An economic slowdown is coming

Experts from the European Commission (EC) judge that the economy of the European Union (EU) reached the peak of the business cycle in 2017. In the two subsequent years there will be a slowdown, but not a recession.
An economic slowdown is coming

(Paul Heaberlin, CC BY-SA)

At the beginning of November 2018, the European Commission presented its cyclical assessment and forecast of the economic situation in the EU member states entitled “Autumn 2018 Economic Forecast”.

The EC forecasts that GDP growth in the Eurozone will decline from 2.4 per cent in 2017 (which was the highest rate of growth in 10 years) to 2.1 per cent in 2018, 1.9 per cent in 2019, and 1.7 per cent in 2020. A similar trend will be observed throughout the EU. Economic growth in the EU will reach 2.1 per cent in 2018, 2.0 per cent in 2019, and 1.9 per cent in 2020. The EU economy is entering the sixth year of uninterrupted growth, and everything seems to indicate that positive growth will continue in all the member states until 2020, that is, the final year of the forecast horizon. However, the decline in the growth rate in the H1’18 and the deteriorating leading indicators also suggest that a slowdown is coming.

Global economic growth

In recent years, the development of the world economy has proceeded evenly in all the important regions. However, the EC expects that in the forecast period, i.e. until 2020, the differences in the growth rate in individual regions of the world will increase. Emerging markets may suffer the most, as they will be hit the hardest by the policy of trade protectionism pursued by the United States. Emerging economies, which are dependent on external financing, will also be adversely affected by the increase in interest rates and the strengthening of the dollar, as well as geopolitical tensions and growing uncertainty in domestic policy.

The developed economies will be positively influenced by the high growth rate of the US economy, strengthened by the pro-cyclical fiscal stimuli (tax cuts) and the good situation on the labor market. The fiscal incentives will compensate for the tightening of the monetary policy in the Unites States, but the import tariffs will have a negative effect on the growth rate of the US economy.

Global growth (excluding the EU) will settle down at 3.8 per cent in the two subsequent years. The decrease in the global growth rate will result from the deterioration in the growth outlook for emerging market economies, as well as the increase in oil prices. Customs tariffs imposed on Chinese exports to the United States will weaken that country’s economy, but the decline in the growth rate will be partly offset by the stimulation of domestic demand. The Chinese government is planning a significant reduction of income taxes starting from January 2019 and intends to continue the transformation of the economy from investment-led to consumption-driven growth.

The EC expects global trade growth to decrease significantly in the next two years as a result of international tensions. In 2017, the growth rate of global trade (excluding the EU) amounted to 5.5 per cent, but a slowdown is visible in 2018. The growth rate of international trade will amount to 4.8 per cent in 2018, and in the two subsequent years it will reach 4.0 and 3.7 per cent respectively.

Domestic demand in the EU

In light of a further weakening of external demand, GDP growth in Europe will mainly depend on domestic factors. In the H1’18, private consumption growth slowed down as a result of deteriorating consumer confidence. However, the EC predicts that it will continue to be the main driver of growth thanks to a further fall in unemployment and the higher disposable incomes of households. Private consumption in the Eurozone is forecast to grow by by 1.8 per cent in 2019, and as lower inflation should offset the impact of a further moderation in the pace of job creation, it will fall back to 1.6% in 2020. Interest rates will remain low in Europe, which will help sustain the high prices of privately owned assets.

Despite a certain slowdown in the economy, the conditions on the labor market in the Eurozone will improve. Net job creation in the Eurozone will increase by 1.1 and 0.9 per cent in the two subsequent years. The unemployment rate will also fall.

The good condition of the global economy was conducive to an acceleration in investment in the Eurozone and throughout the European Union. Investment also grew faster than GDP in the H1’18. This trend will continue in the coming years due to the high rates of production capacity utilization. However, the rate of growth of business investment may suffer as a result of the tensions in global trade. The growth rate of Eurozone exports decreased in the H1’18. This trend will continue in the coming years, which will negatively affect the GDP growth rate.

The Eurozone’s current account surplus (in relation to GDP) reached its peak in 2017. It weakened in 2018, before settling at around 3.6 per cent of GDP in 2019 and 2020. Germany and the Netherlands — traditionally — have the largest share in the surplus.

Inflation will rise slightly, while public debt will fall

In the Q3’18, the Eurozone inflation rate rose slightly above 2 per cent, mainly driven by the increase in energy prices. Crude oil prices reached their peak in the Q2 and will fall slightly in the next quarters, reducing the inflation rate. In turn, the upward pressure on wages could be the driving force of inflation. Overall, the European Commission’s experts predict that inflation in the Eurozone will amount to 1.8 per cent in 2018 and 2019, and 1.6 per cent in 2020.

It is projected that the Eurozone’s general government deficit to GDP ratio will decline further, mainly due to lower debt servicing costs. However, in 2019 the deficit is expected to increase slightly for the first time since 2009, reaching -0.8 per cent. The debt-to-GDP ratios are likely to fall in almost all the Eurozone member states. In 2020, the general government debt to GDP ratio will reach 82.8 per cent.

Threats from the United States and beyond

The favorable forecasts may not come true, however, because of several threats faced by the European Union’s economy. The overheating of the American economy, fueled by the significant pro-cyclical fiscal stimulus, could result in a faster-than-assumed turn towards monetary tightening in the United States. An increase in interest rates would have a strong, negative impact on American corporations, which are heavily indebted. It would also affect emerging markets, where the turmoil in the financial markets could spill over even more widely than before. This would also have a negative effect on advanced economies, including the EU economy.

In addition, the expected deterioration of the current account balance in the United States may lead to a further escalation of the trade disputes. This would affect China in particular. Chinese corporations are characterized by a relatively high and rising level of debt, which increases financial uncertainty.

A further escalation of trade tensions would increase uncertainty, negatively affecting confidence, investment, global trade and global economic growth. Europe would be particularly vulnerable to such external shocks considering its high integration in the global value chains. The materialization of any of these risks would most likely occur in 2020, when a fiscal tightening takes place in the United States, leading to a slowdown in the US economy. This will have a negative effect on the major trading partners of the United States, including the European Union.

In China, the authorities’ attempt to strengthen domestic demand in response to American restrictions, may lead to a debt crisis. A crisis may also occur in the most indebted Eurozone countries, and in particular in Italy. Finally, there still remain risks associated with Brexit.

The German locomotive is losing speed

The situation in Germany has the biggest impact on the European economy, including Poland. In the Q3’18, Germany’s GDP fell by 0.2 per cent q/q, and the German government acknowledged that the forecast for annual growth at 1.8 per cent is not realistic. The Munich-based Ifo Institute for Economic Research predicts that there will be a rebound in the Q4’18 — growth will amount to 0.4 per cent, and GDP growth for the whole year will reach 1.5 per cent. “One month of no growth shouldn’t unleash panic, but at the same time we see that growth rates are weakening and there are a lot of unknowns,” said Ralph Wiechers, the chief economist at the German Mechanical Engineering Industry Association, as quoted by the Wall Street Journal.

In its forecast, the EC emphasizes that Germany’s export prospects are weakening. This is related to the global tensions in international trade, which may affect the German automotive industry. A decline in exports (or a slowdown in export growth) may also lead to a decline (or lower growth) in investment. The cooling of the German economy is confirmed by the leading indicators. However, the EC believes that GDP will ultimately grow by 1.7 per cent in 2018.

The economic situation may get more difficult in the longer term, if the protectionist policy of the United States leads to a significant reduction in German exports. The EC signals the possibility of such a scenario, but forecasts that the growth of the German economy will reach 1.8 per cent in 2019, and 1.7 per cent in 2020.

Germany’s growth will be stimulated by domestic demand, including the increase in consumption resulting from the good situation on the labor market and rising wages. The unemployment rate in Germany stands at the lowest level recorded since the country’s reunification. It may fall to 3 per cent in 2020. Germany, like Poland, suffers from a labor shortage which will be mitigated by the influx of foreign workers. In mid-2018, recent refugees accounted for about 0.2 percentage points of the growth in employment, which indicates some progress in their integration into the German labor market.

Despite the immigration, there will be a continued shortage of workers on the labor market, which will drive an increase in wages and labor costs. This will result in a slight deterioration of German industry’s international competitiveness, but in the short term (until 2020) it should also boost consumption and internal demand. New legislation resulting from the coalition agreement between the parties that form the current German government will come into force in 2019. Among other things, child benefits will be increased, which will further boost household disposable incomes.

Germany’s budget surplus is supposed to peak in 2018 at 1.6 per cent of GDP. The good condition of the German budget is the result of previous reforms, falling unemployment and rising wages. It is expected that the budget surplus will fall to around 1 per cent in 2019 as a result of an increase in social spending, but the tendency for public debt reduction will continue. In 2018, for the first time in many years, Germany’s finances will meet the Maastricht criterion (60 per cent of debt in relation to GDP), and in 2019 the general government debt will fall to 57 per cent of GDP.

In Poland — growth driven by consumption

The EC forecasts that GDP growth in Poland will reach 4.8 per cent in 2018. Private consumption is and will remain the main driver of growth, fueled by favorable developments in the labor market. For the first time in three years investments will increase at a faster rate than GDP (by 6.2 per cent, according to the forecast), owing to the faster utilization of EU funds and the concurrent acceleration in public investments.

However, economic growth is slowly weakening. The EC predicts that GDP growth will slow down to 3.7 per cent in 2019 and to 3.3 per cent in 2020. This will be the result of the cooling private consumption caused by higher inflation and a slowdown in job growth. Investment growth will remain high, albeit slightly lower than in 2018. It will be supported by high capacity utilization levels, and low interest rates, as well as a further inflow of EU funds.

Exports will continue to grow in 2019 and 2020, although at a slower pace on account of the problems in global trade. Imports will also increase. As a result, the contribution of net exports to GDP growth will be negative in the next two years. Poland will have a negative trade balance in 2018 and in the next two years.

Low unemployment and the noticeable labor shortage will lead to an increase in wages, which in turn will increase inflationary pressure. The rising inflation rate — by 2.6 per cent in 2019 and by 2.7 per cent in 2020 (Harmonized Index of Consumer Prices) — will also be the result of higher electricity prices.

The EC predicts that the headline fiscal deficit in Poland will decrease from 1.4 per cent of GDP in 2017 to 0.9 per cent of GDP in 2018. This will be the result of a strong increase in revenue from personal income tax, corporate income tax, and social security contributions.

The fiscal deficit is expected to remain at 0.9 per cent in 2019, and to increase slightly to 1.0 per cent in 2020. One problem, however, is the excessively high structural deficit, which will reach 2 per cent of GDP in 2018 and 2019, and 1.8 per cent in 2020. The public debt to GDP ratio will continue to decrease and is set to reach 47 per cent in 2020.

The main risks to the outlook primarily relate to the external environment. The Polish economy is strongly connected to the economy of the EU, and especially Germany, which means that potential American restrictions on the German automotive industry would also strongly affect Poland.

(Paul Heaberlin, CC BY-SA)

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