European Economic Recession Ahead? 2

On a trade-weighted basis, the exchange rate of the euro against the zone’s major trading partners strengthened since the beginning of 2007 to reach its highest level since 1999 in April 2008. At a time when foreign demand for Eurozone products, particularly from the United States but also from the weakening United Kingdom economy, is sliding, a strong currency is an obvious impediment.

That said, more positive factors should also be considered. One is that Eurozone exporters have benefited significantly from the rising import demand from oil-exporting countries. Export revenues of major oil-exporting countries rose to $1.3 trillion in 2007 from about $412 billion in 2002, on the back of the sustained rise in oil prices.

A study in the July 2008 issue of the European Central Bank’s (ECB) monthly bulletin showed that despite the growing share of Asian exports in these markets, Eurozone exporters have been able to maintain a high and stable market share in recent years, averaging 25% in 2007. This positive outcome must be nuanced, however, as it has been driven mainly by Russia, as Eurozone exports’ market share in other oil-exporting countries (mainly OPEC) declined slightly to 21% in 2007 from 25% in 2002.

But over that same period, the U.S. market share in total imports of oil-exporting countries (Russia included) decreased to 7.5% from 12.0%. In other words, Eurozone exporters were able to maintain or even increase (in Russia) their market share despite the handicap of a strong currency. Between 2002 and 2007 the annual growth in export volumes of goods to OPEC and Russia was on average 7% and 17%, respectively, significantly above the average growth in extra-Eurozone exports of around 5%. Strong demand from those economies will continue to boost Eurozone exports in 2008 and 2009.

The second mitigating factor comes from the outlook for the euro exchange rate itself. Our baseline forecast expects the euro exchange rate to peak against the U.S. dollar in the third quarter of 2008 near 1.60. Then, the rate should slowly decline, as the fundamentals begin to turn in favor of the U.S. currency, with weaker growth prospects in the Eurozone and an increased probability of an interest rate hike in 2009 in the United States. We expect the euro to retreat toward 1.45 in the fourth quarter of 2008 and to 1.40 by mid-2009.

Overall, Eurozone export growth should drop to 4% in 2008 (6% in 2007) and 3% in 2009. German exports are likely to follow a similar trend, rising 4.7% in 2008 (8.0% last year) and 3.0% in 2009. French exports, after an upbeat performance in the first quarter of this year, should experience a very modest rise in the second half of the year, leading to an average increase in 2008 of 3.9% (3.6% in 2007). French export growth in 2009 is likely to ease further to 3.0%.