Document View

Production data for Q1 show that activity is collapsing at a faster rate than many expected: in Germany, industrial production in the first two months of the year was 19.3% lower than in the same period of 2008. The collapse of world trade is hitting exports: In the year to January, export values are estimated to have fallen by more than 13% and firms expect a further worsening of the outlook. The fiscal stimulus measures introduced by member states amount to nearly 1% of GDP. However, they will have an impact on domestic demand only in the final months of the year. In the meantime, automatic stabilizers are giving some support to the household sector. Despite the fall in interest rates and the measures to support the banking industry, credit growth to the private sector is decelerating, especially loans to businesses and for home purchase.

Highlights and Key Issues

* Production data for Q1 show that activity collapsing at a faster rate than many expected: in Germany, industrial production in the first two months of the year was 19.3% lower than in the same period of 2008

* On April 2nd the ECB cut the policy rate to 1.25%. Interbank rates are falling rapidly too, but credit conditions remain tight. ECB hinted that it will start quantitative easing from next month.

* The collapse of world trade is hitting exports: in the year to January, export values are estimated to have fallen by more than 13% and firms expect a further worsening of the outlook. We forecast a 10.5% fall in overall export volume this year.

* Firms' capacity utilisation has fallen to historic lows, making a surge in unemployment likely and worsening the prospects for investment. In 2009 the unemployment rate is forecast to reach 9.3%, climbing to over 10% next year. Investment is projected to fall 9.8% this year and remain basically flat in 2010.

* The fiscal stimulus measures introduced by member states amount to nearly 1% of GDP. However, they will have an impact on domestic demand only in the final months of the year. In the meantime, automatic stabilisers are giving some support to the household sector. The fiscal deficit to GDP ratio is expected to climb to 4.8% this year and to 5.8% in 2010.

Overview

Production plunges in Q1

* Production data for Q1 show that activity is collapsing at a faster rate than many expected: in Germany, industrial production in the first two months of the year was 1 9.3% lower than in the same period of 2008, with a similar figure for Italy.

Interest rates fall...

* On April 2nd, the ECB cut the policy rate to 1 .25%. The 300 basis point reduction since the end of September has been accompanied by an even steeper decline in interbank rates. Nevertheless, given the extreme weakness of domestic demand, the ECB is expected to engage in further measures in the following months, including further rate cuts and possibly non-standard monetary measures such as 'quantitative easing'.

...but credit conditions remain tight...

* Despite the fall in interest rates and the measures to support the banking industry, credit growth to the private sector is decelerating, especially loans to businesses and for home purchase. In February the 3-month annual ised growth rate of loans to nonfinancial corporations dropped to just 1 .8%. Household lending actually contracted 2.5% on a 3month annualised basis, with lending for house purchases especially weak.

* On top of the worsening credit conditions, firms face continuously weakening demand, both internationally and domestically. In the year to January, export values are estimated to have fallen by more than 13%, while the latest figures for export orders show international demand in free fall. We forecast a 10.5% fall in overall export volumes this year.

* The medium term outlook for investment is negatively affected by the rapid build-up of unused capacity: in 2009Q1 capacity utilisation fell to 75%. Investment is projected to fall 9.8% this year and remain basically flat in 2010.

...weighing on domestic demand...

* Slowing activity is leading to a surge in unemployment, which reached 8.5% in February. Employers' hiring expectations are at historic lows in all sectors, indicating that the unemployment rate is likely to keep rising in the next months. In 2009, it is forecast to reach 9.3%, climbing to over 1 0% next year.

* The fallout on consumption is already visible. In January retail sales, excluding cars and construction, fell 3.5% year-on-year. We forecast household consumption to fall in both 2009 and 2010, by 1 .5% and 0.2% respectively.

* In some countries, the sharp falls in car sales recorded in the last months of 2008 have been reversed by government incentive plans: in Germany, March car registrations were up 40% year-on-year. However, this may be a sign of households shifting their expenditure from other goods into cars. Moreover, given the location of car production in Europe, a pick-up in car purchases in Eurozone member states will increase imports as well as consumption, reducing the positive effect on GDP.

* Collapsing demand and the fall in commodity prices pushed Eurozone inflation to an all time low of 0.6% in March. Core inflation remains somewhat higher, standing at 1 .7% in February, but a further decline in inflation is likely, and there is a high likelihood of a period of negative inflation. According to our forecast, inflation for 2009 as a whole is expected to average 0.4%, increasing to 1% next year.

...waiting for the fiscal stimulus.

Almost all the Eurozone member states have in recent months introduced fiscal stimulus measures aimed at propping up domestic demand. The combined size of these amounts roughly to 1% of GDP. However, it is unlikely that the packages will provide a major boost to domestic demand before year-end, and their effect will be blunted if the proper functioning of the credit market is not restored.

* The fiscal stimulus measures and the normal operation of the automatic stabilisers will cause a sizeable deterioration in government fiscal balances. The euro area fiscal deficit is forecast to reach 4,8% of GDP this year and increase to 5,8% in 2010.

* Larger fiscal imbalances are putting pressure on sovereign bond spreads, especially for the countries with larger debts or in need of substantial government involvement to fix the banking system. In March, the spread between the yields of 1 0 year Italian BTPs and German bunds widened to 135 basis points, while the spread between Irish bond yields and German bund yields reached 260 basis points.