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Stagflation in Europe a bigger worry than China’s economic slowdown

On Tuesday, the Organisation for Economic Cooperation and Development (OECD) published its latest outlook for the global economy. Describing the prospects for growth as “weak”, with risks “tilted to the downside”, the OECD singled out two worrying trends.

The first was the much weaker-than-expected recovery in China. A sharper downturn would have significant spillover effects for the rest of the world, especially if it were accompanied by much tighter financial conditions stemming from an abrupt repricing of risk.

The second major source of concern was increasing evidence that the dramatic increase in interest rates since the middle of last year was taking its toll on global growth and trade.

Yet, despite these headwinds, the OECD urged leading central banks to keep policy restrictive until there were clear signs that “underlying inflationary pressures were durably lowered”. Tellingly, it warned there was limited scope for rate cuts “until well into 2024 for most advanced economies”.

The fact that the OECD is worried about contagion from China shows the extent to which the distress and loss of confidence in the country’s property sector pose a risk to global growth. However, the title of its report – “Confronting inflation and low growth”– makes it clear that stagflation is the biggest threat.
People sit beside a clothing shop in Beijing on September 7. China’s economic downturn and general uncertainty about the future have led to more savvy spending. Photo: EPA-EFE

Europe, on the other hand, not only has a growth problem but also an inflation one. The plunge in manufacturing output in Germany, Europe’s largest economy, makes the decline in China look mild by comparison. A German purchasing managers’ index for the sector stood at a calamitous 39.1 last month. This contributed to the fastest rate of contraction in the euro zone since November 2020, survey data compiled by S&P Global shows.

As if that were not bad enough, core inflation – which strips out volatile food and energy prices – in the bloc has remained above 5 per cent for the past year, higher than in the United States and much higher than the 2 per cent target of the European Central Bank (ECB).

While China – which is trying to escape deflation – is easing its monetary policy, the ECB had little choice but to raise interest rates earlier this month for a 10th straight time even though the euro zone will struggle to grow this year. According to the OECD, Germany’s economy will contract – the only major economy that will shrink in 2023.

The Economist recently warned that Germany was at risk of becoming “the sick man of Europe”. This is debatable. What is clear is that Germany has been hit by a triple whammy of an energy price shock, a botched transition to net zero carbon emissions and, crucially, the downturn in China’s economy.

Indeed, not only are Germany’s exports to China as a share of economic output the highest in Europe, its big carmakers are threatened by China’s increasingly competitive and fast-growing electric vehicle industry. A report published by UBS on August 31 predicted China’s share of the European car market could reach 20 per cent by 2030, with all the cars sold being electric.
An Xpeng P7 electric vehicle is displayed at the Munich Motor Show in Germany, on September 5. Germany’s big carmakers are threatened by China’s increasingly competitive and fast-growing EV industry. Photo: Bloomberg

Yet, at least Germany has enjoyed decent growth since the 2008 financial crash. The euro zone’s other big economies have fared worse, in particular Italy, whose output per capita – a better measure of living standards – has fallen. It is these economic divergences, which almost tore the euro zone apart in 2011-12, that are coming back to haunt the bloc.

Only one country uses the renminbi. In Europe, 20 use the euro. Conducting policy in the euro zone is like herding cats, especially at a time when borrowing costs are rising sharply in the face of a steep downturn.

Not only have interest rates reached their highest level since the euro’s launch in 1999, the ECB “has delivered as much tightening in the space of 15 months as [Germany’s central bank] did from the start of our data in 1948”, noted Deutsche Bank in a report published on September 15.

This has fuelled concerns about a major policy mistake. Not surprisingly, Italy – whose massive public debt burden makes it particularly vulnerable to rising rates – has accused the ECB of exacerbating Europe’s downturn. Its prime minister, Giorgia Meloni, said the anti-inflation cure “will prove more harmful than the disease”.

Italian Prime Minister Giorgia Meloni speaks at a summit in Budapest, Hungary, on September 14. Meloni has criticised the ECB’s “simplistic recipe of raising interest rates”. Photo: Reuters

She may well be proven right. But with underlying inflation still too high – and oil prices up nearly 30 per cent since late June – the ECB cannot afford to cut rates and may even be forced to raise them further.

While there are doubts about whether the Federal Reserve can pull off a soft landing for the US economy, Europe is already suffering a hard landing. High inflation and weak growth are the nightmare scenario for policymakers.

Although the euro zone has so far been spared a financial crisis, it is knee-deep in an economic one. China faces a similar predicament. But stagflation is the worst of both worlds. Europe, not China, is the biggest cause for concern right now.

Nicholas Spiro is a partner at Lauressa Advisory

Article was originally published from here

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