Is Europe Rolling?

Maybe, but without sweeping reform, recovery won't last

Henri de Castries, chairman and CEO of Paris-based insurance and financial-services giant Axa, is widely credited with keeping his group afloat during Europe's worst economic storms in three decades. Over the past two years, he has battened down Axa's hatches by cutting costs -- almost $225 million in the past 12 months -- and jettisoning noncore and underperforming units such as insurance operations in Austria and India. Although its reach is global, Axa still depends on Europe for 55% of its $70 billion in annual revenue. That exposure was evident when de Castries announced first-half results in mid-August: net income down 75%, to just $216 million.

Yet de Castries is turning more hopeful about the future, as are many other captains of industry and finance throughout Europe. Like leaves on the sea announcing landfall, signs are increasing that suggest Europe's long recession may be nearing an end. Sure, unemployment continues to rise, and vast areas are still reeling from an unprecedented August heat wave that killed thousands and devastated agriculture. But in Germany, manufacturing is unexpectedly starting to pick up for the first time in months. In France, new-business creation is suddenly zooming. "That's a good sign," says Jean-Paul Betbeze, chief economist of France's Crédit Lyonnais. "There is a certain amount of optimism now," says de Castries. But he adds an important caveat: "Once more, we'll see structural growth lower than the U.S. and even probably lagging behind Japan."

That's the catch. Europe does look set for a cyclical rebound -- but it is unlikely to be a strong one. To make any kind of meaningful dent in continent-wide unemployment of 8.1%, Europe needs to grow next year by at least 2.5%. That looks almost unattainable, given low recent rates of investment by European companies. In France, for example, business investment has been declining for nine straight quarters. "The economy has bottomed out, and the downward part of the cycle is over. But there is little real momentum," says Michael Heise, chief economist of German banking and insurance giant Allianz Group. He predicts growth next year in Germany, which accounts for one-third of Europe's total economy, at just 2%.

If there are surprises in store, a growing number of observers think they may well be on the upside this time rather than the down. "The stage is set for the European economy to grow now, and we believe people are being too gloomy," says Nicolas Sobczak, senior European economist at Goldman Sachs Group Inc.

If he's right, it would be the opposite of the false dawns Europe witnessed over the past couple of years. In mid-2002, for example, Germany's top economic-research institutes started signaling sharp rises in business sentiment, indicating a turnaround was imminent. Yet Germany's economy slid back into recession soon after. "[Our] poll is not always correct," admits Volker Kleff, an economist at Mannheim's Center for European Economic Research. "But we hope it will be right this year."

Part of the new optimism is due to corporate housecleaning. Net corporate debt levels in the European Union are now less than in the early 1990s, and interest rates are at record postwar lows, making the debt much easier to service. Profit margins in France, Germany, and elsewhere are starting to creep up as a result. In recent weeks, companies as diverse as electronics giant Royal Philips Electronics (PHG ) and Germany's BASF have reported better-than-expected results despite the terrible economic environment. "This is a real difference [compared] with previous down cycles," says Axa's de Castries. "It means companies may come back faster than before, since balance sheets are stronger."

The most important change is political. In what is looking increasingly like a significant break with the postwar tax-and-spend welfare state, some traditionally hesitant politicians are starting to enact pro-growth policies. Although France's 15-month-old center-right government has been backtracking on some promises to reduce the size of the civil service, public-sector payrolls are being shaved back for the first time in five decades. And Prime Minister Jean-Pierre Raffarin recently announced a raft of personal and corporate tax cuts. Silvio Berlusconi, the head of Italy's center-right government, declared in late August that sweeping pension reforms are in the works.

Germany, Europe's growth laggard, could now yield the greatest surprise of all. Against a grim backdrop of two straight quarters of recession and rising unemployment, German Chancellor Gerhard Schröder -- fresh on the heels of bringing forward billions in tax cuts from 2005 to next year -- looks set to carry through much of an economic-reform program he unveiled in March. For the first time, Schröder seems to have overcome critics within his Social Democratic Party. The opposition Christian Democratic Union, meanwhile, looks too fractured to stop the reform process. Still, the opposition's control of Germany's upper house of parliament, where reforms need to be approved, means that some parts of the program could be rejected.

Schröder may be counting on what is beginning to look like a broad change in attitudes about reform. Over the past few months, the German media has been flooded with stories highlighting the perceived failures of Germany's welfare state. "This was unthinkable even a year ago," says John C. Kornblum, former U.S. ambassador to Germany and now head of Lazard & Co.'s German merchant banking operations. "There is an important cultural shift under way."

That may be because the pain has now worked its way through the very heart of Germany Inc. Take Germany's mighty automobile industry, the country's biggest employer and a traditional bellwether for the rest of the economy. It is now suffering on the back of European car sales, which are declining about 2.6% this year. Although registrations of new cars began rising in June and July, Japanese and Korean manufacturers are the ones benefiting. At the same time, brutal competition in a stagnant market has triggered an alarming squeeze on margins at thousands of suppliers. Their profitability in 2002 declined by as much as 30%, calculates Bernd Kreutzer, partner at the Frankfurt office of A.T. Kearney. "Their financial situation is dramatic," he says.

Tax cuts and continued low interest rates certainly can help energize a sluggish continental economy. But without sustained structural reforms, Europe's overall recovery could prove to be limited and short-lived, economists warn. Over the past few years, Europeans could take heart that, while they may not be as fast-growing as the U.S., they were at least a far cry from recession- and deflation-racked Japan. Will the knowledge that Europe is falling behind Japan -- as may well happen next year -- be enough to spur action?

By John Rossant in Paris, with David Fairlamb in Frankfurt and bureau reports

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