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Indebtedness Is the Biggest Hurdle to Growth

Published on , , Twitter: @euinside
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The European economy is facing a not very inspiring growth, according to the European Commission's winter forecast. And although the situation is not as cloudy as it was in the autumn or the winter of 2013, the perspectives continue to be uncertain. A week after the publishing of the winter forecast it becomes clear why, although improved, the expectations for growth do not cause a desire to open the champaign. The published on March 5th reviews of the macro economic imbalances show that the main challenges of cross-border nature in the EU are high indebtedness - both private and public - low inflation, fragmentation of the financial market and high unemployment. 17 member states are covered by the macro economic imbalances procedure and three countries are leaving it successfully - Luxembourg, Malta and Sweden - but Ireland comes in after it successfully exited the adjustment programme.

The Commission has found imbalances in Belgium, Bulgaria, Germany, Ireland, Spain, Hungary, The Netherlands, France, Finland, Sweden and Great Britain. And in Croatia, Slovenia and Italy the imbalances are excessive. During its monitoring of the economic indicators of the member states, the Commission has found out that the correction of imbalances, which is a result of a combination of policies and restructuring, has contributed to economic improvement, but recovery is still fragile and uneven. The expectations are that in 2014 and 2015 the EU and the euro area will return to the pre-2007 levels of economic activity, but it will take some countries more time to do it.

Those are the unreforming states

Generally speaking, those are the countries that implement timid or inconsistent reforms, countries that suffer from excessive public indebtedness, low domestic consumption, high unemployment rates, countries which have lost external trade positions. The most important thing that should be noted in this context is the European Commission's conclusion that the interdependence of the economies suggests spill-overs of imbalances from country to country. The channels of spill-over are several - trade, financial and money links, structural reforms, confidence and uncertainty.

Specifically in the euro area, the main problems are several. Growth enhancing policies should be directly related to structural reforms aimed at increasing competitiveness in the vulnerable economies and in the bigger and not so indebted countries the Commission recommends an increase of domestic demand. The second problem is financial fragmentation which suffocates the economic potential of the problematic states because of hampered access to credit for businesses. The existence of various interest rates and credit conditions for businesses and households is a problem. Hence, the Commission recommends the efforts to establish a banking union to continue. This remains a "cornerstone" for the restoration of confidence in the financial sector and for reduction of fragmentation.

Indebtedness and very low inflation are another problem for the eurozone's economic recovery. In the past months, a rather scientific dispute is going on about whether there is deflation in the area of the common currency or not with European Central Bank President Mario Draghi insisting that there is no deflation, but the Commission sees problems in the low inflation and proposes an adequate level of nominal flexibility to enable correction of wages, which is considered necessary to reduce unemployment.

Among the problems the Commission found are also huge external liabilities that create vulnerability. In the past quarters, the current account deficits have significantly dropped in countries that had huge deficits in the pre-crisis period. In some states, the current account moved to the positive area. Those are Bulgaria, Spain, Croatia and Hungary, while Ireland and Slovenia have huge surpluses. This is due to improvement of labour costs, but it should also be taken into account that in those countries domestic consumption is seriously subdued. The outflow of investments from Spain, Croatia and Hungary is close to or above their annual gross domestic product, while in Bulgaria it is huge. According to the European Commission analysis, in Bulgaria, Ireland and Hungary the investment outflows have a very big share. The bad news is that a large part of the current account  improvement is not cyclical which means that during the recovery this improvement could disappear and the deficits could again start building up.

Cost competitiveness remains of crucial importance in the countries which had huge current account deficits. Those, again, are Bulgaria, Spain and Hungary, but also Croatia, Italy and Finland which suffered huge export market share losses in the past years. In some member states, corrections of unit labour costs is still ongoing. It is relatively weak, though, in France, Italy and Slovenia. Despite that, however, in many countries labour legislation still is unreformed which hampers employment. And it is unemployment and other indicators for social stress that remain very high, the Commission reports. Stabilisation of unemployment and fragile reduction are noted in Bulgaria, Ireland, Hungary and the United Kingdom.

Specifically for Bulgaria the report says that the labour market is too closed which hampers the economy's capability to correct and is one of the reasons that hampers the country's potential. In addition, it is pointed out that labour market policies and the education system are inefficient and do not support the process of correction.

The most problematic states this year are Slovenia, Croatia and Italy

Out of the 17 member states that are under scrutiny within the macro economic imbalances, three countries show excessive imbalances. Croatia is the newest in the group after it joined the EU on July 1st, 2013 and a few months later it entered an excessive deficit procedure. The problems found during the scrutiny are quite serious and require long-term coherence of correction policies. One of the grandiose problems, typical also for another former Yugo republic in the EU - Slovenia - are the losses generated by state-owned enterprises. In its report, the Commission points out that in some Croatian sectors state-owned companies continue to play a dominating role, often they are not restructured, highly indebted and have weak perspectives for profit.

The Commission has also found another problem which statistics show most clearly - unemployment which in the past years has been growing steadily. Croatia has the lowest employment level in the EU which, according to the analysis, is due to some extent to institutional set-up and applied policies. Better functioning of the labour market will be essential for the country's growth and for corrections of external and domestic vulnerabilities, the Commission believes. Business environment is also bad and is much below the average for Central and Eastern Europe. Croatia is expected to do more to put its public finances in order. The publication of the report on the macro economic imbalances coincided with the first for this year budget revision which reflects the already announced measures by the government to reduce the budget deficit and increase revenues.

Last year, Zoran Milanovic's government proposed changes to the labour legislation and the pension reform which caused strong reactions and protests by the trade unions. Reforms are ongoing in the area of health care and education which are also met with hostility by the trade unions. This means that the government and the ruling majority should launch a national debate on the situation of the Croatian economy and to develop scenarios for the future if reforms are half-way, painful or none. If the current policies are maintained, the Commission forecasts that the Croatian economy will exit recession this year with gross domestic product growth of 0.5% which will be thanks to exports and investments. Private consumption, however, will continue to weigh on recovery because of unemployment rise and household indebtedness. Unemployment is expected to remain as in 2013 at 17.6%.

The Italian political dynamics, of which the Commission warned Rome in the autumn, has irrefutable impact on the country's economic performance. After a tumultuous 2013 when Berlusconi attempted to return to power and with the help of allies succeeded in toppling Enrico Letta's government, the cabinet of brand new Prime Minster Matteo Renzi is facing severe challenges. The biggest among them are well known but are steadily deteriorating - too high a level of public debt and weak external competitiveness. The Commission believes that the reasons are rooted in the very sluggish growth of productivity. The Italian economy is very important for the functioning of the euro area mainly because of its size and that is why the Commission calls for an urgent attention on the necessary policies.

In this regard, Matteo Renzi has questioned some of the indicators saying that the 3% threshold for the budget deficit is outdated, but added that Italy will comply with it until it is valid. In its winter forecast the European Commission expects Italy to return to growth this year, also with a dynamic of 0.6%. Unemployment is expected to increase slightly this year to 12.6%.

In Slovenia, problems also stem from the Yugoslav economic structure which the European Commission describes like this: "More specifically, the risk stemming from an economic structure characterised by weak corporate governance, high level of state involvement in the economy, losses in cost competitiveness, the corporate debt overhang, the increase in government debt warrant very close attention". Further on in its analysis, the Commission points out that the weak corporative governance affects not only state-owned enterprises and that it reduces the overall efficiency of the economy because of inefficient allocation of resources. Significant withdrawal of the state from the corporative and financial sector in a combination with a comprehensive strategy for management of key assets could significantly improve the economy's capacity to adjust.

In spite these problems, though, the Commission has revised upward its forecast for the expansion of the Slovene economy. The contraction in 2014 will be less than expected -0.1% and in 2015 the country is expected to exit the recession and the economy to grow by 1.3%. The level of unemployment in Slovenia is not among the highest but is expected to grow slightly to 10.8% this year from 10.2% in 2013.

The European Commission will present in the spring specific recommendations for each country that is under macro economic surveillance. Until then it is important to reach an agreement on the second pillar of the banking union and to see what will be the distribution of powers in the European Parliament. Because of the European elections the Commission announced it will delay the presentation of the country specific recommendations. Notwithstanding, the politicians are expected to show innovation in the campaign, but most probably populism will prevail as the easiest to digest by voters while the Commission will continue to bark.

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