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					Eurozone
Ernst & Young Eurozone Forecast   Winter edition — December 2012


                                                   Austria
                                                   Belgium
                                                   Cyprus
                                                   Estonia
                                                   Finland
                                                   France
                                                   Germany
                                                   Greece
                                                   Ireland
                                                   Italy
                                                   Luxembourg
                                                   Malta
                                                   Netherlands
                                                   Portugal
                                                   Slovakia
                                                   Slovenia
                                                   Spain
Ernst & Young Eurozone Forecast — Winter edition December 2012




Outlook for Spain


17 Eurozone countries




                                                                                               Finland




                                                                                                Estonia




                      Ireland
                                                 Netherlands

                                                         Germany
                                          Belgium
                                                     Luxembourg
                                                                                 Slovakia
                                                                       Austria
                                        France
                                                                         Slovenia

                                                               Italy




                                Spain

           Portugal                                                                         Greece




                                                                           Malta

                                                                                                          Cyprus



Published in collaboration with
Highlights
                                                                                                Policy-makers need
                                                                                                to do more to deliver
                                                                                                a lasting solution to
                                                                                                Spain’s crisis




•	 The continuing improvement in Spain’s          W
                                               •	 	 e	expect	the	budget	deficit	to	              •	 Our main concern is that it seems
   competitiveness has made us more               amount to 8.2% of GDP in 2012 and                 the Government will remain liable
   optimistic regarding export prospects,         6.5%	in	2013.	This	is	significantly	in	           for the European Union (EU) loan
   resulting in a modest upward revision to       excess of the Spanish Government’s                made to recapitalize the country’s
   our near-term GDP forecasts. Following         targets of 6.3% for 2012 and 4.5% for             banks, so investors will continue to
   an expected decline of 1.3% in 2012,           2013. But we believe that attempting              question the underlying solvency
   we now expect GDP to decline by 1.4%           to correct these overshoots with even             of	state	finances.	Although	the	
   in 2013, with positive, albeit sluggish,       more austerity measures would prove               European Central Bank (ECB) bond-
   growth of 0.3% forecast for 2014.              self-defeating, as they would merely              purchase program should prevent the
   But Spain will need to make further            deepen and prolong the recession.                 development of a downward spiral in
   progress on improving competitiveness          European	officials	should	therefore	              the bond markets, a lasting resolution
   in order to lay the foundations for            allow a more balanced approach to                 to the crisis in Spain requires EU
   positive growth in the medium term.            the	fiscal	adjustment,	with	greater	              policy-makers to separate banking
                                                  flexibility	around	fiscal	targets	                and sovereign risks by allowing the
•	 Investment expenditure is expected             and more emphasis on supply-side                  European Stability Mechanism (ESM)
   to prove particularly weak in the              reforms that will boost the potential             to recapitalize Spain’s banks directly.
   near	term,	reflecting	the	uncertain	           for economic growth.
   economic outlook as well as constraints
   on the availability of credit. After four   •	 The slight upward revision to our
   consecutive years of sharp falls, we           headline economic forecasts belies
   estimate that capital outlays in the           the deep uncertainty that continues
   economy as a whole will contract by            to shroud the outlook. Although the
   a further 8.8% in 2012 and forecast            immediate threat to Spain of a forced
   them to fall by 5.5% in 2013 and a             exit from the Eurozone has been
   further 0.2% in 2014.                          reduced, more still needs to be done
                                                  to address the interplay between
•	 Households’ ability to spend will also         sovereign and banking-sector risks.
   be curtailed for some time due to
   ongoing declines in housing wealth
   and rising unemployment, which we
   forecast will peak at almost 27% of the
   workforce in early 2014. And with wage
   growth remaining very subdued, lower
   inflation	will	only	slow	the	erosion	of	
   real incomes. As a result, we expect
   consumer spending to fall by 1.8%
   in 2012 and by 2% in 2013, with a
   further slight decline forecast in 2014.




                                                                        Ernst & Young Eurozone Forecast Winter edition December 2012 | Spain   1
Policy-makers need to do
more to deliver a lasting
solution to Spain’s crisis


Recent actions by Eurozone policy-makers                GDP forecasts revised up, but the                 targets of 6.3% for 2012 and 4.5% for 2013
appear to have stemmed the financial market             recession is far from over …                      look out of reach. This seems particularly
pressures that were threatening to engulf the           GDP surprised on the upside in Q3 2012,           likely given that the official projections are
Spanish economy. In particular, the creation            delivering a smaller than expected 0.3%           based on an overly optimistic forecast of GDP
of the Outright Monetary Transactions (OMT)             contraction on the quarter. In part, this         declining by just 0.5% in 2013. Our
program by the ECB has significantly                    probably reflects consumers bringing forward      expectation for a much deeper contraction in
dampened yields on government debt by                   major purchases ahead of the VAT hike on 1        output in 2013 is now very close to the
providing a liquidity backstop to the Spanish           September, thus reducing the negative             International Monetary Fund (IMF) forecast
Government. Investor sentiment has become               influence of domestic demand on overall           for a 1.3% decline and the European
more positive despite Spain having still not            output. Still, the continuing improvement in      Commission’s forecast of a 1.4% fall.
formally applied for assistance under the               Spain’s competitiveness has also made us
scheme. But we believe it is only a matter of                                                             Against this background, we have raised our
                                                        more optimistic regarding export prospects,
time before Spain enters into the program,                                                                forecast for the budget deficit to 8.2% of GDP
                                                        resulting in a modest upward revision to our
thereby ensuring that sovereign risk                                                                      in 2012 and 6.5% in 2013. We now believe
                                                        near-term GDP forecasts. Following an
premiums are contained.                                                                                   the budget shortfall will only near the 3%
                                                        expected decline of 1.3% in 2012, we now
                                                                                                          Maastricht level in 2015. We believe that
                                                        expect Spanish GDP to decline by 1.4% in
We still feel that more needs to be done by                                                               trying to correct these overshoots with even
                                                        2013, with positive, albeit sluggish, growth of
policy-makers to address the underlying                                                                   more austerity measures would prove
                                                        0.3% forecast for 2014.
solvency of the public finances and deliver                                                               self-defeating, as they would merely deepen
a lasting solution to the crisis in Spain.                                                                and prolong the recession. European officials
                                                        … and budget deficit targets are
Necessary measures include both domestic                                                                  should therefore allow a more balanced
reforms to further enhance the economy’s                likely to be missed again                         approach to the fiscal adjustment, with
competitiveness and agreement at the                    Revised data from Eurostat indicate that the      greater flexibility around fiscal targets and
Eurozone level to allow the ESM to                      budget deficit last year was even higher than     more emphasis on supply-side reforms to
recapitalize Spanish banks directly.                    previously estimated at 9.4% of GDP. Against      boost economic growth potential.
                                                        this background, the Government’s deficit



Table 1
Spain (annual percentage changes unless specified)                                                                                Source: Oxford Economics

                                                                    2011          2012           2013           2014           2015            2016
    GDP                                                              0.4          -1.3            -1.4           0.3            1.2             1.4
      Private consumption                                            -1.0         -1.8            -2.0          -0.1            1.0             1.4
      Fixed investment                                              -5.3          -8.8           -5.5           -0.2            2.0             2.1
      Stockbuilding (% of GDP)                                       0.6           0.6            0.3            0.3            0.3             0.3
      Government consumption                                        -0.5          -4.1            -5.7          -3.4            -1.0           -0.3
      Exports of goods and services                                  7.6           3.7            5.5            4.1            4.4             3.4
      Imports of goods and services                                  -0.9         -4.5            -2.3           1.1            3.8             3.3
    Consumer prices                                                  3.1           2.4            1.8            1.0            0.9             1.0
    Unemployment rate (level)                                       21.7          25.0           26.5           26.6           25.9           25.3
    Current account balance (% of GDP)                               -3.5         -2.3            -1.4          -1.3            -1.1           -1.0
    Government budget (% of GDP)                                     -9.4         -8.2           -6.5           -4.7           -3.2            -2.2
    Government debt (% of GDP)                                      69.3          79.0           87.8           93.7           97.4            99.7
    ECB	main	refinancing	rate	(%)                                    1.2           0.9            0.8            0.8            0.8             0.8
    Euro effective exchange rate (1995 = 100)                      120.8         115.4          115.3          112.9          110.2          110.3

    Exchange rate ($ per €)                                         1.39          1.28           1.27           1.21           1.17            1.17



2         Ernst & Young Eurozone Forecast Winter edition December 2012 | Spain
Foreign sector helps to offset weak domestic demand                                       sustainable growth in activity. Fortunately, the structural changes
The dynamism of the export sector is expected to remain the key                           required to achieve this goal are already under way, with the
factor helping Spain to avoid a more severe recession. One of the main                    Government’s labor market reforms proving more ambitious than
drivers behind this sector’s outperformance of the economy as a                           measures so far agreed in Italy or proposed in France. But more needs
whole is the significant progress that Spain has made in boosting                         to be done to increase the flexibility of the labor market and bring
competitiveness in recent years. Nominal unit labor costs have fallen                     down the high level of structural unemployment in Spain. For example,
by 5.5% over the past three years, for example, compared with a rise                      there is still a significant difference in costs for dismissing workers on
of 1.4% in the Eurozone as a whole. And productivity in Spain has risen                   permanent versus temporary contracts, which should be reduced.
by 11.2% since the beginning of 2008, compared with an average rise                       Qualification-related entry barriers to certain professions are also
of just 0.4% across the Eurozone.                                                         higher than elsewhere in Europe. And access to vocational education
                                                                                          and training needs to be widened for the unemployed.
In light of the improvements in competitiveness achieved in Spain, we
have raised our forecast for exports and we believe there is still a risk                 Although structural reforms will pay dividends in future years, they
that they could surprise on the upside. After growing by an estimated                     will not prevent further job destruction in the near term. Indeed, it is
3.7% in 2012, we forecast growth to pick up to 5.5% in 2013. And with                     likely that the short-term impact of these reforms together with
imports falling sharply over this period, foreign trade is estimated to                   the weakness of the economy will contribute to a further rise in the
have added 2.5 percentage points to GDP growth in 2012, with a                            number of unemployed workers over the coming year, pushing the
further 2.4 percentage point contribution forecast in 2013.                               unemployment rate to a peak of almost 27% of the workforce in early
                                                                                          2014. Households’ ability to spend will also be curtailed for some time
Weak labor market to dampen consumer spending                                             due to ongoing declines in housing wealth. And with wage growth
Spain will need to make further progress on improving                                     remaining very subdued, lower inflation will only slow the erosion of
competitiveness if it is to lay the foundations for sustained growth in                   real incomes. As a result, we expect consumer spending to fall by 1.8%
the medium term. Importantly, higher productivity will have to be                         in 2012 and by 2% in 2013, with a further small drop expected in 2014.
achieved, together with rising employment, in order to generate




Figure 1                                                                                  Figure 2
Contributions to GDP growth                                                               Government balance and debt
% year                                                                                    % of GDP                                                                  % of GDP
8                                                                            Forecast      4                                                            Forecast          120
                                                         Domestic                                                    Government budget balance
                                                         demand                            2                         (left-hand side)
6
                                                                                                                                                                          100
                             GDP
4                                                                                          0

                                                                                                                                                                          80
2                                                                                          -2


0                                                                                          -4                                                                             60


-2                                                                                        -6
            Net exports                                                                                              Government debt                                      40
                                                                                                                     (right-hand side)
-4                                                                                         -8

                                                                                                                                                                          20
-6                                                                                        -10


-8                                                                                        -12                                                                             0
     1985    1988     1991   1994   1997   2000   2003    2006      2009   2012    2015         1992   1995   1998     2001       2004    2007   2010   2013       2016

Source: Oxford Economics                                                                  Source: Oxford Economics


                                                                                            Ernst & Young Eurozone Forecast Winter edition December 2012 | Spain                3
Policy-makers need to do
more to deliver a lasting
solution to Spain’s crisis
Investment continues to contract amid deterioration                              Independent audit fails to rebuild confidence in
in business sentiment                                                            Spain’s banks …
Investment expenditure is expected to prove particularly weak in the             With the housing market in free fall and the economy forecast to
near term, reflecting the uncertain economic outlook as well as                  remain in recession throughout 2013, non-performing loans (NPLs)
constraints on the availability of credit. The continuing drain of               are likely to keep rising, as will the associated losses to banks. Latest
confidence from Spanish businesses has been reflected in recent                  data on NPLs certainly offer little reason for optimism, with a new
survey indicators. For example, the November Purchasing Managers’                record high of 10.7% of outstanding loans reached in September
Index (PMI) for the manufacturing sector reported that both                      2012. Moreover, the deterioration in credit quality has not been
production and new orders continued to decline. Profit margins were              limited to sectors related to construction; rather, it is spreading to all
also being squeezed as firms were forced to cut charges amid strong              sectors of the economy. Such is the pessimism regarding the outlook
competition and in the face of rising input costs. A similarly downbeat          for credit quality in Spain that the €59 billion capital shortfall
view was reported in the November PMI for the services sector, with              estimated by the independent audit of Spain’s banks has been
respondents generally pessimistic regarding prospects for the                    questioned by many analysts, who fear that the true scale of eventual
coming year.                                                                     losses may be far greater.

After four consecutive years of sharp falls, we forecast capital outlays         … and the link between banking and sovereign
in the economy as a whole to contract by a further 8.8% in 2012 and              risks persists
by 5.5% in 2013. Investment spending should finally stabilize during             The results of the bank audit will be used to calculate the amount
the second half of 2014, driven by an upturn in corporate investment             Spain needs to draw from the €100 billion credit line the EU has made
amid an improving outlook for profits. But the deep structural                   available for bank recapitalization. But it now appears that the Spanish
adjustment under way in the construction sector means that a                     Government could remain liable for these loans, rather than the ESM
significant recovery in residential investment remains unlikely in the           being used to recapitalize Spain’s banks directly. This only became
near term. In fact, latest data show that the downturn in the housing            apparent in October, when some Eurozone governments stated that
market is deepening, with the price of non-subsidized housing down by            existing aid programs cannot be transformed retroactively into a
9.5% in Q3 2012 compared with a year earlier. The correction of the              direct ESM bank-aid scheme. If the Government remains liable for the
real estate bubble is still far from over, particularly as the creation of a     EU loan made to recapitalize the country’s banks, then investors will
bad bank in the coming months will accelerate disposals of                       continue to doubt the underlying solvency of the state’s finances.
property assets.
                                                                                 Despite the immediate threat to Spain of a forced exit from the
                                                                                 Eurozone having been reduced, Eurozone policy-makers still need to
                                                                                 address the corrosive interplay between sovereign and banking-sector
                                                                                 risks in Spain by allowing the ESM to recapitalize banks directly. Against
                                                                                 this background, the upward revision to our headline GDP forecasts
                                                                                 belies the deep uncertainty that continues to shroud the outlook.



Figure 3                                                                         Figure 4
     Spain: Unemployment rate
Unemployment rate                                                                Non-performing bank loans
%                                                                                     % of loans outstanding
30                                                                    Forecast   12



26                                                                               10



22                                                                               8



18                                                                               6



14                                                                               4



10                                                                               2



6                                                                                0
 1980      1984      1988       1992   1996   2000   2004   2008   2012   2016     1980          1984          1988   1992   1996   2000   2004   2008   2012

Source: Oxford Economics                                                         Source: Haver Analytics


4       Ernst & Young Eurozone Forecast Winter edition December 2012 | Spain
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