False Dawn

Recent trends show eurozone output is set to outstrip the UK. Don't worry, though, it's still safe to gloat

Schadenfreude is a particularly appropriate German word for how many Brits have probably felt about the recent performance of the main EU economies, including Germany. During the 1970s and 1980s, the UK trailed in Germany’s wake by most of the key economic indicators and we were very much the ‘sick man’ of Europe.

But, in the 1990s, there was a reversal of fortunes and the UK’s humiliating exit from the ERM in 1992 is usually seen as the turning point. It sparked a revival in our economic performance, which has put the UK at the top of the European economic league, in terms of growth and jobs, despite our semi-detached status within the EU and our shunning of the single currency.

This seems as though it might be about to change. Although GDP growth in the eurozone and the UK for 2006 as a whole was broadly the same (2.7%), there was an impressive acceleration of activity among the 13 single currency countries towards the end of the year. In the fourth quarter, annualised growth increased from 2.1% to 3.6%. Survey evidence, moreover, usually regarded as a good lead indicator, has been pointing to a robust 2007. On the basis of very recent trends, output in the eurozone could out-pace the UK this year for only the second time in the last decade.

Despite denting British pride a little, such a development would really be good news for the UK. In 2006, sales of goods to the EU (15) of £144bn accounted for 59% of total UK exports, around four-and-a-half times more than the US share. With the UK consumer under pressure from debt and higher interest, as well as an increasing tax burden, the authorities are looking to exports to make a bigger contribution to sustain growth. Expanding exports markets is a pre-requisite if UK companies are going to boost overseas sales. Although a more buoyant EU will put upward pressure on interest rates and commodity prices globally, robust growth in its biggest export market is more important to the UK.

But is the upturn securely based and will it offer opportunities for British companies? It seems there are a number of factors that are likely to push growth back to the sub-2% rates that have been the norm since 2001. Rather than the start of a period of self-sustaining growth in the EU, the last three months of 2006 might well have been another false dawn.

Because the EU remains a collection of disparate economies, there is no single factor that has spurred growth. In Germany, for instance, exports is the key and net exports contributed four-fifths of GDP growth last year. And in Q4, Germany resumed its traditional role as the main driver of Europe, with a 0.9% rise in GDP. As exports surged, so there was an upturn in investment in countries like Germany and the Netherlands, which have substantial balance of payments surpluses.

In Spain, France and Italy, on the other hand, trade tends to act as a drag on activity. These countries have traditionally relied more on consumption to stimulate growth and, as in Britain and the US, rapidly rising house prices (and the borrowing this facilitates) have underpinned consumer spending. In 2006, the growth of consumer spending could not match exports and so these countries did not see the same strong pickup as Germany and the Netherlands.

It is easy to see how growth could be derailed. Exports outside the EU are, of course, sensitive to the exchange rate and the euro appreciated by almost 4% (in trade weighted terms) over 12 months. With the ECB having just raised rates and possibly raising them again, and US and UK rates potentially edging down during 2007, the euro could well strengthen further against the dollar and the pound. And Germany is vulnerable to fluctuations in emerging markets, particularly in Eastern Europe, which have made a disproportionately large contribution to the recent export growth. A combination of a stronger currency and weaker demand could lead to the export boom running out of steam.

Most observers believe consumption will be dented by the forthcoming VAT increases in Germany and Italy, as well as higher utility prices and the fact that the most recent interest rises have yet to work their way fully through the systems. (It takes longer in the EU than the UK because of the more widespread use of fixed rate lending in Europe). In this environment, consumer spending is not expected to accelerate.

On balance, the evidence points to growth falling back below 2% in 2007 rather than pushing on to 3%. There are signs, especially in Germany, of supply side reforms (in the labour market in particular) that will improve the economy’s longer-term prospects. But the short-term outlook is less encouraging and the UK is likely once again to achieve growth a bit faster than the major countries of the eurozone.