Economics: False dawn

Dennis Turner

Schadenfreude is a particularly appropriate German word for how many Brits
have probably felt about the recent performance of the main EU economies,
including Germany. During the 1970s and 1980s, the UK trailed in Germany’s wake
by most of the key economic indicators and we were very much the ‘sick man’ of
Europe.

But, in the 1990s, there was a reversal of fortunes and the UK’s humiliating
exit from the ERM in 1992 is usually seen as the turning point. It sparked a
revival in our economic performance, which has put the UK at the top of the
European economic league, in terms of growth and jobs, despite our semi-detached
status within the EU and our shunning of the single currency.

This seems as though it might be about to change. Although GDP growth in the
eurozone and the UK for 2006 as a whole was broadly the same (2.7%), there was
an impressive acceleration of activity among the 13 single currency countries
towards the end of the year. In the fourth quarter, annualised growth increased
from 2.1% to 3.6%. Survey evidence, moreover, usually regarded as a good lead
indicator, has been pointing to a robust 2007. On the basis of very recent
trends, output in the eurozone could out-pace the UK this year for only the
second time in the last decade.

Despite denting British pride a little, such a development would really be
good news for the UK. In 2006, sales of goods to the EU (15) of £144bn accounted
for 59% of total UK exports, around four-and-a-half times more than the US
share. With the UK consumer under pressure from debt and higher interest, as
well as an increasing tax burden, the authorities are looking to exports to make
a bigger contribution to sustain growth. Expanding exports markets is a
pre-requisite if UK companies are going to boost overseas sales. Although a more
buoyant EU will put upward pressure on interest rates and commodity prices
globally, robust growth in its biggest export market is more important to the
UK.

But is the upturn securely based and will it offer opportunities for British
companies? It seems there are a number of factors that are likely to push growth
back to the sub-2% rates that have been the norm since 2001. Rather than the
start of a period of self-sustaining growth in the EU, the last three months of
2006 might well have been another false dawn.

Because the EU remains a collection of disparate economies, there is no
single factor that has spurred growth. In Germany, for instance, exports is the
key and net exports contributed four-fifths of GDP growth last year. And in Q4,
Germany resumed its traditional role as the main driver of Europe, with a 0.9%
rise in GDP. As exports surged, so there was an upturn in investment in
countries like Germany and the Netherlands, which have substantial balance of
payments surpluses.

In Spain, France and Italy, on the other hand, trade tends to act as a drag
on activity. These countries have traditionally relied more on consumption to
stimulate growth and, as in Britain and the US, rapidly rising house prices (and
the borrowing this facilitates) have underpinned consumer spending. In 2006, the
growth of consumer spending could not match exports and so these countries did
not see the same strong pickup as Germany and the Netherlands.

It is easy to see how growth could be derailed. Exports outside the EU are,
of course, sensitive to the exchange rate and the euro appreciated by almost 4%
(in trade weighted terms) over 12 months. With the ECB having just raised rates
and possibly raising them again, and US and UK rates potentially edging down
during 2007, the euro could well strengthen further against the dollar and the
pound. And Germany is vulnerable to fluctuations in emerging markets,
particularly in Eastern Europe, which have made a disproportionately large
contribution to the recent export growth. A combination of a stronger currency
and weaker demand could lead to the export boom running out of steam.

Most observers believe consumption will be dented by the forthcoming VAT
increases in Germany and Italy, as well as higher utility prices and the fact
that the most recent interest rises have yet to work their way fully through the
systems. (It takes longer in the EU than the UK because of the more widespread
use of fixed rate lending in Europe). In this environment, consumer spending is
not expected to accelerate.

On balance, the evidence points to growth falling back below 2% in 2007
rather than pushing on to 3%. There are signs, especially in Germany, of supply
side reforms (in the labour market in particular) that will improve the
economy’s longer-term prospects. But the short-term outlook is less encouraging
and the UK is likely once again to achieve growth a bit faster than the major
countries of the eurozone.