The coming economic fall

The coming economic fall

The European economy is facing a relatively difficult economic fall, with some bright spots but also quite a few dark ones.

The positive part is that inflation seems to be moderating, and everything points to a consolidation of this trend. Of course, it all depends on there being no surprises in the energy or food markets. In this sense, the end of the grain export agreement by Russia threatens to tighten the markets again (Russia and Ukraine are two of the main producers and large exporters of wheat and other basic products), including fertilizer, now that they were moderating. It is a bad time for countries that are already suffering for other reasons, such as Somalia, Ethiopia and Kenya or Egypt, where there could be social protests.

The problem, in any case, is that European monetary policy is not defined by low inflation in specific countries (such as 1% in Luxembourg or 1.6% in Belgium or Spain), but by the eurozone average, where, although headline inflation fell to 5.5% in June (from 6.1% in May), the underlying rate remains high, at 5.5%. lagarde announced that decisions would be made “meeting by meeting”, and although the weakness of the German economy (after two quarters of negative growth, with a Bundesbank more optimistic than the IMF) could point to the end of rate hikes, it is still early to discard them.

29% of households have a variable-rate mortgage, and families are assuming increasingly higher costs that deteriorate household disposable income

According to the Commission, the eurozone economy should grow by 0.9% in 2023 (with 1.5% in 2024 and 1.6% in 2025). However, if interest rates continue to rise, it cannot be ruled out that they end up affecting the economy faster than we might think. In Spain, the Bank of Spain has already warned of the rise in the percentage of households that cannot meet their essential costs with their income (from 7% to 9%, approximately 1.6 million families). According to this same body, 29% of households have a variable-rate mortgage, and families are assuming increasingly higher costs that deteriorate household disposable income. In addition, across Europe businesses are experiencing a notable decline in new fundingand although in some sectors margins and profitability are improving, the increase in financial costs is beginning to seriously deteriorate profits in general, especially those of smaller companies.

European states will also have to get used to more complicated public financing. In general, due to the rate hike itself, but also due to the new framework of fiscal rules, which should be finalized throughout the Spanish presidency and which will force all European countries to carry out strong fiscal consolidation. Today it seems clear that the figures of the 3% deficit and 60% debt will continue to be valid as benchmarks, and although there will be adaptations of the fiscal adjustment paths depending on the different GDP growth rates, there will also be minimum mandatory annual adjustments (hopefully via deficit, rather than via debt).

The trajectory of the debt in the European countries will be determined more by GDP growth than by nominal reduction

It should be noted that, although in principle some countries such as Spain would have the advantage of having a certain margin of indebtedness via European debt of the Next Generation EU (recently requested through the addendum), in the end European bonds are coming out somewhat more expensive than initially thought (with a premium over some national bonds). There are several reasons for this higher cost, from their worse liquidity (NGEU bonds will stop being issued in a few years and, therefore, it will be increasingly difficult to sell them on the secondary market) or the fact that, as supranational bondsits use as a guarantee to obtain liquidity has a small discount or cut (haircut) that sovereign bonds do not suffer (something that, in theory, would be easy to solve by regulation).

It should be kept in mind that, in any case and as usual, the course of debt in European countries will be more determined by GDP growth than by nominal reduction. Countries that manage to maintain high growth rates will remain safe from potential financial stress. However, if growth across Europe falters, the most indebted countries will be the ones that will suffer the most.

In any case, it must be borne in mind that, as a consequence of the reactivation of the Stability and Growth Pact (with or without new tax rules), all the national finances of European countries will be looked at with a magnifying glass. So come times of much greater control.

Two key choices

In summary, it will be necessary to be attentive to the evolution of inflation and interest rates in the euro area and their impact on growth, as well as the new framework for European public finances. To all these elements, of course, other geopolitical elements must be added: apart from possible unforeseen events with Russiathroughout 2024 two key elections will have to be taken into account: in January, those of taiwanwhich, if they provide a clear victory for the Taiwanese nationalists, could provoke a reaction of China; and, in November, those of the United States, which could bring a president much less willing to help Europe economically and militarily. In this volatile scenario, all precaution is little.

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