Europe Wrestles With Conflicting Demands

Global Finance, Jan 2005 by Hawser, Anita

After struggling through a tough 2004, Europe's prospects for the coming year are hardly any brighter. Brent crude oil prices topped $53 a barrel in October, pushing up European consumer prices. Headline inflation in the eurozone increased to 2.4% in October and was expected to reach 2.6% by the end of the year, exceeding the ECB's target. "Historically, given such conditions we would have thought that the ECB would intervene," says Philippe d'Arvisenet, global chief economist, BNP Paribas, adding that policymakers were waiting to see if there were any secondround impacts from the rise in inflation before acting on interest rates.

D'Arvisenet predicts that some respite may come in the second half of 2005 as oil prices ease, with headline inflation in Europe expected to decline to 1.8% over the year. "We expect oil prices to come down from next winter," d'Arvisenet says, "but it depends on the political situation." The appreciation of the euro against the dollar has also helped ease the inflationary burden of oil prices, which means the ECB is unlikely to intervene until at least the end of the first quarter 2005, and even then, BNP Paribas predicts, any hike in interest rates will be minimalperhaps 25 basis points.

The strong euro has bolstered eurodenominated government and bond markets, but with interest rates expected to rise, the outlook for government paper in 2005 is less optimistic. "The government bond markets could struggle," says Paul Hearn, global head, primary markets, BNP Paribas, adding that the outlook for issuance in other credit bonds in 2005 remains low. "There is relatively limited supply in the corporate bond markets, with investment grade volumes down significantly," he says.

The ECB's September forecast for 2005 growth (1.8% to 2.8%) now looks optimistic, with economists predicting that growth of 2% is more realistic. Continued appreciation of the euro, depressed consumer demand, high unemployment (8.8% predicted for the eurozone in 2005) and insufficient balance sheet restructuring could affect growth stability in 2005."More could be done to increase sustainable long-term growth and improve the euro area's ability to adjust to shocks," the IMF writes in its 2004 World Economic Outlook.

With unemployment in Germany exceeding the 4.4 million mark in October, the government instigated a program of wage restraint and labor flexibility. D'Arvisenet anticipates that other major eurozone economies such as Italy could implement similar measures. Western European countries have also had to combat competitive pressures from lower cost centers within the accession countries. German manufacturers DaimlerChrysler and Siemens negotiated increases in the working week up to 40 hours, without any wage compensation, in return for guaranteeing that jobs would not be cut or production sites relocated to cheaper centers. Although the 10 accession countries account for only 5% of EU GDP, economic growth (upwards of 4% in real GDP terms) and equity performance has historically been stronger in Central and Eastern Europe (CEE) than in Western Europe.

But weakened economic growth for the EU in general, the prospect of interest rate hikes and further weakening of the US dollar are likely to trim growth prospects for CEE. "2004 was the best year for emerging Europe because global growth was strong and interest rates globally were low," comments Peter Szopo, head of market research, Bank Austria Creditanstalt. "Equities in the region had outperformed Western Europe for the last three years, but next year prospects are less benign."

One of the consequences of high growth has been an increase in imports, which has widened current account deficits in countries such as Estonia, where it currently stands at 14.5% of GDP. Szopo says while this is cause for concern, deficits in the region were not expected to widen further, and opportunities for FDI in the region remained attractive. -Anita Hawser