Consulting » Economics – Europe dodges US recession.

Economics - Europe dodges US recession.

European businesses will be affected by the US downturn, but recent ecomic reforms will help them avoid the worst effects.

The US economy has now recorded its third quarter of sluggish growth since the middle of last year. The worst fears of recession have not so far been borne out and consumer spending is keeping the economy afloat.

But the continuing bad news from the US corporate sector is offsetting the stimulus provided by falling interest rates.

However, we are now seeing signs that the slowdown is crossing the Atlantic.

The UK economy grew even more slowly than the US in the first quarter of this year. Across the eurozone, industrial production has slowed and business confidence has fallen. Germany appears to have been particularly hard-hit, with unemployment now rising in Europe’s largest economy.

There are a number of reasons why Europe is being affected by slower US growth. The most obvious is through trade. US imports from other countries fell for the second quarter in succession in the first three months of this year. Imports are being squeezed as companies run down their stocks and cut back on capital spending. UK exports to the US dropped by about a fifth in March; whether this is a blip or the start of a trend remains to be seen, but it is worrying. Exports to Asia and South America are also likely to suffer, as these regions are vulnerable to a downturn in demand from the US.

There are a number of other ways in which a US slowdown might affect the UK and other European economies. Companies hit by a US downturn are cutting back their operations in other markets to restore profitability – as we see from recent job cuts by companies such as Motorola, Ericsson and 3M. Falling business confidence worldwide encourages firms to postpone investment and put expansion plans on hold.

Global financial markets can also transmit economic shocks across the globe. Falls on Wall Street hit markets worldwide earlier this year, and, even though share values have recovered, UK and European stockmarkets are still 15% to 20% below their record highs.

Because of these linkages across the world economy, we should expect growth in Europe to slow to some degree in response to a weaker global economy. The IMF has downgraded its forecasts for growth in Europe this year and now expects growth of less than 2.5% – down from a projection of over 3% last Autumn. But there are some important offsetting factors which should prevent Europe being dragged too far into the mire.

First, UK and European consumers and businesses are not in the financially exposed position of their US counterparts. Retail sales are holding up well in the UK, France, Spain and a number of other European countries.

The British economy should also be supported by the government’s plans for higher spending and tax cuts, which were recently announced in the Budget.

Second, there should be scope to cut interest rates to support growth.

The Bank of England has reduced UK rates from 6% to 5.25% so far this year and UK interest rates could follow US interest rates to below 5%.

Partly because of worries about inflation, the European Central Bank has been slower to cut rates but has now begun to move – cutting rates by a quarter point in May.

Finally, European economies should benefit from the economic reforms of the past decade, including the formation of the Single European Market.

These reforms have strengthened the links between the economies of the European Union and helped to make markets more flexible. However, some countries are better placed than others on this score. Germany appears to be struggling as the legacy of unification, allied to a narrow industrial base and high social costs, takes its toll. By contrast, France and Spain are exhibiting more dynamism. These countries have more diverse economies and may be benefiting from the changes in attitudes bred by a prolonged period of high unemployment.

The UK has traditionally been regarded as one of the most flexible European economies. However, we may see this change as some of the increases in regulation, business taxation and social legislation under this government begin to alter perceptions.

Overall though, as long as the ECB and the Bank of England are prepared to cut interest rates to sustain growth, Europe should avoid the worst effects of the US slowdown. But we should expect to see some differences in performance between European countries, with Germany looking particularly vulnerable.

Big rise in profit warnings

Downgraded profit forecasts rose dramatically to 136 in Q1 2001, up 77% on the previous quarter, says Ernst & Young. The problems suffered by the software and computer services sector were compounded by the foot and mouth outbreak, creating the highest number of profit warnings since E&Y began its survey in 1998.

Pay rises stay low

Pay awards remained steady in Q1 2001, indicating that falling unemployment is not pushing up inflation, a new CBI survey reveals. Settlements averaged 4.1% in the three months to February 2001. A year before they averaged 3.4%.

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