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Economic Research:
An Oil Price Shock Would Accentuate Divergence
Between European Economies
Publication date: 11-Sep-2006
Economist: Jean-Michel Six, London (44) 20-7176-3185;
Credit Analyst: David T Beers, London (44) 20-7176-7101;

Although the fragile ceasefire between the Israeli military and Hizbollah following their recent conflict in the Lebanon may have calmed immediate fears of an ever-escalating oil price, geopolitical risks in the Middle East–including diplomatic concerns over Iran’s nuclear program–still remain. With this in mind, Standard & Poor’s has applied several extreme oil price scenarios to the economies of Europe, the results of which pose important questions on policy for the European Central Bank (ECB).

The past 10 years have provided a very favorable economic environment for Europe. Since its inception in 1999, the Eurozone has benefited from an international context where, apart from a short slowdown in 2001, world trade has been growing at a strong rate. In addition, inflation trends have been moderate, aided by the cooling effects of globalization, despite highly cyclical commodity prices.
Such conditions should never be taken for granted, however. Dramatic geopolitical events, as have occurred recently in the Middle East, are a constant reminder that the environment could become much tougher. In particular, the world may not be sheltered indefinitely from a new supply driven oil shock (that is, a sudden and dramatic hike in oil prices caused by a disruption in oil supplies rather than by strong demand). Similar shocks, albeit caused by an agreement among OPEC oil producers to set a new price level rather than by an actual disruption in supplies, occurred in 1973 and in 1979. Yet, although the factors that might trigger such an event today may be different, the end result is the same: oil-dependent economies will suffer, and to varying degrees.

Two Alternative Scenarios Test Europe’s Economic Mettle
So how well would the economies of Europe withstand an oil price shock? We have already examined the potential sensitivity of the U.S. economy to significantly costlier oil by running a series of simulations (see commentary article titled “Conflict In The Mideast: Four Oil Supply Scenarios,” published on July 31, 2006). For Europe, we have taken a similar tack: Our baseline forecast, used in all our global economic projections, assumes that oil prices will fall back toward $70 per barrel by the end of 2006, and fluctuate around that level over the next two years. Two alternative scenarios were also considered, both of which assume that prices would be driven higher by a significant deterioration of the geopolitical situation in the Middle East, causing more or less severe disruptions in oil supplies.

Scenario 1: A 3% cut in world oil supplies

In the first scenario, oil supplies would be cut by 2.7 million barrels of oil (3% of world oil production). This would cause the price of oil to soar above $100 per barrel temporarily, but then settle near $95 per barrel. By the end of 2007, the price would start to decline as oil supplies were progressively increased, falling to $60 per barrel by the end of 2008.

Scenario 2: A 20% cut in world oil supplies
The second, more extreme scenario sees world oil production cut by 20%, causing the oil price  o spike to $250 per barrel and remain at that level throughout 2007. The oil price would then retreat back toward $75 per barrel by the end of 2008.
Before outlining the findings from these simulations, it is important to note that the economic data should be treated with caution. Although we have used conventional econometric models, we have pushed them well beyond their historic range. Therefore, it is more important to compare the reactions of each economy
to the same external shock than focus too much on absolute numbers such as the magnitude  if the European recession revealed in scenario 2.

The results from scenarios 1 and 2 clearly show that a supply driven oil shock would act as a wedge inside Europe’s single currency zone, dramatically amplifying the divergence in terms of economic performance among the 12 zone members.
Overall, European economies barely escape a true recession in scenario 1. GDP growth in the Eurozone, for example, is cut by a cumulative maximum of 2.4 percentage points over 2007-2009 (see table 1). Outside the single currency zone, the U.K. appears most affected, with GDP growth reduced by almost 5 percentage points. This is because in our baseline scenario, we expect the U.K. to grow more rapidly than the Eurozone over the period 2007-2009 (2.6% per annum on average versus 2%, respectively), thanks to more robust consumer demand and stronger investment.

The effect on CPI of an oil price hike to $100 per barrel appears relatively muted on average: 1% is added to the Eurozone price inflation, but with significant differences across countries. Austria emerges as the most resilient economy, with a very small (0.22%) increase in CPI, and Greece as the most vulnerable (3.01%; see table 1). Unemployment, meanwhile, unavoidably creeps back up to around 8.5% by 2009, instead of drifting down to just below 7.5% as per our baseline forecast for the Eurozone (see table 2). The effect is even stronger in the U.K., where the jobless rate reaches 5.8% in 2009 from 3.0% in the basecase.
In the second, most extreme scenario, where oil prices reach $250 per barrel in 2007, European economies experience a severe recession in 2007 followed by two years of stagnation. Overall, real GDP is cut by 6.7%. And outside the Eurozone, the U.K.’s GDP drops 12% lower than in our baseline forecast by the end of 2009.

A Single Shock, But Different Reactions
Yet beyond those global results, which could be expected given the magnitude of the shock factored into the simulations, what appears most interesting is the fact that countries differ quite widely in their reactions to the shock.
The impact on GDP growth in Finland, Italy, Austria, and Belgium is smaller than the Eurozone average. Germany, Spain, and France come close to the average, while The Netherlands, Portugal, and Greece are worst hit. Outside the single currency zone, the U.K. and Denmark appear far more vulnerable than Sweden. These significant differences can be attributed to different wage and income elasticities on the one hand, and on different investment reactions on the other. Looking first at real incomes, two main country groups emerge. Germany, Austria, France, and The Netherlands manage to contain at least to some extent the inflationary shock and as a consequence real incomes, whilst falling, do not take as much of a hit as with the second group of countries. Real incomes in this group–which includes Portugal, Greece, and (outside the Eurozone) Denmark–are significantly affected by a higher inflation rate. As a result, consumer demand collapses in the second group more dramatically than in countries of the first group.
Business investment reaction is the other key variable that explains the diverging impact of the oil shocks on the various European economies. Our simulations suggest that outside the Eurozone, the U.K. and Sweden would be most impacted from an investment standpoint, while Greece, Belgium, France, and The Netherlands would feel the greatest pressure within the currency zone. At the other end of the spectrum, Ireland, Finland, and Austria would be least impacted. Germany and Spain would stand close to the average, with business investment cut by about 25% in scenario 2 by the end of 2009.

Results Push Case For Greater Economic Convergence
As we have already pointed out, our simulations, especially scenario 2, have pushed the econometric models beyond their normal range and therefore the results need to be treated with caution. Nevertheless, they do stimulate debate as to what policy response might arise in reaction to such dramatic developments, particularly from the ECB. In scenario 2, for instance, the central bank’s choices appear extremely difficult when confronted by a situation where inflation rates in the Eurozone range between 19%(Greece) and 5% (Germany), and where government deficits reach 5% of GDP (Germany). Jacking up interest rates to double-digit levels would accentuate the negative growth effects of the oil shock, pushing countries such as Germany, Austria, and The Netherlands into a severe deflation (growth recession combined with falling prices). Taking a more accommodative stance would push countries such as Greece, Portugal, or Italy further into an inflationary bust (high inflation combined with growth recession).
Although such scenarios hopefully remain highly unlikely, they show that the convergence of European economies through structural reforms such as greater labor market flexibility and improved fiscal balances remains a top priority in order to build a genuine monetary union in the region.

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