Regional Focus: Weak Outlook Continues for the Eurozone’s Peripheral Economies

With the background of riots in Greece and protests across the western world, the eurozone crisis has continued in 2012. Despite the announcement of a second bailout agreement for Greece in February 2012, prospects remain weak for the peripheral countries in the eurozone. Disposable incomes have been squeezed and the crisis has hurt spending, investment and global growth prospects. EU members are at risk of suffering a “lost decade” but the eurozone overall should return to growth in 2013.

Key Points

  • The so-called peripheral countries of the eurozone, the “PIIGS” (Portugal, Ireland, Italy, Greece and Spain) have all suffered significantly between 2007 and 2011 following the global economic downturn, with levels of public debt that are deemed unsustainably high by the bond markets;
  • Years of cheap credit in the peripheral markets supported bubbles in construction in Spain and Ireland, while bloating public spending in Greece and Italy, with public debt in Greece reaching 170% of GDP in 2011;
  • Unemployment has hemorrhaged during the crisis; in Spain unemployment rose by 13.3 percentage points to reach 21.6% between 2007 and 2011, while Ireland’s unemployment rate increased three-fold. Even more striking has been the increase in unemployment rates of 15-24 year olds. Greek youth unemployment stood at 40.4% in 2011;
  • Rising unemployment and a lack of growth prospects is fundamentally affecting consumer confidence. Consumer expenditure has fallen by an average of nearly 8.0% across the PIIGS in real per capita terms between 2006 and 2011;
  • On-going uncertainty is affecting all eurozone countries, with the impact being felt globally. Low investor confidence and the unwillingness of a weak banking sector to provide loans is stifling output and business expansion. This has led to forecasts of negative growth in the eurozone area in 2012 but a return to growth is projected for the eurozone overall in 2013.

Unemployment Rates in Selected Economies and Youth Unemployment in the PIIGS: 2006-2011

% of economically active population

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Source: Euromonitor International from ILO

The rise of the PIIGS

Prior to the introduction of the euro, interest rates on government bonds in the EU were strongly divergent, with Greek 10-year government bond rates reaching around 25% compared to less than 6% for bonds in France and Germany. This represented the endemic risk associated with each country. There was almost complete convergence of government interest rates running up to 2002, when the Euro was put into circulation. Interest rates then fluctuated at the low rate of 3-5% between 2000 and 2006, as the fiscal rectitude of countries such as Germany was assumed in countries such as Greece. Greece and other riskier countries were able to borrow at the same rate as Germany resulting in significant investment in these countries, where high returns were available.

  • Cheap credit led to strong expansion in the PIIGS economies, which grew by 14.1% in real terms between 2001 and 2007;
  • In Spain and Ireland construction booms occurred. Between 2001 and 2007 the industries expanded by over 60.0% in real terms in both countries amid cheap credit and low mortgage costs;
  • In the case of Greece, fiscal prudence was shunned resulting in ballooning public spending and public debt, which reached 170% of GDP in 2011. A result of the bubbles and cheap credit was to increase wages above the level supported by the economy, leading to a lack of competitiveness in the PIIGS economies.

Harmonised Competitiveness Index for Selected Economies: Q1 1995-Q3 2011

Index: 100 = Q1 1999 period average for each quarter

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Source: European Central Bank

Note: Harmonised competitiveness indicators based on GDP deflators. A higher index score represents a lower level of competitiveness.

Results of the crisis

As financial hubs across Europe were brought to their knees, the cost of propping up weak banks has resulted in significant increases in government spending:

  • Increased costs of social security and government support have further damaged the public debt of countries across the eurozone. Ireland, the most extreme example, went from 24.9% public debt-to-GDP ratio in 2007 to 111% in 2011. Interest rates on sovereign bonds in Ireland reached 12.45% in July 2011 as bond markets responded to the government position. High interest rates increase the cost of borrowing for a government;
  • The crisis has crushed economies on the periphery of Europe that are reliant on credit, as the cost of borrowing soared. In 2010 the European Financial Stability Facility was set up, a euro area fund to support weakened countries through loans and bailouts. Very large bailouts have been required since 2010 to finance spending in Ireland, Portugal and especially Greece;
  • Spain and Ireland’s property bubbles burst as credit dried up across Europe, leading to precipitous drops in employment rates. Unemployment in Ireland increased from 4.6% in 2007 to 14.3% in 2011, while Spain’s unemployment rate hit 21.6% in 2011, the highest in the eurozone, with youth unemployment at an unprecedented 43.9% in 2011 for those aged 15-24;
  • Severe fiscal austerity across the eurozone has been enacted in an attempt to maintain credit-worthiness. A mix of increased taxes as well as large reductions in public spending has been pushed on the public. Legislation cutting back social security, downsizing of public sectors and increases in retirement ages has also been passed across the region. The resulting non-growth policy is slowing or in some cases reversing output across the eurozone in 2012;
  • As banks have continued to deleverage toxic assets from their balance sheets, the appetite for high risk investments remains subdued. Only safe loans are handed to businesses, choking off loans to small and medium sized enterprises as well as to consumers in the form of mortgages. This has resulted in low demand for goods and services;
  • Construction and manufacturing have been the hardest hit sectors; manufacturing output declined by 14.4% in real terms in the eurozone between 2007 and 2011. Much of this is due to low demand for new goods as investor and consumer confidence remain subdued;
  • Capital flight from the PIIGS has been significant in a bid to find safer investments. Two beneficiaries of this trend have been Germany and the Netherlands. This led to growth in the German construction sector between 2009 and 2011, where it grew on average at 2.5% a year in real terms, while unemployment has remained low in the Netherlands, reaching 4.5% in 2011. This provides some opportunity, though these countries remain susceptible to changes in other parts of the eurozone;
  • Weak consumer confidence is resulting in a movement of consumers to purchase lower cost items, with discount shopping and promotional offers having met with success. Internet shopping is another area of opportunity, providing a stronger performance over traditional outlets as consumers look online for bargains.

Impact of the crisis outside of the union

The eurozone crisis is having a profound effect outside of the region as well:

  • Euromonitor International expects global real GDP growth to slow in 2012 to 2.7% from 3.8% in 2011 as a contraction of 0.9% in the euro area creates a drag on global output;
  • The focus of trade in the developing world is becoming more introspective, as declining demand from the EU forces a reorientation towards South East Asia and other emerging regions. A reorientation of Brazil’s exports to South East Asia, for example, is opening up new opportunities, while growing domestic markets in China, Brazil and many other emerging markets are also helping to support growth;
  • Due to the proximity of the region, Eastern Europe has been the hardest hit by the slowdown in the eurozone. Foreign direct investment inflows, a major driver for employment and industrial development, have suffered. Eastern Europe is teetering on the precipice of another financial crisis and credit crunch. Many Eastern European banks were bought by Western European institutions during the transition from communism in the 1990s, leaving the Eastern European banking sector highly dependent on the European Union for credit support;
  • Slower growth in some of the major global economies is expected to ease commodity prices, although risks remain on the upside. This is expected to lower inflation which will benefit business and consumer spending.

Prospects

The eurozone as a whole is expected to see negative real GDP growth of 0.9% in 2012. The peripheral countries will continue to suffer from a lack of competitiveness. Weak credit markets, the impact of austerity measures and low consumer confidence remain a challenge across the eurozone. Recessions are expected in the periphery in 2012. Euromonitor International also forecasts negative growth for some of the eurozone’s largest economies with real GDP growth of -0.6% in Germany in 2012 and -0.3% in France, as the effects of the ongoing eurozone sovereign debt crisis take their toll.

There remain systemic problems with the euro that have yet to be addressed. A lack of a eurozone-wide fiscal authority has meant fundamental interest rate and real exchange rate mismatches are rife between the core and periphery of the eurozone. The spectre of Greek default or contagion to larger economies continues to threaten the stability of the eurozone.

On the 20th February 2012 Greece reached agreement with the European Commission, IMF and European Central Bank on its second major bailout, worth €130 billion. This is another attempt at keeping the economy afloat as it faces unsustainable debt servicing costs. Private holders of Greek government bonds have also agreed to take a 50% haircut on their investments in an attempt to reduce the debt levels Greece currently has. Strict austerity measures, including increased retirement ages, reduced pensions and lower minimum wages look likely to affect growth significantly over the next decade.

Euromonitor International forecasts growth will return to the eurozone in 2013 but that some countries such as Greece will not return to pre-crisis growth levels until after 2020. Real per capita consumer expenditure is expected to decline in the eurozone year-on-year in 2012 by 0.5% but will return to sluggish growth at an average annual rate of 1.0% between 2012 and 2016.