Germany and Italy are flirting with recession while eurozone business growth has slumped to a four-year low, leaving the region nakedly exposed to the possible shock of a no-deal Brexit.
The closely watched IHS Markit index of German manufacturing fell to 50.2 in November, close to the ‘boom-bust line’ that divides growth from contraction. It is the weakest level since the tail-end of eurozone banking crisis in 2013. Foreign export orders fell to a six-year low.
Germany’s data office Destastis confirmed on Friday that the country’s economy contracted by 0.2pc in the third quarter. It blamed crumbling global demand and disruption in the car industry from new vehicle test standards called WLTP.
Italy’s economy has also stalled. Peter Praet, the European Central Bank’s chief economist, warned that the country is uncomfortably close to a fresh crisis as the budget showdown between Brussels and the insurgent Lega-Five Star coalition in Rome continues to escalate.
Risk spreads on 10-year Italian bonds have been stuck above 300 basis points for nearly two months, gradually tightening the noose on the economy. Italian banks are mostly unable to roll over their bonds, forcing them to curb lending. Mortgage rates are being reset upwards. “No country can sustain such high spreads for a long time,” he said.
Mr Praet told the Handelsblatt that there would be no ECB reprieve for Italian lenders at the next meeting in December, a warning that may cause alarm in banking circles. “It is too early to decide on a new TLTRO,” he said, referring to a renewal of the ECB’s €800bn (£708bn) lending window for banks.
Hopes that the economic slowdown in the third quarter would prove nothing worse than a 'soft patch' have been dashed as a blizzard of ominous figures point to further trouble in the fourth quarter. The eurozone’s open trading economy and heavy reliance on export demand makes it more leveraged to the ups and downs of the world cycle than the US economy.
It is becoming clear that the credit crunch in emerging markets - caused by vanishing dollar liquidity - is doing more damage to Europe than anticipated. So is the economic slowdown in China, where monetary and fiscal policy stimulus has so far failed to gain much traction.
Phil Smith from IHS Markit said Germany had seen a “sustained loss in underlying growth momentum”. The manufacturing sector has been hit by “falling sales in China, Italy, and Turkey”. The composite PMI survey for manufacturing and services across the eurozone dropped to a four-year low.
The abrupt downturn in Germany and Italy has echoes of mid-2008. We now know that the two economies went into recession in the second quarter of that year, leading the rest of the eurozone into crisis.
The ECB was oblivious to this at the time, distracted by the short-term ‘noise’ of oil prices. It famously raised interest rates into the storm in July 2008. This was a crucial ingredient in the strange mix of events that led to the near-collapse of the western financial system two months later.
The central bank is under more sophisticated management today but it is nevertheless taking a risk by proceeding with pre-set plans to wind down quantitative easing and halt bond purchases at the end of this year - not least because it has been the lonely buyer of Italy’s net debt issuance for almost three years.
The reduction in QE has mechanical effects on the growth rate of broad M3 money, and therefore constrains bank lending. M3 was growing at around 5pc a year during the peak QE period when the ECB was buying €80bn of bonds a month. It has been slowing ever since. The rate dropped to 2.1pc in September on a three-month annualized basis.
“On announced policies M3 will stop growing completely in 2019. Frankly, they are setting themselves up for a catastrophe unless there is a change of course,” said Professor Tim Congdon from the Institute of International Monetary Research.
“The eurozone is in state of monetary civil war. There is a game of chicken going on between Italy and the protestant ethic countries of the North, and Germany in particular. This is very dangerous for the whole world economy,” he said.
Italy's Minister of Labor and Industry Luigi Di Maio gestures next to Interior Minister Matteo Salvini
Italy's populist leaders are on a collision course with the EU. Italy's Minister of Labor and Industry Luigi Di Maio (left) gestures next to Interior
Fabio Balboni from HSBC said the ECB’s forecast for a growth rebound late this year and into 2019 “look increasingly at odds with reality” and may have to be torn up. The European Commission’s prediction for 2.1pc growth in 2018 issued just two weeks ago already looks impossible.
The clear risk for the eurozone is that a no-deal Brexit would push the region’s fragile economy over the edge, setting off an unstable chain reaction. This would be hard to counter, if allowed to happen. The ECB’s policy rate is already minus 0.4pc. The apparatus of fiscal rules makes it almost impossible to respond quickly with radical budget stimulus.
The outcome would be worse if the EU chose to act on any of the threats circulated during the Brexit talks of shutting air links and transport ties, and severing the cross-Channel supply chains of European multinationals, let alone imposing a de facto blockade on their biggest export market, as some have suggested. The shock to the German car industry would be systemic. It is already reeling from multiple blows.
The EU side would have to introduce emergency “continuity measures” in the current global circumstances as a matter of vital self-interest. If it did not do so - by misjudgment, or to make an example of Britain - the eurozone would risk crashing into a deep recession. This would open a political Pandora’s Box within monetary union.
There is no sign yet that EU leaders are fully alert to this risk, just as they were slow to recognize the danger in September and October 2008, when most of them thought the banking crisis was a contained Anglo-Saxon affair with no implications for them.
The shocking PMI data is a wake-up call. The eurozone is weak, brittle, and once again on the cusp of trouble. Pressuring Britain into accepting the indefinite writ of the European Court in Brexit talks is a high-risk strategy. What if Parliament says no?