July 2007

A view on Europe and Japan along with China and India

Originally published in the July 2007 issue

The euro area continues to show a favourable development. Economic growth is around 2.75% and the latest inflation figures are just below 2% (1.9%). This is a pace of growth well above the trend of between 2% and 2.5%. Unemployment now stands at 7%, the lowest level since 1993. This is the first year for which harmonised unemployment figures for the euro area are available.

Leading indicators are at high levels. This is true both for indicators related to consumers and those for producers. My impression, however, is that broadly speaking we do no longer see an acceleration in many of the indicators. Some of them, like the German Ifo-index for producer sentiment, have slightly fallen. This leads me to expect that the euro area business cycle is close to its peak or has just passed it.

The ECB kept its policy rate at 4% at its meeting at the beginning of July. The outlook is that growth will somewhat moderate from above trend this year to around trend in 2008. Inflation is projected to be slightly above 2% both this and next year.

Although past interest rate increases are starting to impact narrow money growth, the tightening process has not yet reduced broad money growth (M 3), which continues to grow at double digit figures, and overall credit growth. Liquidity remains very ample. Under these circumstances, the ECB will probably hike again in the third quarter of this year, bringing the policy rate at 4.25%.

Different from many other market observers, I do not a priori expect further ECB interest rate increases beyond 4.25%. Should the signals that euro area growth has peaked become stronger, the ECB may well go on hold at an interest rate of 4.25%. I would consider this rate to be slightly restrictive, but it has to be kept in mind that at the same time liquidity is very ample and lending conditions appear to be rather lax. The next move may then as likely be up or down.

Long term rates (ten years government bonds) have the past month moved within a range between 4.5% and 4.75%. Like in the United States this appears to be a reasonable level given the economic outlook. A flatter yield curve in the euro area seems to be possible with a further ECB interest rate hike in store.

The risks to the outlook for growth seem rather balanced. One of the downside risks that is often mentioned is protectionism. This risk has increased now that president Sarkozy of France has made clear that he is rather in favour of protecting France industry than of promoting an environment conducive to competition. Although the risks to price stability are still predominantly upward, they will become more balanced after interest rates have reached 4.25% and if growth slows down to potential or somewhat below it.

European stock markets have done well over the past month, those in Germany in particular. Like in the US this was to an important extent driven by the ongoing merger and acquisition boom.

The process of mergers and acquisitions has been fuelled by strong profit growth over the past years, low interest rates, resulting strong cash flows and balance sheets and financial innovations in combination with very ample liquidity. Some of these factors are no long working (low interest rates and very strong profit growth) or are getting weaker. The most profitable deals have been done in the meantime.

Risk appetite of investors seems to be coming off its heights and may decline further, with some probability of falling abruptly at some point. Since interest rates are not really high and a lot of money has flown and continues to flow to private equity for the time being, an immediate turnaround in the wave of merger and acquisitions may not be imminent.

On the other hand, the peak may be reached in the next quarters given the disappearance and weakening of important driving forces. This would also imply that an important supporting factor of stock prices would no longer be present. Therefore, we have probably had the best part of the rally in euro area equities.

The past month the euro has appreciated against the dollar and the yen. The euro depreciated a little against the British pound. The further tightening of monetary policy in the UK may be the main causal factor. The Bank of England has raised its policy rate to 5.75%. A number of other European countries, both in 'old' and 'emerging' Europe have also hiked interest rates in the period under review.


The Japanese recovery remains on track. Economic growth in the first quarter has been revised up from 2.4% to 3.3% annualised. Consumption has now grown for five consecutive months. The Tankan survey shows a positive outlook on the part of businesses. The economy will probably continue to grow at a rate of around 2.5%.

At the same time consumer prices are slightly falling again. Deflation proves to be stickier than previously expected. However, this should not be taken too seriously. Prices are now falling in a climate of healthy growth and sound balance sheets of banks and non-financial firms. This is very different from the past when banks and firms were struggling with the fall out of the bursting of the bubble of the end of the 1980s.

The Bank of Japan (BoJ) has kept its interest rate at the very low level of 0.5%. The BoJ remains rather hesitant to tighten further. To my mind she has her policy determined too much by short term economic considerations. Instead it would be wiser to set her policy in the context of a longer term process of interest rate normalisation.

In such a context the BoJ would almost automatically hike interest rates every quarter, undisturbed by short term economic developments unless they were really unfavourable. Only when a more normal interest rate of around 3% has been reached, this normalisation process can be seen as having come to an end. Although the BoJ is more cautious than warranted, one or two interest rate hikes before the end of the year seem to be likely.

Japanese long term interest rates (ten years government bonds) have increased to a level of around 1.9% at the end of the period under review. The Japanese yield curve is relatively steep. Increases in the policy rate will probably be more or less followed almost one for one by long term rates.

An important by product of the very loose monetary policy of the BoJ is the continuation of yen carry trades. They put ongoing downward pressure on the exchange rate of the yen, which appears to have become significantly undervalued.

A sudden reversal cannot be ruled out and the risk of such a reversal increases the longer the undervaluation lasts and the larger it gets. This is not only a risk for the Japanese economy, but is also a financial stability risk from an international perspective.

For unclear reasons the Japanese stock market has been underperforming of late. A rebound relative to the US and the euro area may well be on the cards. For euro area based investors Japan could even become more attractive should the yen exchange rate start the correction of its undervaluation.

China and India

The story of the emerging economies has not changed since last month. They are growing very rapidly. China and India both run the risk of getting overheated and address this risk by gradually tightening their monetary policies.

Lex Hoogduin is Chief Economist at Robeco