Analysis: Euro zone making scant headway on growth and reform

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LONDON (Reuters) – The euro zone is finally getting a move on and slinging a safety net under the single currency. If only it were making as much headway in correcting the economic imbalances that made a rescue plan necessary in the first place.

The European Central Bank has bought time for the euro with a scheme for secondary-market purchases of bonds of countries such as Spain if they are shunned by investors. And the European Stability Mechanism is set to buy the debt as it is auctioned, after Germany’s top court approved the establishment of the permanent rescue fund. Immediate market pressure has subsided.

Yet European finance ministers meeting in Cyprus on Friday should be worried. Economic trends remain dispiriting: euro zone output is contracting, forecasts for 2013 are being downgraded and the myriad reforms needed to boost longer-term productivity and competitiveness are for the most part conspicuously absent.

“Implementing structural reforms to make an economy more competitive is more difficult when you’re in recession, there’s a credit crunch and confidence is going down the drain,” said Riccardo Barbieri, chief European economist at Mizuho in London.

This week alone, Portugal abandoned hope that 2013 would be a year of recovery — it now expects the economy to shrink 1 percent after a 3 percent drop this year — and two leading German research institutes slashed their growth projections for Europe’s biggest economy.

Even if things look up in the second half of next year, the level of output at the end of 2014 will still be lower than it was when the downturn started in the first quarter of 2008, according to economists at Jefferies.

That’s seven lost years.

The euro zone is making undisputed progress in unwinding the trade imbalances that built up between northern creditors and southern debtors during the go-go years of easy, cheap credit.

Portugal’s trade deficit, for example, is at the lowest level since the mid-1980s. Rising exports explain part of the improvement. Portugal’s services surplus is at a record high.

But Antoine Demongeot, an economist at Goldman Sachs, said the main explanation lies not in underlying improvements in competitiveness but in weak domestic demand. Imports are slumping as austerity bites and households pay down debt.

“In order for the single currency to become sustainable, the correction of the ‘core-periphery imbalance’ should be structural in nature and needs to carry into the medium term, rather than simply reflect different cyclical positions,” Demongeot said in a report.


With so much slack in the euro zone economy, symbolized by record unemployment of 11.3 percent, it is perhaps a surprise that inflation is not lower than the August rate of 2.6 percent.

Lofty oil and food bills are partly to blame. Stripping them out, inflation was 1.7 percent in July. Indirect tax increases forced on many governments by the need to balance their books have also propped up headline inflation.

But economists say the stickiness of inflation is in part another reflection of Europe’s structural shortcomings – excessive regulation of prices, inflexible labor laws and insufficient competition because of rules blocking new entrants in many sectors.

Take Greece. By the end of this year, the economy will have shrunk by more than 20 percent since the recession began, but consumer price inflation accelerated to 1.7 percent in the year to August.

Dimitris Drakopoulos, an economist with Nomura in London, said Greece’s gross domestic product deflator, the broadest measure of inflation, fell 0.5 percent in the second quarter. Labor costs, too, were falling.

“Wages are not that sticky anymore – the drop in wages has started accelerating this year,” he said. “The main reason prices have not come down is rigidity in Greece’s product markets: oligopolies, rent-seeking and other types of behavior that don’t allow prices to drop.”

That suggests companies are preserving their profit margins rather than passing on lower prices that would stimulate domestic demand and lure more foreign tourists. Of course, firms might be acting not out of choice but necessity.

“One answer could be that corporations are in an extremely dire financial situation after such a significant drop in output and so they would like to preserve their mark-ups,” said Zsolt Darvas, a researcher with Bruegel, a Brussels think tank.


While wage restraint to reduce unit labor costs is a necessary part of the policy mix for restoring competitiveness, the process is arduous.

For example, wages in Italy are rising 1.5 percent a year, less than half as fast as in Germany. But at that rate it would take a decade for Italy to achieve the improvement in cost competitiveness that would come over the medium term from a devaluation, Barbieri at Mizuho estimates.

To complement wage moderation, Italy needs a swathe of reforms to reverse the decline in economic dynamism over recent years, typified by the diverging fortunes of Italy’s and Germany’s car industries. Barbieri said he was not optimistic.

Prime Minister Mario Monti’s already modest proposals to inject more competition into professions such as pharmacies and notaries have been watered down, while attempts to improve public sector efficiency were achingly slow.

Barbieri cited a bill bogged down in parliament to reduce the number of defense employees, military and civilian, by a sixth.

“For me this is a litmus test. If this is not completed by the end of the year I will draw more pessimistic conclusions,” he said.

Another test could be France, currently enjoying very low bond yields but vulnerable in the eyes of some economists should market sentiment take another turn for the worse.

In contrast to Spain, Portugal, Greece and Italy, France has seen its trade deficit widen since the onset of the financial crisis, pointing to limited economic rebalancing and weakening competitiveness- in particular, the latest figures suggest that its bilateral gap with Germany is widening, said Demongeot at Goldman.

Moreover, structural reforms are advancing very cautiously, especially on talks to make the job market more flexible, because the government’s priority seems to be fiscal consolidation, according to Fabrice Montagne with Barclays Capital in Paris.

“While we agree that sequencing is extremely important, we believe that the economic outlook warrants a quick and ambitious outcome for the negotiations,” Montagne, who this week halved his forecast for 2013 French growth to 0.5 percent, said in a report.

(Editing by Mike Peacock)

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