KfW Business Cycle Compass Eurozone: Political uncertainty delays vigorous upswing

• Economic growth remains on track despite slight downturn in the second quarter
• KfW Research lifts forecast for 2016 to 1.5% (previously 1.3%) and for 2017 to 1.4% (1.1%)
• Economic risk of Brexit is not yet over
• Divergences between euro states are growing again

Euro area economic growth remains on track. The first half-year of 2016 was one of the stronger ones since the financial crisis – despite the already expected downturn in the second quarter. So far, a general reversal of sentiment in the business community after the Brexit vote has not become apparent, even if the risks it has created for the economy are far from over. KfW Research has revised its growth forecasts for the euro area upwards both for this year and for the coming year. It now predicts growth of 1.5% for 2016 (previous forecast 1.3%) and 1.4% for 2017 (1.1%).

“The euro area remains in a trend of cautious recovery”, said Dr Jörg Zeuner, Chief Economist of KfW Group. “However, it is again facing stronger headwinds – not just from the Brexit”. A number of political uncertainties are dampening the economic recovery such as the situation in Turkey, continuing tension in Ukraine, the ongoing delay in the formation of government in Spain and the upcoming referendum in Italy. “The hope that investment gradually replaces consumption as a driver of growth and a strong, self-sustaining upswing takes hold will not be fulfilled for the time being”, said Zeuner.

The generally robust growth in the monetary union again masks widening divergences between states. Among the large economies, Germany and, in particular, Spain have posted very vigorous growth, while France and Italy stagnated. “Convergence, which is important for the euro area, still appeared to be in good shape at the start of the year; growth rates became aligned. That is over for now”, commented Zeuner.

While the disappointing development in France is probably attributable in part to one-off effects of the fierce strikes in May and June, Italy is giving more cause for concern. The stagnation there reflects the current state of the economy. The country is still struggling with the legacy of more than three years of recession. The recovery on the labour market has now weakened, investment remains almost 30% below the pre-crisis level of 2008, and the economy has made hardly any advances in productivity in 20 years. Another legacy of the crisis is a high stock of impaired loans and an ailing banking sector. Zeuner: “Italy is facing many problems. But with the reforms the country is on the right path.”

The current KfW Business Cycle Compass Eurozone is available at www.kfw.de/research (only in german language).