Capital Markets

All Fall Down

A broad-based contraction is well under way in Europe.
Economist StaffNovember 7, 2008

Just a few weeks ago the main question about the euro-area economy was whether it would avoid recession. Now it is how deep will the downturn be. The region was already struggling before the financial crisis intensified in mid-September. GDP seemed set for a small drop in the third quarter, after shrinking at an annualised rate of 0.7% in the three months to June. A reading of the runes suggests there is worse to come. Alarmed by the speed of the economy’s decline, the European Central Bank (ECB) cut its benchmark interest rate on November 6th by half a percentage point, to 3.25%, the second reduction in the space of a month.

Such action is more than justified by recent economic data. In October the purchasing managers’ index, a closely watched gauge of activity in manufacturing and service industries, dived from 46.9 to 43.6, a nadir for the ten-year-old survey. A score below 50 indicates the economy is shrinking: October’s reading points to a big contraction. Other indicators are scarcely cheerier. The European Commission’s measure of economic sentiment slumped to a 15-year low in October (see chart). The Commission slashed its GDP-growth forecast from 1.5% to 0.1% for 2009. Even firms in Germany, the region’s hardiest economy, are fearful: a gauge of business expectations compiled by Ifo, a Munich-based research institute, fell in October to its lowest-ever level.


The latest leg of the downturn appears to be broad-based, as the credit drought cramps consumer spending, business investment and exports. Consumers were in retreat long before the recent assaults on their fragile confidence. Household spending shrank in each of the year’s first two quarters. It shows few signs of reviving. Retail sales fell by 1.6% in the year to September, and economists at Barclays Capital reckon new-car sales fell to their lowest level in October since 1997, once seasonal factors are adjusted for.

Exports had also already been hurt by the downturn in Britain and America, the euro-zone’s two largest overseas markets. As the credit freeze spreads beyond the rich world, sales to fast-growing emerging markets are threatened too. Europe’s big capital-goods firms, suppliers of the equipment used to make goods or to build roads, railways, water systems and power plants, have enjoyed four rich years of revenue growth, says James Stettler at Dresdner Kleinwort. Commodity-producing countries flush with cash have been keen buyers. Infrastructure booms in China and eastern Europe have also helped to fatten up order books.

There are some signs that this source of demand has cooled. The share price of ABB, a Swiss-Swedish infrastructure firm, fell by a fifth on October 23rd after it reported that new orders from the Middle East, and from within Europe, had slowed in the three months to September. It is difficult for buyers to pull out of ambitious capital projects, and there is still plenty of high-priced work in the pipeline. According to Mr Stettler, Alstom, a French engineering group, has an order backlog worth €47 billion ($61 billion), equivalent to more than two years of revenue. A more alarming omen is the 8% fall in German factory orders in September, led by weak foreign demand.

Another likely casualty is capital spending at home by consumer-goods firms, which may now think they have too much capacity. Three luxury carmakers, BMW, Porsche and Daimler, have all said that weak sales mean they will try to trim output by extending their usual Christmas shutdown. Another sign that firms are cutting back came from SAP, a German software giant. The firm’s joint chief executive, Henning Kagermann, said recently he had “never witnessed such a sharp decline in customer spending in such a short time.“

Is the credit crunch forcing firms to retrench directly? One fear is that as banks scale back their balance-sheets, firms that rely on bank loans will have to act in step, axing their spending to reduce debts. That process would be especially painful for European firms, which rely more on bank finance than American companies do.

Yet the recent fall in business confidence may have more to do with anxiety about customer spending than worries that banks will cut credit lines. Bank loans to non-financial firms rose by 12.1% in the year to September, more slowly than a few months ago but still a fair clip. That said, banks are being more selective about loans. Some industries are likely to suffer more than others. Lenders may look to strengthen ties with their more stolid customers (manufacturers, utility companies and so on) at the expense of retailers, property developers and private-equity firms.

One crumb of comfort for euro-zone firms is that the currency has plunged against the dollar. The long preceding period of euro strength may have left European firms stronger, by forcing them to be more efficient. Its fall should now give exporters a better shot against American rivals in emerging economies. European firms have also been quicker to gain a foothold in these markets. The euro-area’s exports to oil-producing countries, for instance, are more than three times bigger than America’s, according to the ECB.

The downside of being so cosmopolitan is that European jobs may migrate to low-cost countries. That makes workers at home more anxious (and more loth to spend). Employees are probably right to be wary. The message from recent business surveys is that jobs, as well as capital spending, are in the firing-line.

Thomas Mayer, an economist at Deutsche Bank, believes that the impact of all this will be marked. He reckons GDP in the euro area will shrink by 1.4% next year. Fiscal stimulus will be slow in coming. Germany is best-placed to use fiscal policy to boost demand, because its government bonds are prized by investors fleeing risky assets. But the modest package unveiled on November 5th is too small to provide much of a lift.

Interest rates have also been cut too late to stop the slide. At least inflation is now far less of a worry for policymakers: it has already dropped from a peak of 4% in July to 3.2% in October and is set to fall further. The ECB, having long resisted calls to ease policy, still has some catching up to do.