Eurozone Recovery: Is it a False Dawn?

After years of recession, stagnation, financial crisis, social unrest, and the threat of dissolution, the eurozone finally looked to have begun its long-awaited economic recovery in the second half of 2013.

But is the sudden light on the continent's horizon a false dawn?

Eurostat, the official European Union (EU) statistics agency, said the eurozone economy grew by just 0.2% in the first three months of 2014, lower than the 0.4% that had been expected. This was the fourth consecutive quarter of GDP growth, minimal though it is.

"While this means that the troubled and crisis-hit region seems to have finally entered a virtuous cycle of growth, which is in turn anticipated to translate to higher employment and living standards, growth remains too slow to heal the deep scars of the recession," said Danae Kyriakopoulou, economist at the Centre for Economics and Business Research (CEBR).

"What is more, the overall figure masks divergences among individual member-countries – this time beyond the traditional core-periphery divide.

"Within the currency bloc's very core, today's data showed clear divergence among the region's two biggest economies: while Germany is estimated to have posted quarterly growth of 0.8% (compared to 0.2% for the bloc as a whole), France was reported to not have grown at all."

What's the problem?

In order for an economy to grow, money needs to be injected in. That growth can come in a number of ways, but mostly through government or business investment.

The trouble for the 18 member state eurozone is that neither of these levers for growth are being pulled particularly hard.

On the government side of things, eurozone states are still wading through billions of euros of cuts to public spending under austerity programmes to erase the deficits in public finances.

In simple terms, less is coming in than is going out. And to reverse this governments are cutting back on budgets, particularly areas that they have to spend out on year after year, such as welfare payments.

This is inevitably pulling money out of the economy and the austerity programmes are far from over.

France alone, the eurozone's second largest economy, announced in January a further €50bn ($68.3bn, £40.7bn) of spending cuts by 2017 to address the government's budget deficit.

As for business investment, in areas such as job creation and expanding output, this relies on money firms already have or loans they are able to get from the banks.

Given the economic difficulties since the financial crisis, many businesses don't have the cash to hand to invest.

And the self-fulfilling uncertainty around the recovery – business won't invest because the economy isn't strong enough, the economy isn't strong enough because businesses aren't investing – is putting them off.

But many who do want to boost their firms can't get hold of affordable credit from the banks. Inflation figures from the European Central Bank (ECB) show money growth of just 0.2% in April 2014. This sluggishness is driven in large part by declining lending by banks to businesses.

Italy is a good example of this. It surprised markets when Istat, the country's governmental statistics agency, said Italian GDP contracted by 0.1% in the first quarter of 2014 when compared with the previous period. Many were expecting a 0.2% increase.

And this is because the country's financial sector is still reining in bank lending. The ABI, Italy's banking industry association, said loans to non-financial companies and families dropped by 1.9% annually in March.

Though this slowed from February's 2.6% decline, it is still yet another unwelcome contracting in lending.

Germany

John Clarke, chief investment officer at GHC Capital Markets, warned that most of the eurozone's economic growth is skewed towards its most powerful state, Germany – and things aren't necessarily healthy there either.

"The eurozone as a whole, excluding Germany, has not really recovered at all. The thing I'm worried about with regards to the eurozone is that money supply growth is pretty much basically zero," he said.

"And if you look at the main drive of monetary growth, which is bank lending, bank lending in the eurozone is falling. That includes within Germany. In the last 12 months, bank lending in Germany is down 3%. Bank lending in the eurozone as a whole is down 3%.

"Unless that turns around any time soon, it means that monetary supply growth which is pretty close to zero across the eurozone is going to carry on weakening. That means you will not see sustainable rates of growth in GDP across the eurozone as a whole for quite some time to come."

But bank lending may not turn around for some time. Despite much help from the European Central Bank (ECB), through ultra-low interest rates and schemes to make lending less risky and cheaper for financial firms, lending to non-financial businesses in the eurozone dropped by 3.1% (€62.9bn) in the year to March 2014 said Eurostat, to the lowest level since the data was first collected in 2004.

"Overall, the figures suggest that lending has still not bottomed at the start of 2014, despite historically low policy and market rates and much more favourable funding conditions for banks," said a research note from Citi's European economics department.

ECB action?

The ECB is likely to step up a gear in its attempts to get banks lending into the eurozone economy again.

"We expect the ECB to step in with more decisive action at its June meeting," said Kyriakopoulou of CEBR.

"ECB President Mario Draghi recently stated that the Governing council is 'comfortable with acting next time', and this has been followed by hints from other ECB sources pointing to the likelihood of monetary expansion in June.

"This is likely to take the form of a rate cut, bringing the deposit rate into negative territory for the first time in the ECB's history, and may also include a new long-term refinancing operation (LTRO) to improve liquidity and encourage bank lending."

Policymakers face a dilemma, however. They want banks to lend more out, but are also imposing tougher regulation on the financial sector to prevent another financial crisis.

Much of that regulation is centred on forcing banks to hold more capital against their lending, so if things do go awry and defaults happen they have enough of a buffer to soak up the losses rather than turn to national governments for taxpayer-funded bailouts.

But rather than increase the amount of capital they hold, many banks are just cutting back on their lending and selling of existing loan assets.

Whether any more action by the ECB actually increases bank lending remains to be seen, but the sustainability of the eurozone recovery rests heavily on its success.