The pandemic hit Southern countries harder, but the recovery has been strong across eurozone economies
Eurozone countries were impacted differently during the pandemic crisis, with GDP losses in the second quarter of 2020 ranging from 7% in Finland to staggering 22% in Spain, compared to the levels seen in the last quarter of 2019 (Figure 1). Clearly, an economy's structure played a major role. The Southern countries, heavily reliant on tourism, took a big hit, while their Northern, industry-focused neighbours saw smaller GDP losses.
But even within the two groups of countries, different dynamics in activity were observed. Among the Southern economies, Greece has returned to pre-pandemic levels while Spain is experiencing a sluggish recovery and continues to lag well behind (GDP in Q2 2021 remained 8.0% below its precrisis level). Meanwhile, France saw its GDP drop 18% in the spring last year (a decline comparable to Italy’s), with private consumption and exports components performing similarly.
But while speed may vary by country, the economic recovery of the bloc is proceeding apace. Thus, we see activity across the eurozone returning to pre-pandemic levels by early or mid-2022.
Figure 1: Our baseline sees every eurozone economy with the exception of Spain returning to pre-pandemic levels by early 2022
The difference in policy response, compared to the previous crisis, has helped to drive the recovery
Given the symmetrical nature of the shock across the bloc, greater flexibility was granted at the European level: even those countries most affected did not have to tighten their fiscal belt and did not have to undergo a credit crunch when the crisis began. For example, the EU’s decision to activate the general escape clause of the Stability and Growth Pact offered greater fiscal firepower to address the crisis.
Firstly, the prompt and extensive fiscal support granted by the national governments had an effect on confidence and on financial markets, allowing the countries, independent of their fiscal position, to make use of a wide range of instruments to counteract the economic damage of the pandemic and support households and firms. European governments agreed on huge fiscal measures including furloughs, tax deferrals, public guarantees, and loan moratoriums. These efforts helped to limit the economic damages from the pandemic (Figure 2).
Figure 2: Eurozone countries endorsed vast fiscal packages to counteract the Covid-19 crisis
Secondly, the ECB’s monetary stance was crucial in maintaining calm in the financial markets and keeping policy transmission smooth. The PEPP and the new TLTRO measures were implemented to keep borrowing costs low for households, firms, and governments and to support the banking sector so as to prevent a credit crunch. National governments were able to finance their deficits at favourable rates, and good liquidity and credit conditions were preserved in the real economy. Notably, with financial conditions similar to those of the previous crisis and countries unable to tap markets, it would have been impossible to lay the groundwork for a recovery.
The combination of support measures created a level playing field for European countries, with government spreads not signalling major risk of sovereign distress. As a result, fiscal policy has been able to offset part of the economic shock, rather than subtract from growth, as was the case during the sovereign debt crisis, and monetary policy has been key in preserving financial stability.
Initially, the manufacturing sector recovered quickly from the pandemic, benefitting from increased demand as consumers spent less on services and shifted to consumption of goods. Manufacturing boosted the initial rebound, with eurozone industrial production returning to pre-pandemic levels in 13 months. But over the past few months, supply-chain bottlenecks have prevented industry from making further gains. Despite the likelihood that disruptions will last well into 2022, we expect the industry-dependent Northern economies to recover to pre-pandemic levels by Q2 2022.
Elsewhere in the eurozone, construction represents a key driver of growth. Less impacted by restrictions and often supported by tax incentives, building has returned to 2019 levels. In our view, strong developments in house prices coupled with growing demand for energy-efficient buildings and related incentives puts a floor under sector activity in the coming years. However, the construction sector outlook may become clouded from prolonged supply-chain disruptions and shortages in materials, thus undercutting momentum.
The vaccine rollout meant a strong pickup in the pace of recovery
As we noted, the institutional response to the Covid-19 crisis has been timelier and more coordinated than the sovereign crisis, which heavily impacted the Mediterranean countries. Indeed, the vaccination campaigns of European countries have been coordinated at a European level and administration has been synchronised. The EU reached its initial target of vaccinating 70% of adult population by summer, with the Mediterranean countries among the highest-ranking vaccination efforts. As a result, economies have been able to reopen gradually, and services sectors, where spending came to a halt for much of the crisis, have resumed activity (Figure 3).
Thus, tourism has started to rebound in the Southern countries, where services exports dropped between 40% and 60% last spring. Since then, the recovery has been marginal, with exports levels in all four Mediterranean countries still roughly 40% below their pre-pandemic peaks. But summer 2021 has represented an opportunity to play catchup, as our Tourism Tracker suggests. With social distancing and some international restrictive measures still in place – and travellers’ behaviour partially changed – it will take some time for tourism to reach pre-pandemic levels. We see exports returning to 2019 levels by mid-2023. And given the still sizeable current performance gap, further gains in tourism activity provide Southern countries with an additional chance to catch up to Northern ones.
Figure 3: Compared to the Northern countries, the Mediterranean countries have been more impacted by the crisis as they rely heavily on tourism
Looking forward, other factors will boost the recovery and potentially reduce the ‘North-South’ gap
Consumption will play a major role in shaping the recovery, in our view. Eurozone households are sitting on an estimated €800bn in excess savings accumulated during the crisis when they were unable to spend. We believe that households will begin to release some of those savings in the coming quarters. Despite a certain degree of heterogeneity in consumption behaviours across European countries, we expect consumption to pick up further, reaching pre-crisis levels in the first quarter of 2022. But new challenges such as rising energy prices could dim the spending outlook.
The Next Generation EU funds are a crucial opportunity to speed recovery in Europe and represent a unique occasion for Southern countries to narrow the performance gap with the North. Indeed, the allocation of the €750bn recovery package and the maximum amount of loans eligible to EU member states depend on both the economic losses recorded during the pandemic and on structural factors such as demographic and labour market indicators. Therefore, Southern European countries will be the main beneficiaries of the facility when comparing the allocated amounts to their GDP, seeing a considerable inflow of resources in the coming years, subordinated to an ambitious plan of reforms.
So far, we have seen a clear impact on confidence since agreement on the stimulus package was reached in July 2020. But the real effects on the economies will only start to be seen in the coming months as funds begin to flow and are invested. Italy’s Recovery and Resilience Plan is illustrative of those effects. We estimate that the plan, which entails spending an additional 10% of GDP through 2026 alongside a package of ambitious structural reforms, could directly add 1.5%-2.0% of GDP in the medium term. Furthermore, the reforms Southern countries have committed to will play a crucial role in deciding the real impact while offering those countries a chance to overcome structural issues and improve their pre-pandemic growth trendlines.
All in all, we see rebounds in activity symmetric to the declines experienced last year, and we expect the scarring effects of this crisis to be minimal compared to the previous one. Most notably, the post-Covid European outlook will look similar to the pre-crisis one without a further divergence between North and South.