EEF blog

As Andrew mentioned in his blog earlier today, there are a multitude of ways in which fallout from the Eurozone crisis could hit the UK. In part, this is because each of the countries involved is a significant export market for the UK.

When trying to guage how big this impact will be, two pertinent questions arise: in what ways are our key export partners vulnerable to the crisis? And which exports are most at risk?

I'll attempt to answer those questions here.

Greece

Italy

Spain

France

Next week we will be looking at how the crisis in the Eurozone is infecting markets, in particular through its impact on confidence.

And then we’ll go into why we still have reason to be optimistic in the medium term…

…but a reminder that we can’t take opportunities for growth for granted. The government needs to work hard to attract investment and growth.

At the start of the year we identified four main challenges to growth over 2011: government cuts, access to finance, commodity prices, eurozone trainwreck.

This was also in the context of what we already knew to be weak consumer demand driven by reductions in real incomes, a weak housing market, and higher unemployment.

Domestic demand was undoubtedly weak and with the uncertain spillover impact of government cuts to come, the fear was it could become weaker.

The big shift since the start of the year has been the substantial weakening in external demand.

Though we might try to claim we had this risk in our sights, our flagging of the eurozone as a risk was more in the nature of an apocalyptic Lehman-scale financial markets meltdown. The sort of risk that was undoubtedly hugely negative but hard to be specific about.

While that unfortunate scenario could still yet materialise, the actual impact of the crisis that we are seeing, the generalised downward pressure on overall external demand is something we perhaps didn’t appreciate.

So how exactly is the eurozone crisis impacting on us?

Felicity has spoken about the three generalised impacts outlined by Mervyn King in May. But these generalised impacts hide a lot of complexity and specificity.

While the eurozone-wide challenges are the main threat to external demand, there’s actually a wide variety of challenges faced by the specific markets in Europe where we are now seeing weakness.

So with this in mind, we’re coming out in the next few days with a series of blogs on:

Specific challenges to eurozone countries that are key UK export markets;

The spillover of the crisis into external demand more generally via confidence impacts on markets outside of Europe;

Why in the medium term, we still have reason to be optimistic about the prospects for UK manufacturing, despite the impacts on Europe;

Why the UK cannot afford to take opportunity for granted and must compete hard to attract investment and drive growth.

Ah, the Eurozone, one minute you think the crisis is on the brink of resolution and the next a referendum has been called, stock prices have plummeted and the musical hopes of the Italian premier have been dashed.

Although the fact that the UK is not a member of the Eurozone has limited the extent to which we've been affected by the immediate impact of the sovereign debt crises, we are by no means immune. There are three key reasons what what happens in the Eurozone matters.

Firstly, what happens in Europe matters because Europe is our biggest export market. Given weak domestic demand, UK growth is dependent on export growth, which is being held back by ongoing weaknesses in the Euro area.

Europe buys around half of UK exports
Value of goods exports (2004 £m)

Secondly, what happens in Europe matters because of systemic risk

Back in May, Mervyn King gave evidence to the Treasury Select Committee, he said that crisis in Europe could lead to concerns about UK banks.

He said:

If, as their crisis evolves and develops, financial markets came to the view that these problems had not been tackled, there was no long-run plan for dealing with the need to regain competitiveness in these other countries, then of course the crisis could not only spread, but it would lead people to speculate, "Well, okay, here is a UK bank, which we are told has rather little exposure to Greece and we can see that, but we don't necessarily know all the exposures of the French and German banks to which the UK banks are themselves exposed". So trying to work out these other links is very hard to judge.

Finally, what happens in Europe matters, because no-one really knows how bad the outcome a disorderly default would look.

The crisis in Europe has knocked the confidence of households and investors around the world. If things were to escalate in Europe it is unclear what the impact of this would be. In the same Treasury Select Committee meeting King argued that:

Even knowing the mechanical links—a matrix of interconnections between banks—does not guarantee that there can't be a sudden loss of confidence in which those who fund banks decide to step back and say, "Look, we have no idea which European bank is exposed really to which other European bank, therefore we will just stop funding European banks". I think US banks and other national banks could be drawn in in those circumstances.

At the time King did not think this was the most likely scenario, but he also added "There is no alternative ultimately for dealing with the fundamental problems." Here's hoping Greece – and the rest of Europe – can deal with these.

The Germans are having a tough old time of it lately.

For months a coterie of southern European basket-cases have been pushing hard for them to sign on the dotted line re euro-bonds read Germans bailing out everyone else by standing behind their debts.

Then, in the weekend, German footy has taken a faecal turn with disgraceful behaviour at the Cologne v Schalke match.

And this week we have the news that the German economy only expanded by 0.2% in the second quarter.

So is it the end of the wirtshaftswunder (economic miracle)?

One cloud is well and truly within the gambit of the politicians to address – and I don’t mean the football.

That is the eurozone debacle that has lurched from train-wreck to train-wreck since the (first) decision to bail out Greece last year.

Were this to be resolved, it’s possible that Germany’s fortunes and those of the eurozone more generally could turn up. And there’s no doubt this is the schwerpunkt for Chancellor Merkel at the moment.

Sadly Ms Merkel’s summit with French President Nicolas Sarkozy this week, seemingly did not deliver.

Markets have been tripping over themselves to punish the heads of Europe’s two largest economies for failing to countenance eurobonds.

Yet you can understand Germany’s reluctance to get their hands dirty with southern European debt.

Speculation about the possibility of one or more eurozone members leaving the single currency has helped keep the euro low and therefore helped German exporters.

While a stronger Europe is certainly in Germany’s long term interests, at least in 2010 and the first quarter of this year, export growth in Germany powered impressive growth.

A more important factor is the impact Eurobonds could have on Germany’s cost of borrowing – it would increase. Again hardly a welcome development for the German economy and one the populace would feel is ill-deserved given Germany’s relative control over its finances.

A third factor has to be the bargaining aspect. As soon as Germany agrees to stand behind eurobonds the pressure comes off the peripheral European countries to reform rigidities holding back their economies.

Perhaps that’s why Germany is trying to drive reform in the direction it favours first before contemplating any Eurobond arrangement, starting with the announced intention this week for France and Germany to harmonize corporate tax rates.

As European politicians engage in further crisis talks, growth in the Eurozone is slowing. At least, that is, if today’s “Flash PMIs” for the region are anything to go by. Perhaps most concerning was the fact that although Germany and France saw growth, for the rest of the currency area, output fell for the second successive month. Even growth in Germany and France was at the slowest rate since the recession ended.

Source: Markit Economics, 2011

A glimmer of good news, perhaps, is that the slowdown has meant price pressures have started to ease. Producers experienced the smallest rise in input prices since January 2010. In addition, job creation seems to have edged up a little from last month’s low-point, largely driven by the area’s manufacturers.