CIAO DATE: 02/05/08
European Affairs
Eurozone: A New Global Context Favors Long-Term Growth
Yves Mersch
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The economic prospects of Europe and other parts of the world have traditionally hinged on the U.S. economy. Now most economists concur with the view that the U.S. economy is sneezing. Yet this time the rest of the world is not expected to catch a cold. Why not? Why is there so much confidence that the euro area can successfully decouple its economic trajectory from the current U.S. slowdown? Let me lay out some thoughts in this regard in the context provided by recent macroeconomic developments – at the global level, in the U.S. and in Europe.
Let me start with the global macroeconomic environment. The dynamism of the world economy since its rebound in mid-2003 has been exceptional both in the pace of growth and its duration. Cyclical factors, underpinned by favorable financing conditions, have supported this expansion. But, equally so, it is likely that there is also a structural trend favoring a rising path for world growth. For example, the integration of the eastern European economies into the global trading system, followed by China and India, is one such structural factor. The “catch-up” potential of these economies is so large that it is unlikely that trend for growth will revert soon.
This year we are likely to witness a mild drop of global growth to slightly below five percent, according to the International Monetary Fund’s (IMF) recent World Economic Outlook report. Despite this moderation of growth, the favorable macroeconomic situation is expected to continue. As overall global growth continues to be rebalanced – away from the U.S. to the euro area and Japan – the risk of a more abrupt global slowdown continues to abate. While the U.S. economy can expect sub-par growth and the euro area will probably ease (from 2.8 percent growth in 2006 to 2.5 percent in 2007), the current expansion in Japan is set to continue at the pace it enjoyed in 2006. Emerging economies, particularly in Asia, seem set to continue robust growth. So the spillover effects of U.S. developments, including a soft landing for the economy, should be contained.
The latest episode in the ongoing correction of the U.S. housing market, notably the bankruptcies of 40 “sub-prime” (i.e. high risk) mortgage lenders, is, technically speaking, a sign that some lenders failed in their risk appraisals because, in this sector, a significant number of borrowers have defaulted on their loans in a situation where house prices have merely stabilized, not fallen, after a period of exuberant rises. A contained correction in the U.S. housing market is welcome because it prevents a further build-up of the prevalent disequilibrium. In addition, there are benefits in the market failure of lenders in this category. For one thing, it halts the aggressive lending practices that have partially nurtured the run-up of house prices. And, second, it reminds us of the risks involved – risks that should be assessed and priced accordingly. So far, there are no visible knock-on effects to the prime segment of the mortgage market. With this, and provided the labor market remains in good shape (and it is, according to the latest employment data), one can be fairly assured that the U.S. economy will weather these challenges – even if figures for the first quarter in 2007 do not look too good.
Taking a more pessimistic view, one could say that the housing adjustment remains incomplete (inventories continue amounting to more than eight months’ stock of unsold properties). So if the risk of adjustment would materialize, the resulting damage to the “wealth-effect” could cause a drop in demand. In its latest World Economic Outlook, the IMF foresees U.S. growth slowing to 2.2 percent in 2007 and 2.8 percent in 2008.
Keep in mind that the slowdown in the U.S. economy has not come as a surprise. The Federal Reserve Board (the U.S. central bank), like international bodies, had anticipated this moderation of growth and factored it into their projections, together with an adjustment scenario for redressing global imbalances. Overall, the economic slowdown stems mainly from adverse developments in the housing market, mainly the residential investment component. So the primary issue is domestic in nature. If concerns remain confined to the housing market, there is unlikely to be any severe direct consequences for the euro area.
Recent studies have tried to quantify the spillover effects from a potential hard-landing scenario in the U.S., and they have also concluded that the impact would be fairly muted on growth in the euro area. The European Central Bank staff has estimated that a one percent point cut in GDP growth in the U.S. would lower growth in the euro area by a mere 0.2 percent point. These results encompass the effects passed through direct and indirect trade channels and are in line with recent estimates by the European Commission. It also estimated that, if these trade effects were to be compounded by spillovers (through balance sheets, equity markets and other channels affecting general levels of confidence), the impact could increase to 0.5 percent points in two years. An additional 10 percent depreciation of the dollar vis-à-vis the euro could raise the impact to 0.8 percent points. Of course, these scenarios assume that the correction in the U.S. housing market is not further exacerbated by a weaker labor market. If that negative contagion occurred, a more thorough reassessment of the growth outlook would be necessary.
Overall, seven global risk factors have evolved in diverging directions since September 2006. On the one hand, there are now reduced risks for: recession in the U.S. housing market; a disruption in oil supply; a disorderly unwinding of global imbalances and inflation. On the other hand, there are higher upside risks for slumping domestic demand in the European Union and decline in growth in emerging markets. And there is an increased downside risk for financial stability.
While macroeconomic risks are moderating, credit risk has increased. Global markets seem to have been rather unimpressed by the current U.S. slowdown. The financial market jitters observed in late February appear to have only been a short episode. But assets of all kinds continue to be priced at high levels: Large amounts of liquidity are chasing comparatively rather scarce assets, so we observe low pricing of risks and flat yield curves. And long-term interest rates are strikingly low. These easy financing conditions have led to a rising “risk appetite,” reflected in leveraged buyouts, mortgage lending and carry trades. If a volatility shock triggered a market correction, the impact could be amplified by leveraged positions and uncertainties about risk concentration, notably in less liquid secondary markets for innovative financial products. But while pockets of vulnerability have increased in household and corporate sectors, on average financial positions remain sound and the financial sector appears resistant to shocks.
The shift of power in terms of credit creation from banks to the market with Hedge Funds and Private Equity Pools with much higher multipliers than banks risks loosening the transmission channel of central bank monetary policy, and this new situation is largely untested in stress. As Jacques de Larosière [Chairman of the Strategic Committee of the French Treasury] said recently: “High asset valuations and low risk pricing are, as they have always been, a source of vulnerability, because they can well be reversed.”
Let me now come back to the euro area. As you know, 2006 was a very good year for growth and the European Central Bank’s (ECB) Governing Council accompanied the upswing with a series of moderate increases in the key policy interest rates. These were aimed at progressively normalizing the level of interest rates and anchoring inflation expectations. These developments have continued in the first quarter of 2007. Business activity appears to remain strong, and in March the Governing Council decided on another moderate increase in interest rates. So far, our decisions at the ECB have proven right. Our interest rate increases were well received by financial markets; inflation expectations remain in line with price stability; and real GDP growth is projected to remain robust throughout 2007 and beyond.
So where do we stand today? What is important to note is that nowadays growth in the euro area depends less on external developments than domestic developments as the main drivers. There is however no room for complacency. Both our economic and monetary analyses confirm that the risks to inflation in the medium term remain on the upside. Among the upward pressures are: the evolution of input prices for manufacturing; the increased pricing power of companies in the services sector; recent survey data and the evolution of producer prices. There are risks of higher oil prices as well as trends in administered prices and in indirect taxes. In addition, there is ample liquidity; growth is strong in money supply and in credit – and interest rates remain moderate. In this environment – strong GDP growth and increases in employment accompanied by falling unemployment – the Governing Council of the ECB keeps stressing the need for moderate wage developments. The goal is to limit inflationary pressures from the wage side. In considering the evolution of interest rates, we have to disentangle structural versus cyclical effects. Looking ahead, as slack vanishes, we have to watch resource constraints, capacity building, the results of structural change, developments in productivity and in potential growth – while interpreting developments in money and credit growth. By acting in a firm and timely manner, we can preserve price stability and, by doing so, continue contributing to an environment of sustainable growth in the euro area.
Yves Mersch is Governor of the Banque Centrale du Luxembourg and a member of the Governing Council of the European Central Bank. This article is based on a presentation at The European Institute’s Transatlantic Roundtable of Finance and Monetary Affairs in April 2007 in Washington.