The euro area continues to recover, supported by advances towards banking union

The economic outlook is still in line with a gradual recovery over the coming quarters. After six consecutive quarters of contraction, GDP growth returned to positive figures in 2013 Q2 with a 0.3% change quarter-on-quarter thanks to the revival in domestic demand as well as the rise in net exports. Nevertheless, leading activity indicators point to a moderation in this recovery for the second half of the year, although the underlying trend in the medium term suggests it will continue to advance. This slight slowdown will be largely due to domestic demand since, in spite of good results in Q2, a more gradual recovery is expected because of the pressure on domestic consumption produced by high unemployment rates and cuts in public spending in some countries. The main star of the recovery will therefore continue to be exports although the supporting actor, domestic demand, is also beginning to stand out on the stage.

Leading supply indicators underline the fact that the recovery is underway. These point to a small correction in the rate of GDP growth with a view to Q3 as the results from the previous quarter were better than expected owing to temporary factors, although the underlying trend is positive. On the one hand, the composite PMI for the euro area, one of the best leading indicators for activity, fell slightly in October, thereby halting the upward trend started in March, caused largely by a drop in the services PMI. Nonetheless, both the services and manufacturing PMI remain in expansionary terrain (above 50 points), suggesting that positive growth figures will continue. On the other hand, August's industrial production for the euro area picked up by 1.0% monthly. However, the year-on-year rate of change is still negative, posting levels that are very similar to Q2. This inability to present any clear change in trend underlines just how fragile the current recovery process is. By country, industrial production in Germany once again provided a pleasant surprise with a 1.4% change quarter-on-quarter, although Italy disappointed with a 0.3% drop, adding to doubts regarding the country's recovery.

Different speeds of recovery can be seen in the euro area depending on the country in question. At one end of the scale are the core countries, Germany and France, growing steadily thanks to improved domestic demand. In 2013 Q3, year-on-year growth of 0.6% and 0.3% is expected for these two countries, respectively. At the other end of the scale, most of the periphery economies still have negative year-on-year growth, although this figure is shrinking. Exports partly offset the fall in domestic consumption. The United Kingdom has now enjoyed three consecutive quarters of positive growth rates and once again provided a positive surprise in 2013 Q3 by growing 0.8% quarter-on-quarter (in 2013 Q2 it had already posted growth of 0.7%), thereby consolidating its recovery.

Domestic demand remains weak in the euro area, albeit with signs of improvement. Q2 was the turning point for domestic demand, which started to post positive growth rates for the first time since the beginning of 2011. Regarding household consumption, this has underlined the upward path started at the beginning of the year, as shown by the indicator for consumer confidence, whose improvement in Q3 has been almost double that in Q2 (4.9 points compared with 2.8). Although consumers may be gradually gaining in confidence, it is still difficult for this to push up consumption, as we can see when we analyse the retail sales figures, whose year-on-year change was –0.3% in August, compared with –0.6% in the previous month. Retail sales are therefore continuing to reduce their rate of decline but quite slowly.

The unemployment rate has hit the ceiling. It has remained stable at 12.2% for the last two months and, if the exit of the recession is confirmed, could start to fall gradually towards the end of the year and the beginning of the next. This is suggested by the employment expectations index which improved in September for the sixth consecutive month and is now coming close to the levels at which, historically, jobs have started to be created (see the Focus «Job creation will come at differing speeds»). Given that the labour market still has high unemployment rates, there is no pressure on wages, with inflation remaining at moderate levels as a result of the economic situation and also the fact that oil prices are still at their annual minimum (see the Focus «Risk of deflation in the euro area?»).

The foreign sector is the main support for the recovery. The current account surplus is improving. In 2013 Q2 this stood at 1.2% of GDP, 1.1 percentage points above the figure for 2012 Q2. Although, to a large extent, this improvement in the current account results from the drop in goods imported (–5.2% year-on-year in 2013 Q2), exports have kept up notable growth rates in the last few quarters: between 2010 Q1 and 2013 Q2 they have grown by an average of 6.1% year-on-year. This has helped to soften the impact of the crisis on economic activity. Moreover, this trend is likely to continue in the coming months. The index of export expectations, for example, is still improving and has now reached the same level as the end of 2011.

The threats to the support represented by the foreign sector for the recovery seem to be under control. One of the factors that, in the last few months, has gained momentum and, should it continue, could slow up growth in exports is the euro's appreciation. The single currency has not only appreciated considerably against the dollar (around 7% in the last twelve months) but also notably against the rest of the euro area's trading partners. A good example of this is the real effective exchange rate which has appreciated by 5.2% since October 2012. The second factor to take into account is the slowdown in the growth of emerging countries. In the last ten months, for example, the GDP growth forecast by the consensus of analysts for 2014 for the main Asian countries has been lowered by 0.20 p.p. and that of the main Latin American countries by 0.80 p.p. In any case, the growth forecast is still high, 4.7% and 3.1%, respectively, and this downward correction is not likely to continue for much longer. These revisions have particularly been due to capital outflows, caused by fears of the withdrawal of monetary stimuli in the USA, the famous tapering. Fears that have now dissipated as the uncertainty surrounding US fiscal policy means that monetary policy must remain accommodative to make sure the recovery in activity does not derail.

Financial markets are still fragmented. Considerable progress has been made over the last few months in sovereign debt markets with significant reductions in the risk premia of periphery countries. But there is still fragmentation in terms of household and corporate financing with great differences between countries; for example, the spread between core and periphery countries in terms of the average interest rate for company loans is close to 2.6 p.p. in 2013 compared with 0.8 p.p. in 2007. This situation is incompatible with the normal functioning of monetary union and the efficient transmission of monetary policy, which is still completely accommodative, keeping the official interest rate at 0.5% and with the possibility of more measures being taken to inject liquidity should the ECB see upward pressure on monetary rates.

Within the framework of the single supervisory mechanism, the ECB publicly announced its roadmap to assess Europe's banks. This will affect 130 financial institutions in eighteen member states and will start in November 2013 with its planned end date for October 2014, when the results per country and bank will be published. This process will consist of three exercises: a risk assessment, an asset quality review (with a capital requirement of 8.0% CT1) and a stress test (the capital thresholds for which still need to be specified). Once this evaluation has ended, and before the single supervisory mechanism enters fully into operation, European banks will have to apply any corrective measures arising from the assessment, which might include recapitalisation and the disposal of assets. Questions arise from the other pillars supporting banking union, namely the single resolution mechanism and where funds will come from should more capital be required. These issues must be tackled at the next Council of Economic and Finance and Ministers of the European Union (ECOFIN), planned for 15 November.