Europe is in trouble as economic skies darken

The eurozone is in trouble and conditions are worsening as the fallout from the Russian invasion of Ukraine and Europe’s own economic challenges coincide.

This week the euro fell to its weakest levels against the US dollar in more than 20 years, breaking parity for the second time this year. While the first time it dipped below parity, in July, was momentary, this time it looks the euro appears likely to remain depressed for a protracted period.

Russia is using Europe’s reliance on its gas – before the war it supplied about 40 per cent of Europe’s gas – to retaliate for the Europeans support for Ukraine and their key role in imposing sanctions on Russia.Credit:AP

The immediate cause for the slump in the euro was the announcement by Russia’s Gazprom that it would shut down the Nord Stream pipeline, already operating at only 20 per cent of capacity, for three days of what it described as “routine” maintenance.

That sent European gas price soaring, again, with benchmark prices – already in unprecedented territory – hitting record levels.

In France, power prices this week hit €645.54 euros ($929.32) per megawatt hour, about seven times their level a year ago. In Germany the price spiked above €700 euros for the first time. The Dutch benchmark for European gas prices hit a record €278 per megawatt hour – a 45 per cent rise this month.

The Europeans are scrambling to increase their gas reserves as winter looms and have almost reached their target levels of about 80 per cent of their storage capacity.

That “success,” however, is coming at prohibitive prices and is having flow-on effects to the global market for gas, with US domestic gas prices hitting their highest levels since 2008 and Asian LNG prices reaching nearly three times their level before the invasion.

Russia is using Europe’s reliance on its gas – before the war it supplied about 40 per cent of Europe’s gas – to retaliate for the Europeans support for Ukraine and their key role in imposing sanctions on Russia. It has throttled back the supply of gas via the Nord Stream pipeline to only 20 per cent of its capacity, citing issues with the turbines, with Gazprom warning that prices could surge another 60 per cent in winter.

The huge increases in energy costs are having economic impacts.

In the UK, Citigroup has warned that Britain’s inflation rate could top 18 per cent early next year because of the rise in wholesale gas prices.

The Europeans are scrambling to increase their gas reserves as winter looms and have almost reached their target levels of about 80 per cent of their storage capacity.Credit:AP

The eurozone inflation rate has crept up to 8.9 per cent and the latest spike in power prices will ensure that the rate continues to rise, intensifying pressure on the European Central Bank to increase European interest rates even as eurozone economies tip into recession.

The zone’s trade balance has swung from solid surpluses to deficits as its soaring bill for gas imports has overwhelmed an otherwise solid export performance.

In the zone’s powerhouse economy, Germany, Bloomberg has estimated power prices have topped the equivalent of $US1000 ($1448) per barrel of oil.

A “flash” index for Germany’s manufacturing and service sectors this month has marked the second month in a row where both contracted. Recession is looming for the key eurozone economy.

The eurozone economies are also being impacted by the divergence in monetary policies with the US, where the Federal Reserve Board is further along the path of monetary tightening than the ECB and far more hawkish about the near-term outlook for policy.

That’s being reflected in the exchange rates, hence the euro falling below parity, something it hadn’t experienced since the early days of the creation of the common currency.

The lower exchange rate, if sustained, means the eurozone will effectively be importing inflation as the costs of imports – most notably energy imports that are priced in US dollars – are inflated.

The stresses faced by Germany, the most reliant of the European countries on Russian gas, pose a severe challenge to the common currency that underpins the eurozone.

As the Europeans continue to wean themselves off Russian oil and gas both will experience significant economic harm and the spillover effects from the conflict in Ukraine will continue to distort and be a drag on a global economy that’s already under pressure from China’s dwindling growth.

There has been a convenient relationship between Germany’s economy and the weaker economies of southern Europe.

German’s export-oriented economy (aided by its dependence on relatively cheap Russian gas) benefitted from a weaker currency because of the inclusion of those southern states while they gained access to lower interest rates because of Germany’s economic performance, its fiscal and monetary conservatism and its pristine credit rating.

Interest rates in the eurozone have been rising but, more disconcertingly, the spreads between German bunds and the sovereign bonds of southern economies like Italy and Greece have blown out to 200 basis points or more.

Rising rates against the backdrop of rapidly-slowing economies and high inflation rates are a recipe – particularly in the overly-indebted southern economies, for economic stresses and social unrest and the kind of political tensions that almost tore the eurozone apart after the 2008 financial crisis and that have recently resurfaced in Italy.

While Germany is maintaining the operations of nuclear reactors that were scheduled to close this year, hiring gloating LNG terminals and building import terminals of its own and other European states are doing similar things – reopening coal mines, competing for LNG cargoes, recommissioning gas fields that had been shut down — to diversify their energy sourcing away from Russia, there are no quick or complete fixes in the near term. It isn’t just this winter that will be impacted.

Russia might also be hurting – its economy shrank four per cent in the June quarter and is likely to keep shrinking as the effects of the West’s sanctions steadily bite – but as the Europeans continue to wean themselves off Russian oil and gas both will experience significant economic harm and the spillover effects from the conflict in Ukraine will continue to distort and be a drag on a global economy that’s already under pressure from China’s dwindling growth.

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