November 7, 2011 5:39 pm

German slowdown likely to lead to eurozone recession

euro sign sculpture

A eurozone recession – possibly severe – looks almost inevitable before the end of the year, even if the region’s debt crisis does not intensify further.

A sharp fall in German industrial production in September, reported by Berlin on Monday, provided the latest evidence that growth had gone into reverse in Europe’s largest economy. Production was down 2.7 per cent on the previous month.

Overall, output from Germany factories in the three months to September was still 1.7 per higher than in the second quarter of the year, but the latest data point to a sudden loss of momentum at the end of the third quarter.

“There has been a general weakening,” said Dirk Schumacher, economist at Goldman Sachs in Frankfurt. “Whether it gets a lot uglier will depend on how the debt crisis and the situation in the banks develop.”

Germany’s role as Europe’s industrial powerhouse means its slowdown has worrying implications for the eurozone. Last week, Mario Draghi, the new European Central Bank president, surprised analysts by talking openly about a “mild recession” in the 17-country bloc before the end of 2011. Central bankers usually try to talk up growth prospects.

However, with other eurozone countries – notably Italy – faring worse than Germany, Mr Draghi’s openness may simply have reflected an uncomfortable reality: the region’s escalating debt woes have already put it on course for a bitter winter. “It is too late to prevent the real economy being affected by what has happened,” said Gilles Moec, European economist at Deutsche Bank.

The risk now is that doubts over the public finances and future political leadership of Greece and Italy turn a “mild” recession into something much worse. “The persisting uncertainty is poison for economic growth,” warned Ulrike Rondorf, economist at Commerzbank.

Unlike the export-led economic slump in Europe that followed the collapse of Lehman Brothers investment bank in late 2008, the causes of the current slowdown are largely domestic – and unlikely to be reversed in the foreseeable future.

Chart: Eurozone composite PMI

Compounding a loss of economic confidence among business leaders and consumers, fiscal austerity measures are squeezing spending on goods and services across the continent, not just in crisis affected countries such as Italy, Spain Portugal and Greece. France on Monday announced another package of tax increases and expenditure cuts.

Europe’s weakened banking sector is also affecting the real economy. The ECB’s latest bank lending survey, released last month, showed a sharp tightening of credit standards applied on lending to business and consumers in the third quarter, which will restrict the extent to which credit can lubricate the wheels of economic activity in coming months.

In the deep recession of early 2009, eurozone gross domestic product fell by as much as 2.7 per cent in a single quarter. So far, there are no signs that the current contraction will be as sharp – but it could be worse than “mild”.

Some of the gloomiest warnings have been provided by purchasing managers’ indices for the region, which were regarded as reliable, up-to-date trends in economic activity and were cited at his press conference in Frankfurt last week by Mr Draghi. In October, the main “composite” index, covering service and manufacturing companies, fell to 46.5 from 49.1 in September – the sharpest monthly drop since November 2008. With a figure below 50 representing a contraction in activity, that was consistent with eurozone GDP falling by about 0.5 per cent a quarter, according to Markit, which produces the survey.

There were big divergences across the eurozone. Germany’s purchasing indices remained relatively benign, suggesting growth in its economy had merely stagnated. But Italy’s decline has been precipitous – its index readings were consistent with the country’s contracting by as much as 1 per cent a quarter.

Eurozone GDP will contract by about 0.4 per cent in both the fourth quarter of this year and the first quarter of next year, according to Now-casting, a company that produces entirely computer-generated forecasts based on published economic data.

The pace of decline could quickly accelerate in the event of a “disaster scenario”, however. The impact on the eurozone of a Greek default and its exit from the bloc, or even continuing paralysis in Italy, are hard to calculate – but most economists would assume something comparable with a “Lehman” style shock.

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