Debt's Dark Cloud

The eurozone’s debt crisis hangs like a dark cloud over Europe’s economic prospects. But it is not yet clear that the Continent’s slow recovery from its worst recession since the second world war will be blown off course.
Convincing evidence has yet to emerge of Europe's main economies taking a turn for the worse as a result of the global financial storm created in its own backyard. Germany’s Bundesbank said on Wednesday that so far market turmoil had not affected Europe’s largest economy, which had grown “sharply” in the second quarter. The Paris-based Organisation for Economic Co-operation and Development revised up its forecasts for eurozone growth this year and next, although it highlighted risks to the global outlook.
The biggest economies have been stabilised by emergency measures taken by governments and central banks. In coming months, sharp falls in the euro – its trade-weighted value is down 8 per cent compared with a year ago – should boost eurozone exports.
But the Financial Times’ European economic weather map – published on Wednesday for an eighth time – is at risk of sudden changes if market alarm about public finances does spread into the real economy, compounding the effects of higher taxes and sweeping cuts to public spending in the pipeline.
“All the talk about austerity measures will have an impact on consumer and business confidence – and then you will get the effect of the fiscal tightening itself,” said Robert Bergqvist, chief economist at SEB in Stockholm. “After the stabilisation we have seen in recent months, I think the big test will come after the summer.”
Erik Nielsen, European economist at Goldman Sachs, added: “My best guess would be that the real economy has another three to six months to convince financial markets that fundamentals are indeed improving before continued frozen credit channels would begin to sink the real sector back into recession.”
The effects of the eurozone sovereign debt crisis – which was started by fears over Greece but has spread to concerns about public finances in much of southern Europe – have so far been limited to the consumer sector. On Wednesday France reported a 1.2 per cent drop in consumer spending in April. Germany’s consumer confidence is falling, the country’s GfK research organisation reported.
In contrast, eurozone factory orders rose 5.2 per cent in March, according to data this week, almost certainly boosted by a weaker euro. Purchasing managers’ indices last week suggested that gross domestic product in the 16-country bloc was still expanding at a quarterly rate of about 0.5 per cent. But the pace of growth slowed this month, with manufacturing worst hit.
A test of policymakers’ confidence comes next month when the European Central Bank revises its forecasts. In March, it expected eurozone growth in a range with a mid-point of 0.8 per cent in 2010. But the OECD projections showed expansion of 1.2 per cent this year and 1.8 per cent in 2011.
One trend seems clear. Diverging performances across the Continent are likely to widen further, complicating the ECB’s task in setting interest rates. The falling euro is less help for countries such as Spain than export-dependent Germany, and fiscal austerity will be harshest in southern Europe. Greece is feeling the icy winds of austerity measures imposed by the International Monetary Fund and European Union. Portugal and Spain face bleak, possibly stormy conditions. Ireland has yet to stage a recovery.
Beyond the eurozone, the Baltics – Estonia, Latvia and Lithuania – have stabilised, and prospects have brightened in Russia, Turkey and Ukraine. But the crisis also makes the outlook uncertain beyond the eurozone’s borders. “If the depression is confined to Greece, Portugal and maybe Spain, then emerging Europe should be largely unaffected,” said Charles Robertson, chief emerging Europe economist at ING. “If the depression infects Germany and France, then emerging Europe growth will be hurt.”
Even for western European economies outside the eurozone with stable public finances, there are risks. Sweden has kept its currency but not complete economic independence. “During the most acute phase of the crisis we had a currency devaluation, so that helped,” said Mr Bergqvist. “But now our reliance on exports means we are very dependent on what happens in the rest of Europe.”

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