Euro area economic recovery to continue at moderate pace, private consumption drives growth

The euro area economic recovery, which had started in Q2 2013, is entering its fourth year now. When it started, the jobless rate in the currency bloc was 12%, as compared to the most recent figure of 10.3%. Clearly, there is progress, but the jobless rate is still around three percentage points more than pre-crisis level. In recent times confidence indicators have fallen, but are still compatible with the GDP growth of 0.3% q/q as in Q4 2015.

The fall in confidence indicators was because of the financial markets turmoil seen in the start of 2016.  Sentiment should stop falling in the next few months as the markets have calmed down. If there is a new shock, the euro area economy can move closer to stagnation and the sub-consensus GDP growth projection of 1.3% for 2016 will likely be very high.

In 2015, the euro area’s GDP growth was mainly driven by private consumption that contributed two-thirds to the GDP growth of 1.5%.Growth in employment accelerated to 1% y/y, while forward-looking indicators showed similar growth going forward. Low inflation and the decline in oil prices supported real income growth and thereby consumption. As inflation is likely to accelerate after the base effect of oil price goes away, rise in consumption is expected to continue but not to accelerate.

At present, fiscal policy is neutral to slightly expansionary as the times of major cuts in spending and tax increases are over. The currency bloc’s GDP is likely to be raised by around 0.2% in 2016 and 2017 due to the increased public spending spurred by the influx of refugees. That said, the number of migrants or refugees coming to the EU or euro area in the future is uncertain.

Capital expenditure has been the weakest demand component in the euro area recovery. In spite of the recent increase in momentum, investment is still 11% lower than the pre-crisis level. However, with the slow global economic growth and the demographic outlook for Europe, considerable rebound in investment is not expected. Meanwhile, net exports are likely to slightly contribute negatively to growth as imports are expected to grow faster than exports.

“For next year, we expect GDP to grow by 1.4%; this is below the consensus and also below the ECB’s most recent staff projection”, says Nordea Bank.

However, there are downside risks to the euro area recovery, both on the external side and the domestic side. On the external side, risks range from a hard landing in China, slower growth in commodity-exporting nations for a prolonged period that will result in weaker exports, capital spending and sentiment. The US and UK are the most important export destinations for the euro area. An economic slowdown in these nations might add to the weaker demand from several emerging nations.

On the domestic side, the continuous requirement for deleveraging in the corporate sector and non-performing loans on the banks’ balance sheets might weaken growth in certain member nations more than projected. Also, the debate of Grexit and the Greek crisis might re-emerge that might be triggered by non-agreement regarding debt relief for Greece.