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News : EU Economy Last Updated: Jun 2, 2009 - 6:25:59 AM

Eurozone consumers holding up but for how long?
By Finfacts Team
May 29, 2009 - 4:29:01 AM

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In the global financial crisis the European Union must stand united since it is only by acting jointly that we will have the opportunity of influencing the international rules, declared German Chancellor Angela Merkel in her keynote speech on European policy, on Wednesday, May 27, 2007.

"In a world with 6 billion people in total, 500 million people in Europe can make quite a difference”, said Merkel at the Humboldt-Universität in Berlin. The Chancellor pointed out that even though it is sometimes quite difficult, there is no alternative to the EU. No country would be able to overcome crises and set standards by acting alone.

The social market economy too must continue to be highlighted and defended as a successful model, she said. This model contained social and ecological standards. "Either we lose these basic principles,” stated the Chancellor, "or we fight to ensure they are also observed elsewhere.” She again spoke out in favour of a charter for sustainable business, on the lines of the Charter of Fundamental Rights of the Union which already exists.

The Chancellor said that what mattered here was for Europe to pursue these objectives jointly. "I will not tolerate divisions in Europe,” said Merkel. "And that incidentally is the reason why I oppose the calls for greater coordination of economic policy in Europe, which are aimed at the Eurogroup (the Eurozone finance ministers' forum). These have often not been fully thought through.” The single market of all 27 Member States continued to be the foundation of the EU, Merkel said.

The Eurozone's biggest economies  - - Germany and France  - - this week signalled that consumers are continuing to spend during the severest recession since 1945. France reported that consumer spending on manufactured goods rose a more-than-expected 0.7% in April, compared with March while Germany's GfK market research organisation said its "consumer climate" indicator was expected to hold steady in June for a fourth consecutive month. However, the situation is fragile and the Bloomberg Eurozone Retail Purchasing Managers' Index (PMI), based on a mid-month survey of more than 1,000 executives in the region's retail sector and published on Thursday, pointed to a slightly faster rate of decline in May, compared with April (see links in Related below).

Consumers are living on borrowed time...

Elga Bartsch, an executive director at US investment bank Morgan Stanley in London, said in a review of the Eurozone this week, when it comes to the consumer cycle, conventional wisdom has it that continental Europe is in much better shape than the US or the UK. Where the Anglo-Saxon economies are likely to see a sizable retrenchment in consumer spending this year, continental consumers will probably keep spending broadly stable.  But, while the relative outperformance of the Eurozone consumer should come true this year, she doubts that it will persist next year.  In the MS view, a number of factors make Eurozone consumers more resilient, but only temporarily.  These factors range from more generous unemployment benefits, to lower-debt-to-income ratios, a higher household saving rate, more resilient housing markets and a smaller role of funded pensions (which were hit hard by the recent financial turmoil). These factors will, along with falling inflation, lower interest rates and reduced income taxes, insulate Eurozone consumers this year.  Eventually, however, the deteriorating labour market will catch up with consumers on the Continent too.

...Also in Germany, courtesy of one-off policy measures

MS says much will depend on Germany, Europe's largest economy, and how its consumers are doing.  Given that German households haven't shown much spending prowess over the last ten years, they might be ready to kick spending into higher gear.  The great take-up of the government's car scrappage scheme suggests that there is some new-found life in German consumers' pockets after an extended period of consumer standstill. 

Elga Bartsch says German consumers will exercise less spending discipline in coming years than in the last decade, and would highlight a number of special factors that are likely to boost consumption temporarily: 

  • First, considerable income tax cuts worth a total of 0.6% of GDP kicked in with the March pay cheques. 

  • Second, the car-scrapping scheme was put in place in mid-February. The budgeting for this scheme already had to be raised from €1.5 billion to €5 billion due to the unexpectedly strong uptake of the €2,500 scrapping bonus. 

  • Third, after several years of stagnation, a major increase in pension benefits by 2.7% is scheduled for July 1st. 

  • Fourth, ahead of the September 27th general election, the government has beefed up its short-shift subsidies considerably, hoping to avoid major job losses.  In addition, the government was reported by various German newspapers earlier this year to have reached a moratorium on mass layoffs with many large German companies.  These measures are likely to partially postpone the labour market reaction to the sharp drop in economic activity. Hence, there should be a more marked rise in lay-offs in late 2009 and in 2010. As a result, it might not be before the winter of 2010-11 that a peak in German unemployment is seen.

SEE: Short-time work in Germany: A flexible instrument to fight the crisis according to Deutsche Bank Research

Eventually, job losses will get to consumers

Bartsch says, by far the most important factor driving Eurozone consumer spending is the labour market. Not only is disposable income the main fundamental variable driving consumer spending, but job growth also has a much bigger effect on consumer spending than wage growth - despite the fact that they both equally go towards wage income. On MS estimates, a 1% increase in real disposable income adds 0.84% to consumer spending over the long term. Real disposable income is driven by a number of different factors, including inflation, wages, taxes and social security contributions paid, benefits received and, last but not least, job growth.  Some factors are largely exogenous to the business cycle, but decided politically (e.g., the marginal tax rate and the benefit levels).

The main endogenous factors - wages and employment - tend to have very different effects on consumer spending (even though their product - wage income - is the main cyclical factor driving disposable income dynamics). According to the EU Commission, the impact of a 1% change in employment can be up to three times (between 0.69% and 0.9%) as large as the impact of a 1% increase in real wages (0.2-0.35%) (see EU Commission, Quarterly Report on the Eurozone, Vol 5, No 3, 2006).  Hence, it is the job market that matters most for consumers.  And this is where concern lies. 

MS says the recent disappointing round of first quarter GDP reports suggests that the MS estimate for a contraction in employment of 3.6% from peak-to-trough could be too optimistic and that the unemployment rate could well rise to more than 10% next year.  Hence, consumer spending should weaken further next year.

Household debt, interest costs and negative wealth effects are less of a concern

Other factors, such as financial and non-financial assets, play a considerably smaller role for Eurozone consumers: a (permanent) 10% rise in housing wealth adds not even 0.8% to consumer spending while a 10% rise in financial wealth lifts consumer spending by 0.2%. In the past, the impact of rising financial wealth is echoed by a falling saving rate, indicating that consumer spending outpaces income.  While the Eurozone saving rate eased steadily over the course of the 1980s and 1990s, it has moved sideways since the turn of the century.  At 15.1% of disposable income at the end of last year, it remains considerably higher than in the US (3.2%) or the UK (4.8%). 

SEE: US personal savings rate rises to 4.2% in March from below zero in 2005; Eurozone rises to 15%; Irish rate jumps from 3% in 2007 to 10% in 2009

According to a study by the European Commission, only financial wealth affects the savings rate in the long run (a 10% increase in the wealth-to-income ratio lowering the saving rate by 0.6pp) (see European Commission, Quarterly Report on the Eurozone, Vol 7, No 3, 2008). Similarly, neither household debt nor debt service costs are likely to be weighing much on consumer spending. While there are a wide range of interest rate arrangements on mortgages across the Eurozone, ranging from Spain or Ireland, where variable-rate mortgages dominate, to Germany or France, where fixed-rate mortgages are de rigeur, at the Eurozone level the consumer debt burden is not very interest rate-sensitive.  A 100bp increase in nominal short-term interest rates will raise the debt burden by only 0.15% of disposable income.  Hence, there is little reason to be concerned about debt, interest costs or wealth effects at the Eurozone level.  The country-by-country picture though is probably more accentuated.

Near-term consumer outlook is still improving

Elga Bartsch says despite being bearish on the medium-term consumer outlook in the Eurozone, she sees some signs of the near-term outlook for the current quarter improving. The MS consumer spending indicator points to a recovery of consumer spending in the second quarter on the back of stabilising consumer confidence, rising car registrations and less steep declines in retail sales.  To provide a real-time estimate of consumer spending, MS uses monthly data on retail sales, car registrations and consumer confidence and plug them into an econometric model.

The MS consumer spending indicator captures 72% of the variations in consumer spending growth. According to this indicator, a 1% rise in retail sales adds 0.4% to consumer spending, a 10% rise in car registrations boosts consumer spending by 0.5%, and a ten-point rise in consumer confidence in the previous quarter lifts consumer spending growth by 0.2% in the current quarter.  In the absence of any other influence, consumer spending would expand by 0.3% quarter per quarter, a notch below the long-term average growth rate of 0.5% per quarter. However, consumer spending estimates vary considerably with revisions of retail sales data, which tend to be frequent and significant.  As discussed above, this near-term recovery in consumer spending is likely to reflect a series of special factors boosting consumer spending temporarily. 

To sum up, the MS outlook for consumer spending in the Eurozone, is mixed.  While a number of factors will still support consumer spending this year, the initial resilience in the consumer may eventually give in to the grim labour reality. Looking beyond this cyclical dip next year, however, the outlook is relatively robust. Lengthy balance sheet repair is less likely to be a drag on Eurozone consumers. Neither have debt to income levels ever reached the lofty heights of the Anglo-Saxon economies, nor do equity holdings (directly or via pension funds) account for the same proportion of disposable income. 

Bartsch says as the German experience over the last decade shows, balance sheet repair, together with the absence of house price rises, coupled with only modest income growth as the country rebuilt its cost-competitiveness and consolidates its fiscal position, can bring consumer spending to a standstill. 

What is driving consumer confidence?

Elga Bartsch says as consumer confidence is the most timely indicator on the consumer cycle in the Eurozone, a key signal to the relative performance of retail stocks in Europe, she looked into the factors that typically affect consumer confidence.  She scrolled through a series of different financial and non-financial variables to see whether any of them have a leading indicator property for consumer confidence.  Among the financial variables looked at, were the exchange rate, the oil price, the equity market and short rates. Within the real economic indicators, business confidence and retail confidence, were looked at. Bartsch says so-called Granger-Causality tests were performed, which establish whether estimates of current consumer confidence can be improved by taking into account past values of the respective indicators. The results are very sensitive to the number of lagged values of consumer confidence considered in the estimation. The higher the numbers of lagged consumer confidence values at which an indicator still adds new information to the estimate, the more robust it is as a leading indicator for consumer confidence.

Bartsch says the results provide a good idea about which variables could potentially cause consumer confidence to make new lows after the recent tentative recovery.  

MS finds that the equity market systematically leads consumer confidence. It still has an additional information content even if the first 12 lags of consumer confidence are considered. The same is true for the unemployment rate. Other variables only have additional information to provide if less than a year's consumer confidence is considered. These variables include industrial confidence and oil prices. Hence, should equity markets hit new lows, so could consumer confidence.  Similarly, rising oil prices and falling business sentiment - either in Europe or in the US - could push consumer confidence lower again.  Last but not least, the rise in unemployment will likely weigh on consumer morale for quite a while. 

Martin Wolf, chief economics commentator of the Financial Times wrote this week:"the European economy gained an illusion of health from unsustainable spending in peripheral countries in its west, south and east. The asset price bubbles, credit growth and investment booms that characterised this spending have all collapsed, at the same time as an even more significant bubble burst in the US. This timing is not, of course, a coincidence. The collapse has devastated activity in the export-dependent countries, of which Germany is much the most important. Moreover, as a result of poor risk management, many European banks have also been badly damaged.

The question is whether the European economy can hope to return to health via a normal private-sector-led recovery. Unfortunately, in the post-bubble economies such a recovery is unlikely: one would have to hope for the piling of yet more debt on to the already highly indebted."

Wolf concludes: "This leaves two European answers, one likely but undesirable, the second unlikely but desirable. The likely answer is that demand will be driven by unsustainable fiscal expansions in post-bubble economies. The unlikely answer is that private demand will pick up in creditworthy economies, particularly Germany. In the absence of either, Europe will wait for the US to spend itself back into (temporary) vigour. It is a sad picture, whatever the “green shoots” may seem to show."

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