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Web Posted on : Mon, 15 May 2017

 

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The victory of Emmanuel Macron in the French elections last week allowed Euro Area policymakers and investors to breathe a collective sigh of relief. Macron’s triumph over eurosceptic candidate Marie Le Pen was a welcomed reassurance for Europe’s monetary union, which in the wake of last year’s Brexit vote and rising populist discontent, entered 2017 facing existential questions. Now, with French and Dutch elections out of the way and the status quo in upcoming German elections widely expected to prevail, heightened political risks have faded. This paves the way for growth to continue strengthening as it has since the second half of 2016 on the back of accommodative monetary policy, stronger net exports and a gradual easing of fiscal policy. While some political and economic risks remain, these factors should continue to drive Euro Area growth in 2017.

 

The first, and most important, factor underpinning growth is the ultra-loose monetary policy provided by the European Central Bank (ECB). Negative interest rates introduced by the ECB in April 2016 have begun to feed through into the Euro Area economy, pushing borrowing costs to all-time lows in the first quarter of 2017. In turn, this has resulted in lending to consumers and non-financial firms to grow at post-financial crisis highs. Consequently, strong consumption growth and declining unemployment have been sustained while investment intentions and orders have dramatically increased. The Euro Area Purchasing Manager’s Index (PMI), a survey based index of output and one of the best high frequency indicators of Euro Area growth, has been rapidly accelerating since the second half of 2016 and reached record highs. With monetary policy continuity widely anticipated in 2017, we expect the pass through of low interest rates to continue aiding consumption and investment over the course of the year.

 

 

Chart 1
 

The second factor supporting growth will be stronger net exports. Monetary policy divergence between the ECB and the US Federal Reserve has caused the EUR/USD to depreciate by 3.4% in Q1 2017 compared to a year earlier. This divergence appears highly likely to continue for the rest of the year, keeping the euro around its multi-decade lows and thereby increasing the competitiveness of exports and deterring imports. Additionally, the global economy is expected to accelerate in 2017, providing a further boost to export demand for the region. Although global trade is not expected to be a key driver of the global recovery, Euro Area exports have bucked this trend in the recent past. In 2016, when global trade slowed to its slowest pace since the financial crisis, export growth actually picked up in each quarter of the year.

 

The third and final factor expected to drive growth in 2017 is a more active fiscal policy. 2016 was the first time in seven years that the monetary union’s structural fiscal balance widened – an indicator of fiscal easing. Although the change was small, it reflected a gradual willingness to open up to higher spending after years of austerity and the building of fiscal space. Conditions witnessed so far in 2017 suggest this will continue. Election years are associated with higher spending as governments often utilise budget resources to influence voters. Adding to that is the victory of Macron, who has called for a more active fiscal policy for Europe as a whole, and other regional governments’ desire to quell rising populist sentiment by spending more. These developments are likely to push fiscal policy to be even more expansionary in 2017.

 

However, the Euro Area is not entirely out of the woods yet. On the political side, the UK will face snap elections in June and the Brexit negotiations loom. Expectations are for the status quo to prevail in the election and that Brexit discussions will be protracted over the next few years, but recent history reminds us that anything can happen. On the economics side, how long the ECB can and should maintain easy monetary policy has increasingly come into question. Negative interest rates have helped lift growth but have squeezed banks’ profits. A prospective policy change is more of a question for 2018 than 2017, but is a key risk on the horizon nonetheless. For now, the victory of Macron is good news for the region and will only add to the positive growth momentum in the year.