by Daniela Schwarzer and Sebastian Dullien
With business and political life slowly returning to normal after the holidays, focus has shifted again towards political and economic developments to come in 2007. The founders of Eurozone Watch have taken a deep look into their crystal ball and present their findings in two posts, one on economic developments in EMU (this post) and one on political developments (to be published later this week).
Will the upswing in the eurozone continue?
Yes, albeit at a slightly lower pace. Restrictive fiscal policies in Germany and Italy will dampen economic growth from the very strong (Germany) and robust (Italy) pace in 2006. The rest of the euro-area is not in a position to make up for this growth slowdown. In France, problems in the manufacturing sector will continue and French fixed investment will continue to be comparably weak. Moreover, the interest rate hikes of the ECB will dampen economic activity all over the eurozone. Overall, an EMU GDP growth rate of slightly above 2 percent seems like a sensible forecast for 2007, after slightly less than 3 percent in 2006. As long as the US economy avoids an outright recession and the dollar does not crash, spill-overs to the EMU economy can be expected to be limited.
Is the ECB going to raise interest rates towards 4 percent?
Yes. The strong growth outlook will push the ECB to raise its interest rates to 3.75 percent in the first half of the year and by a further 25 basis points later on. As inflationary pressure is still limited, the ECB will refrain from tightening much faster. Risks to this call are, however, a stronger than expected US downturn or a strong appreciation of the euro. In these cases, the ECB might delay a further hike beyond 3.75 percent.
Will the euro further gain value in 2007? If so, what are the consequences? Who will suffer most?
The euro will most likely further gain in value. There is a significant risk that it rises above 1.40 $ in 2007. Two factors are supporting the young currency: With further interest rate hikes by the ECB, investment in the Eurozone will become more attractive. Moreover, the possibility of a rate cut by the US Federal reserve still remains. Finally, there is a risk that central banks in Asia and from OPEC countries continue to diversify their portfolios and buy euros.
As long as the euro appreciates only gradually and does not overshoot strongly over 1.40 $, the euro economy seems well prepared to weather a stronger currency. However, if the appreciation comes amid news of a strongly decelerating US economy, the tripple shock (together with fiscal tightening) might become a danger for the upswing in the euro-zone.
Country-wise, a further appreciation of the euro is set to hurt those countries most which compete mainly with Asia, such as Italy or Portugal. Countries which have weak domestic demand will also be hurt, as in those cases, internal demand cannot make up for the shortfall in external demand.
Will economic divergences in EMU continue to grow bigger?
Yes, albeit they will not be noticed much in 2007. Dispersion in headline GDP growth will be lower than in the past years. Especially Germany will not be a stark outliner anymore. Growth in high-flyers like Finland and Ireland is set to moderate. However, below the surface, the diverging trends in unit labour costs are set to continue. Italian, Portuguese and Spanish unit labour costs will continue to increase much more quickly than is compatible with a sustainable competitiveness position. Germany will continue its beggar-thy-neighbour policy not only with a continuing low (albeit slightly accelerating) wage increase, but has also lowered employers' contribution (payroll taxes) on January 1, further depreciating in real terms relative to its partners in EMU. The debate on divergences is thus set to re-emerge.
Will Italy and Portugal, the EMU's problem cases, finally do better in 2007?
No. Italy's growth is dampened by massive fiscal consolidation which mainly relies on increasing revenues. Both countries are still losing competitiveness relative to the rest of the euro-area. In contrast to Spain or Greece, Portugal is not in a position of the business cycle in which domestic demand could compensate for the continuing problems of the export sector. None of the two countries is thus set to come anywhere close to the region's average growth rate of about 2 percent in 2007.
P.S.: Happy New Year to all our readers!