Can Emerging Markets Save Europe?

The head of the European Central Bank thinks exports to emerging markets will help the EU offset a U.S. slowdown. Some economists aren't so sure

It was the kind of subtle shift in wording that professional European Central Bank watchers live for. Back in September after the bank's monthly meeting, President Jean-Claude Trichet predicted that global growth would remain robust because a slowdown in the U.S. would be "largely offset" by growth in emerging markets. But following the ECB's Nov. 8 meeting, Trichet modified his statement slightly. A slowdown in the U.S., he now says, will be "partly offset" by emerging-markets growth.

Is Trichet wavering in his conviction that the European economy can continue to power along even if U.S. growth falters? Jacques Cailloux, chief euro area economist for Royal Bank of Scotland (RBS.L), thinks he should be. Cailloux's somewhat contrarian view is that Europeans are fooling themselves if they think their economy has decoupled from that of the U.S. "We think the ECB is going to be surprised on the downside," Cailloux said in an interview in Frankfurt, Germany.

While it's true that Asian demand for European products is growing fast, the region's absolute share of European exports is still relatively small, Cailloux says. China still accounts for just 3% of German exports, compared with the 7.6% share bound for the U.S. To compensate for the slowdown in exports to the U.S. that has already occurred this year, he calculates, German exports to China would have to grow by 75% annually. So far this year, they've risen just 14.2%.

U.S. Decline's Wider Impact

The RBS analysis comes amid growing pessimism about the overall European economy, which has been exceeding expectations for the past two years. On Nov. 12, Zurich (Switzerland)-based UBS (UBS) revised downward its forecast for the countries that use the euro common currency, to 1.6% growth in 2008, vs. a previous forecast of 2%. "We have turned from bulls to bears," UBS analysts said in a note to investors.

UBS economists interpret the data differently than RBS's Cailloux, but come to a similar conclusion. Demand for European goods from China, Russia, Latin America, and Asia (not including Japan) theoretically could compensate for a U.S. slowdown, UBS notes. Those markets now account for 26% of European exports, vs. 13% to the U.S. The problem is that a decline in U.S. consumption would hurt China and other countries that sell goods to America, which would then feed back into the European economy. Chinese factories would buy fewer machines from German capital-goods suppliers, for instance, and the European economy would slow. Cailloux agrees with the UBS analysis: "Those indirect linkages are quite powerful," he says.

Professional economists are definitely rethinking their forecasts. On Nov. 20, the Munich (Germany)-based Ifo Institute for Economic Research released its quarterly survey of economic experts, which showed a clear decline in assessment of the global economic climate. The global index fell to 99.3 from 113.6 in the third quarter, though the barometer of sentiment was still above its historical average of 95.3. For Europe, the survey showed sentiment plunging to 93 from 110.9, compared to a long-term average of 91.

Waiting for a Consumer Spending Spree

The one thing that could save European growth would be consumers. Demand from Central Europeans, who are enjoying big gains in wages, has helped boost the whole European Union. Fewer jobless people also should bring an increase in consumer spending throughout the EU. Unemployment in the euro zone will be about 7% this year, down from 8.8% in 2004, and will fall further to 6.3% in 2009, UBS estimates.

Despite all the focus on Asia and the U.S., the most important market for European products is still Europe. Germany, for example, sells 65% of its goods within the EU. So if consumers boost spending, the European economy won't be hit as hard by slower growth elsewhere.

Unfortunately, economists have been predicting for years that Germany's famously cautious consumers, who account for a third of private consumption in the euro zone, would go on a spending spree now that unemployment is plummeting. A real boom has never materialized. Even if the prediction finally proves true, the effect will be to cushion the impact of a U.S. slowdown, not eliminate it altogether. Conclude UBS analysts: "Euro zone GDP [gross domestic product] growth will not be immune to a sharp correction or even recession in the U.S."

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