EEF blog

Merkel and Sarkozy met earlier today, with both parties once again agreeing to work together to develop closer fiscal integration, arguing that deficit reduction is the way forward. For even a casual follower of the Eurozone crisis, this is not really news.

More interesting, perhaps, was Merkel’s additional comment – that the next tranche of Greek aid cannot be paid out unless there is progress on negotiating the aid package –hints at just how close we could be to a Greek exit from the Eurozone.

Last week I blogged about EEF’s central, best-case and worst-case scenarios for the UK economy in the year ahead. Needless to say, the outcome of the Eurozone crisis was a key variable.

But how might the different outcomes of the Eurozone crisis affect the Eurozone itself?

Other forecasters have suggested a best case scenario – a quick resolution which shows determination to hold the currency union together and allows the ECB to inject significant amounts of liquidity – would improve growth prospects in 2012. PWC say that in these circumstances, the Eurozone could grow by 1.5% (our central forecast is zero growth in 2012).

At the other end, PWC’s worst case scenario would be for a Eurozone split, with the core retaining their currency and the periphery countries adopting different policies. The core countries could see modest growth in 2012, while the remainder would experience a significant GDP contraction of 5%.

But some forecasters are even gloomier. For example, ING offers up a doomsday scenario, with a total breakdown of the Eurozone leading to a contraction of 9% across the area.

Let’s hope it doesn’t come to that.

Earlier today Andrew blogged about the potential fallout from the Eurozone crisis on our other export markets, such as China.

Europe buys about one fifth of Chinese exports, so it is a key market for China. As Andrew explained, this means that problems in the Eurozone could reduce growth and confidence in China, and have a knock-on impact on demand for UK exports.

But, the crisis in the Eurozone is only one of many factors influencing Chinese growth. The Chinese economy is in a state of flux, and undergoing massive structural change. There is significant potential for Chinese domestic demand to grow, especially if they move forward in the way agreed at the recent G20 summit:

Emerging market economies commit to adopting macroeconomic policies to enhance the resilience of their economies and those in surplus will adopt macroeconomic policies to move towards more domestic-led growth, thus supporting the global recovery and financial stability.
…
China will rebalance demand towards domestic consumption by implementing measures to strengthen social safety nets, increase household income and transform the economic growth pattern. These actions will be reinforced by ongoing measures to promote greater exchange rate flexibility to better reflect underlying economic fundamentals, and gradually reduce the pace of accumulation of foreign reserves.

The latter paragraph mentions allowing greater exchange rate flexibility, this could provide a significant boost to exports.

As I mentioned earlier today, emerging economies (and non-EU markets) offer great potential for UK exporters. Many of these economies are growing rapidly, and have large, increasingly affluent populations. China is only one example.

There are real challenges ahead, as the potential downsides of the Eurozone crisis make only too clear, but there are plenty of opportunities to grow exports too.

Today’s trade figures, showing that the deficit on trade in goods has widened to £9.8 billion, are not altogether encouraging. Even though – once again – exports increased, imports rose at a faster rate.

There is unlikely to be much improvement in trade over the next few months, as the Eurozone crisis is weighing heavily on confidence. This is causing firms to hold off on investment and customers to hold back on placing orders. The impact this will have on the deficit is somewhat unclear, though. It is entirely likely that both imports and exports will fall as economic uncertainty saps demand at home and abroad. This weak demand is not great news for growth prospects in the short term.

But in the medium term there are reasons for optimism.

The UK’s largest export market is Western Europe, but in the last five years UK exporters have been developing and expanding in a wide range of new markets from Eastern Europe, to the Middle East and Asia.

UK exports to markets outside Europe have grown rapidly
% change in exports 2005-2010 
 
Source: HMRC, 2011

Newer markets have been the driving force behind export growth. In the last five years exports to Europe grew by 14%. Exports to the BRIC economies grew by over 100%.

And there is evidence post-recession that this trend is continuing. Exports to the BRIC economies were 44% higher in 2011q2 than 2009q4. These four countries alone have accounted for 14% of export growth since the recession ended. Today’s figures give us reason to believe this growth is set to continue, for example they show that the UK’s exports of cars to markets outside of the EU are growing strongly.

Uncertainty in the Eurozone will hurt demand in the short term. But demand from emerging markets is likely to be a growing source of strength in 2012 and beyond.

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.