange rate. Indeed, based on the elasticity of export demand to the real effective exchange rate, a persistent 4.8% rise in the euro since mid-February might reduce export growth by 1.7% over second-half 2020. As about 40%-50% of export content is imported, this would mean a drag of 0.4 percentage points on the eurozone's GDP. Yesterday's decision by the ECB to cut interest rates on targeted long-term repurchase operations--but not the deposit rate--clearly shows the central bank has less room to cut rates and cushion the current downturn than the Fed. The ECB's move to provide additional net asset purchases of €120 billion might help stabilize the euro yield curve differential with its U.S. dollar counterpart. However, the asymmetrical policy room across the Atlantic means the euro still has room to appreciate further versus the U.S. dollar, in our view. This is a downside risk for European exports in 2021. Moreover, the U.S. travel ban is only planned for one month, but persistent appreciation of the euro might hinder a quick return of American tourists to Europe.

Chart 4


The unwinding of carry trades also suggests that European money might flow back to Europe. Since the end of 2014, when European rates went to zero, then negative, and the interest rate differential with the U.S. and the U.K. widened, eurozone investors increased their portfolio holdings outside the eurozone by $871 billion, according to our calculations based on IMF/Coordinated Portfolio Investment Survey data. Most of this money flew into developed markets' long-term debt securities in general, but in particular to the U.S. The shrinking interest rate differential between the euro and the U.S. dollar might lead to volatile capital flows across the Atlantic in coming months, if not a sizable flow back to Europe.

Chart 5


Table 1

Large Increase In The Eurozone's Foreign Portfolio Investment Since 2014
Net changes in portfolio holdings of eurozone investors (2018 versus 2014, bil. USD)
(Bil. USD) Total holdings Equity and investment fund shares Long-term debt securities Short-term debt securities
Investment worldwide excluding eurozone 871 198 691 -18
of which investment in developed markets 719 164 578 -22
of which investment in the U.S. alone 424 134 312 -23
of which investment in emerging markets 145 27 118 1
Note: Eurozone investors are investors in Germany, France, Italy, and Luxembourg. Source: IMF/CPIS, S&P Global Ratings.

Containment measures alone could drive the eurozone economy into a technical recession

The net effect of these multiple shocks to the eurozone economy is negative for GDP growth. The temporary fall in nonessential domestic consumption due to containment measures in Europe is currently the biggest shock. It alone could drive the European economy into a technical recession in the first half of 2020. The appreciation of the euro is looking to be the second shock for 2020, but it might become the biggest one for 2021, if it persists. COVID-19 containment measures in the U.S. would be the third shock to the European economy, given that the country is the EU's most important trading partner. We see the bearish equity markets mostly affecting GDP via business confidence and investment. Disinflation will alleviate but not offset the losses in GDP this year. A targeted fiscal and monetary response will be key to avoid second-round effects on the creditworthiness of SMEs and households.

As a result of the coronavirus outbreak, we have lowered our forecast for eurozone GDP growth to just 0.5% this year under our base case, compared with 1% previously; a recession in Italy (negative 0.3%); and stagnation in Germany. For 2021, when the recovery from the current shock will be still be underway, we expect higher growth than before (1.5% for the eurozone versus 1.2% in our previous baseline; see "The Coronavirus Will Shave 50 Basis Points Off Eurozone Growth," published on March 4, 2020). In view of the risks discussed above, particularly the coronavirus pandemic getting worse than we expect, persistent euro appreciation, and worse than currently expected deterioration of the U.S. economy, risks to our forecast for both years are heavily skewed to the downside.

This report does not constitute a rating action.

EMEA Chief Economist:Sylvain Broyer, Frankfurt (49) 69-33-999-156;
Senior Economist:Marion Amiot, London + 44 20 7176 0128;
Boris S Glass, London (44) 20-7176-8420;
Economist:Sarah Limbach, Paris + 33 14 420 6708;

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