Can southern Europe drive future Eurozone growth?

Growth in southern Europe has made headlines this spring, with countries in the Eurozone periphery bouncing back from the recent growth slump at a faster pace than their northern, far larger neighbours. Spain and Italy, and to a lesser extent, Portugal and Greece, have benefitted from a rebound in tourism and higher wages that has fuelled a rise in consumer spending. At the same time, these economies have been less affected by the global downturn in manufacturing and the surging price of gas after Russia invaded Ukraine.

While it is true that growth rates in the periphery have rebounded, Wolfgang von Hessling, Chief Economist Europe at LGT Private Bank, explains that focusing on this statistic ignores the many nuances in today's European economic situation. To understand the significance of what's going on, he says it's important to examine the main drivers of the different European economies.

Consumption drivers

"Roughly speaking, 60 per cent of GDP in Italy and Spain is driven by consumption," he explains. This is in sharp contrast to France and Germany, where under 50 per cent of the country's GDP is consumption-driven. "Wage gains drive consumption gains, and wages have been rising recently," continues von Hessling. Consumption is also a local and internal driver that is far less dependent on outside economic forces.

"France and Germany have a much higher dependence on exports, which is in effect an external driver that has developed very poorly in the aftermath of the pandemic," he says. Supply chain reshoring, a slowdown in Chinese growth, and a weak global goods cycle have all contributed to the poor performance of German manufacturing exports.

As an example of the difference this makes to the German economy, von Hessling points to the sum of all exports, valued in euros since 2021, as a percentage of GDP. For Germany, it's 51 per cent, versus 36 per cent in Italy, and 41 per cent in Spain. 

Recession in global manufacturing

"What is important to understand in this picture is that the global manufacturing sector has been in recession since mid-2022," von Hessling explains. Although many economies, including those in Europe, have stayed out of technical recession overall, the weakness in manufacturing is naturally more apparent in those economies where manufacturing makes up a larger percentage of the overall picture. "Yes, many developed countries have sidestepped recession, but only because services make up a considerably larger percentage of GDP," he concludes. 

In Germany, the slowdown in manufacturing and exports has been compounded by the gas shock and inflation, both of which jeopardise investment plans. "Indeed, at the moment, the southern European countries contribute strongly, helping Eurozone real GDP growth to step away from the edge of recession into weak, but clearly positive territory," contends von Hessling. "However, it is important to acknowledge that this stepping up in southern growth rates is happening from a rather low base and after many years of underperformance."

Both Italy and Spain have lagged French and German growth rates for years. Italy has only recently reached the GDP level it was at just before the Great Financial Crisis of 2007 to 2008, and Spain has added just 10 per cent. Meanwhile both Germany's and France's GDP figures are about 15 per cent higher than back then. "However, Italy and Spain are now posting stronger GDP growth numbers because of the nature of their economies: strong domestic consumption based on strong labour markets," explains von Hessling. Still, it would be premature to turn outright bullish on European growth on these grounds. Neither Italy nor Spain is a huge force in the overall European economy, and they are affected by relatively higher debt-to-GDP levels as well as structural challenges.

Differences in size and structure

Italy has a significant debt burden, which it has carried for years. But current conditions suggest that the country can lower its debt-to-GDP ratio through increased growth, and potentially raise its average growth rate moving forward. Spain has a larger share of European GDP, a lower debt burden, and earns more from tourism. Higher wages and consumption in both countries should contribute meaningfully to European GDP growth over time, argues von Hessling.

Given the difference in size between the central and peripheral European economies, the pickup in growth in Italy and Spain, while welcome, is probably less important overall than what happens in France and Germany. So what does the future hold?  

Unfortunately, while theoretically cuts in European interest rates by the European Central Bank should be positive for all of the region's economies, major differences between the economies will likely mean different results. For example, the biggest impact from interest rate cuts should be on manufacturing, in that lower rates should drive capital spending, and thus theoretically drive growth. In Italy and Spain, however, growth is likely to normalise rather than accelerate, as services form a greater proportion of GDP and wage growth is likely to flatten. 

Zero growth

In Germany, growth in the manufacturing sector is driven by exports and global demand, which unfortunately won't be turbocharged by lower European interest rates. Rather, an uptick in German exports will only occur when economic weakness in China fades and demand from the US increases, which probably won't happen until Federal Reserve Bank rates are cut substantially.

So while the service sector has kept Europe's largest economies out of recession, according to von Hessling the recent rapid growth in peripheral economies hasn't been, and won't be, enough to counteract the most likely economic scenario: zero to merely marginally positive growth in Europe. Germany and France account for so much of the Eurozone economy that it is really their performance that will make or break the European economic future.