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Economic Research:
Europe's Growth: As Good As It Gets?
Publication date: 31-Aug-2010
Economist: Jean-Michel Six, Paris (33)-1-44-20-67-05;
jean-michel_six@standardandpoors.com
Media Contact: John Piecuch, London (44) 20-7176-3536;
john_piecuch@standardandpoors.com

The summer's latest available economic data have brought no surprises for Western Europe. Standard & Poor's is still
forecasting a two-track recovery, with Europe's Southern rim countries experiencing slower economic growth than their
Northern neighbors.

Although we expect overall growth to slow in the fourth quarter of this year and in the first six months of 2011, we continue
to foresee sustained, though relatively gradual, economic improvement in Western Europe. In particular, broader-based fiscal
tightening in most countries will likely weigh on domestic demand, while high unemployment will continue to reduce real income
growth. The possibility of a double-dip scenario, under which these economies would teeter back into recession in the next 18
months, now appears more remote to us.

Germany And France Pull Most Of The Weight

Growth accelerated throughout the region in the first half of this year, according to the most recent economic indicators. The
eurozone's largest economies, Germany and France, fueled the pickup, with second-quarter euro area GDP up 1.0% over the
preceding three months, and 1.7% against the same period in 2009. Germany turned in a particularly vigorous performance,
with a 2.2% quarter-on-quarter increase in GDP and a 3.7% jump year on year. In the wake of 1.6% growth year on year in
the first quarter, this strong showing has led us to raise our forecasts for Germany's GDP to 2.5% from 2% this year and to
2.3% from 2% next year. The U.K.'s GDP also came in at an unexpectedly high 1.6% year on year in annualized terms, the
strongest quarterly performance in nine years.

The latest Ifo Institute for Economic Research business survey for Germany also underscores broad improvement. Data
published in early August show business conditions at their best since September 2007, or the early days of the global
economic crisis. Equally encouraging, the service sector has joined manufacturing in generating growth. The German services
Purchasing Managers Index (PMI) recorded new highs for both current activity and new business indicators in July.

At the same time, other European economies--particularly the Southern rim countries and Ireland--continue to post lackluster
performances. Spain's GDP dipped 0.2% year on year in the second quarter, while Greece's decreased 3.5%. The divergence
is particularly stark in services: Service PMIs for Italy, Spain, and Ireland decelerated sharply in the beginning of the summer.

The World Trade Rebound Buoys European Manufacturing

Europe's manufacturing growth has resumed chiefly on the strong surge in world trade in the past year or so. Between
September 2008 and May 2009, world trade contracted 20% in real terms, the largest decline in over 30 years. Since then,
however, the bounce back has been impressive (see chart 1). Emerging market imports, especially in Asia, are doing most of
the heavy lifting. The fiscal stimulus packages that China, South Korea, Malaysia, and Thailand implemented early last year
helped to rekindle domestic demand in the region and, in turn, propped up import growth.

The declining euro versus the dollar, coming on the heels of the weakening sterling exchange rate (which started earlier in
2009), has also helped European exporters reap the benefits of recovery. According to our estimates, a 1% decline in the euro
effective exchange rate triggers a 0.25% increase in real exports. From its peak in October 2009 to the end of May, the euro's
effective exchange rate dropped 10%, providing a not inconsequential 2.5% boost to exports. The ensuing lift to GDP growth
exceeds 1.0% in annualized terms. Since the beginning of the summer, however, the euro has regained some of the ground it
lost against the greenback, as investors' concerns about the sovereign debt outlook, especially for Europe's Southern rim
countries, alleviated. In search of a safe haven, many investors had turned back to the U.S. currency. But the U.S. recovery
remains very fragile based on recent U.S. economic trends, which lends fresh support to the euro.

Chart 1
We expect import demand from emerging markets to stabilize or even abate somewhat in the next 12 months, after
rebounding sharply in the past year. The lift to Europe's exports from the weaker euro and pound exchange rates is also likely
behind us. This prompts us to expect European export growth to stabilize this year, probably at a bit below the rate in the first
half (19% year on year in May). Still, we continue to believe that foreign trade will remain a powerful growth engine in the
current cycle.

Companies Appear Poised To Pump Up Capital Spending

Corporate investment has been climbing gradually, which we believe is a tangible sign of rising economic activity. In Germany,
capacity utilization in manufacturing rose to 80% in the first quarter of the year from 71% in the middle of last year. Capital
spending at German firms rose 1.6% in the first quarter. A fresh acceleration in expenditure is likely, in our opinion, thanks to
strong foreign demand. We anticipate investment in machinery and equipment will likely rise 4% in 2010 and 5% in 2011, after
the steep 20% plunge in 2009.

The nonfinancial corporate sector has improved its financial position since the beginning of last year. Companies have reduced
their financial gaps, meaning the difference between their cash flow and their capital expenditures (see chart 2). In the U.K.,
nonfinancial companies posted a strong surplus of 4.5% of GDP in the first quarter, up from 2.9% the same quarter a year
earlier.

Chart 2
The current low interest rates should also help support a gradual recovery in capital spending. Both the Bank of England and
the European Central Bank (ECB) are likely to leave their policy rates at their current levels of 0.5% and 1%, respectively, until
at least the beginning of next year, in our opinion. As fiscal policies become tighter on both sides of the Channel, monetary
authorities have incentives to remain more accommodating. Meanwhile, the risk of accelerating inflation remains remote amid
subpar growth. The Bank of England has put its support behind the fiscal package the new U.K. government has adopted,
indicating that it could be ready to resume its quantitative easing (QE) policy, which consists of buying gilts on the primary
markets, should conditions require. The ECB is understandably less specific: The 16 eurozone member countries are not at the
same stage of fiscal consolidation. But by indicating that ECB policy was still "at an appropriate level" during its August press
conference, the bank's president Jean-Claude Trichet confirmed that no tightening was in sight.

Consequently, some of the conditions for increased capital spending are gradually falling into place: higher demand, rising
capacity utilization, improved corporate financing, and low borrowing costs. This is not to say the pickup will be rapid or that it
will spread evenly across Europe, however. The latest monetary statistics for the eurozone show that corporate credit
demand remains very weak: Loans to nonfinancial companies declined 2.4% in the 12 months to July. While we believe signs
of rising capital spending are likely to become increasingly visible toward year-end in the U.K., the Benelux (the economic union
comprising Belgium, The Netherlands, and Luxembourg), Germany, and France, we expect it to occur later in Spain, Portugal,
and Italy. In these economies, the fiscal drag and weak foreign competitiveness will likely translate into anemic overall demand
in the corporate sector, causing capacity utilization to stay low until at least the end of 2011.

High Unemployment Holds Back Household Consumption

With the positive influence of the inventory cycle waning and fiscal conditions tightening across Europe, the outlook for retail
sales is becoming a key variable as we assess the progress of the overall recovery. Households tended to substantially
improve their financial positions in most countries in 2009. For the eurozone as a whole, households posted a financing
surplus--the difference between their savings and their investment--of 4.3% of GDP, twice the previous year's number. In the
U.K., this surplus swung to 1.1% of GDP from a financing gap of 2.1% a year earlier. Savings rates also rose markedly (see
chart 3). The countries most exposed to high private sector debt--the U.K., Spain, and Portugal--saw household savings rates
at their highest in 10 years.

Chart 3
The question now is whether households will decide to use part of their additional savings to maintain--or even increase--their
spending in the coming quarters. The most recent data, for the first quarter of 2010, provide some initial clues. Real disposable
incomes fell 2.6% in annualized terms in the eurozone, mainly because of a drop in asset income (interest and dividends) and
an increase in taxes and social contributions. Yet real spending slipped only 0.5% because of a decrease in the savings rate to
14.6% from 15% one quarter earlier. In other words, households offset part of the decline in their real incomes by drawing on
their savings. We expect a similar trend in countries where unemployment rates have stabilized or gone down somewhat (see
chart 4).

Chart 4
Labor markets vary considerably from one European country to another. The eurozone unemployment rate stood at 10% in
June, unchanged from May and marginally up against 9.5% a year earlier. Austria and The Netherlands recorded the lowest
unemployment rates, at 3.9% and 4.4%, respectively, contrasting with Spain's 20%--the highest rate in the euro area.
Germany's rate eased to 7% from 7.7% a year earlier, whereas France's figure hit 10% versus 9.5% a year ago. Italy's
climbed to 8.5% from 7.8%. Outside the eurozone, the U.K. jobless rate rose to 7.8% in May (the latest data available) from
7.7% a year earlier.

In our opinion, these diverging trends will likely prevail into early 2011. The latest PMI surveys on employment prospects show
more positive trends in Germany and the Benelux region than in France, Italy, and the Southern Rim countries. The uncertain
labor market outlook in the latter countries is likely to dissuade consumers from dipping too aggressively into their savings. On
the other hand, stable or declining unemployment should help push up consumption, albeit modestly, in Germany, The
Netherlands, and even the U.K. in the coming 12 months, providing some stimulus to economic activity.

Positive Growth Prospects Align To Pull Western Europe Through Gradual Recovery

Our forecast for slow overall growth in Western Europe over the next 18 months remains in place. Germany will likely provide
most of the push, thanks to its surging exports and, to a lesser extent, higher capital spending. France and the U.K. will also
likely shoulder some of the weight. Foreign trade, capital expenditures, and--in 2011--a slow revival in consumer demand are
likely to provide a boost for the U.K. economy.

From one country to another, however, the recovery will remain uneven, in our opinion. Fiscal tightening and sluggish
improvement in foreign competitiveness will, in our view, penalize Spain and other Southern Rim economies, where palpable
signs of positive growth are unlikely to surface before late next year.

Main European Economic Indicators

Germany France Italy Spain U.K. Ireland Eurozone

Real GDP (% change)

2008 1.3 0.4 (1.0) 0.9 (0.1) (3.0) 0.4

2009 (5.0) (2.5) (5.0) (3.6) (5.0) (7.6) (4.0)
2010f 2.5 1.6 0.7 (0.5) 1.4 (0.8) 1.7
2011f 2.3 1.6 1.0 0.3 2.5 2.0 1.9
CPI inflation (%)
2008 2.8 3.2 3.5 4.1 3.6 4.1 3.3
 2009 0.3 0.1 0.8 (0.3) 2.2 (4.5) 0.3
2010f 1.3 1.5 1.3 1.5 3.5 (1.2) 1.5
2011f 1.5 1.5 1.8 1.1 3.3 0.8 1.6
Unemployment rate (%)
2008 7.3 7.8 6.8 11.3 5.6 6.0 7.5
2009 7.5 9.1 7.8 18.0 7.6 11.8 9.4
2010f 7.0 9.8 8.5 21.0 7.6 13.5 10.1
2011f 6.7 9.5 9.0 21.0 7.5 12.0 9.8
f--Standard & Poor's forecast.

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