[Turning Point Approaches] Growing Stagnation Concerns After Prolonged War... Can Eurozone Expansion Be the Escape?

Energy Crisis and Defense Spending Increase Economic Pressure
Expansion such as Croatia Joining the Eurozone is a Positive Factor

[Asia Economy Reporter Hyunwoo Lee] "We will do our best to reduce the high inflation that affects the lives of poor people, and we will steadily raise interest rates until we return to the target rate of 2%."

Christine Lagarde, President of the European Central Bank (ECB), expressed a strong determination to win the war against inflation in her New Year's message announced ahead of last Christmas. Triggered by Russia's invasion of Ukraine, the energy crisis and the worst inflation in 40 years have pushed the European economy into an unprecedented crisis. Additionally, with national defense budgets significantly increased due to security concerns, the economy is under great pressure.

Despite facing a more difficult situation than ever, there is also mid- to long-term optimism for economic recovery as the Eurozone (20 countries using the euro) is expected to expand, centered on Eastern European countries such as Croatia newly joining the Eurozone.

◇Concerns over recession spread amid prolonged energy crisis

[Image source=Reuters Yonhap News]

According to the Wall Street Journal (WSJ) on the 3rd (local time), the ECB forecasts that the annual GDP growth rate of the European Union (EU) will be only 0.5% this year. It is expected to be difficult to recover to the pre-COVID-19 pandemic level of 2-3% until 2025. The EU's Q3 GDP growth rate announced on the 7th of last month was also only 0.3% compared to the previous month.

The poor outlook stems from the energy crisis triggered after the war in Ukraine. In October last year, the EU's average inflation rate rose to 10.6%, the highest since statistics began. In November, it recorded 10.0%, continuing the double-digit streak. The Dutch TTF gas futures price, a benchmark for European gas prices, is currently around 70-80 euros per megawatt-hour (MWh) (approximately 94,000 to 107,500 KRW). Although this is a 77% drop from the all-time high of 346 euros recorded in August, it is still nearly twice the average price of 43.51 euros over the past five years.

From March this year, when Europe's gas reserves are expected to sharply decline, the gas supply crisis will become more severe. According to the UK BBC, the EU's current gas reserves are at 98% of total storage capacity, but if the winter cold wave intensifies, reserves are expected to run out starting from the end of February.

If the price increases caused by the energy crisis continue and lead to a consumption slump, there are concerns that the European economy could fall into a deeper recession. According to CNBC, more than 71% of US liquefied natural gas (LNG) exports in the first half of last year were shipped to Europe. This is overwhelmingly more than the usual export destinations in East Asia such as China, South Korea, and Japan.

Some LNG volumes have shifted export regions from East Asia to Europe at prices 3 to 4 times higher than the usual prices. If the energy price burden becomes too heavy, industrial gas usage will be restricted, which is expected to affect manufacturing production.

◇Sanctions on Russia and increased defense spending also pressure the economy

[Image source=AP Yonhap News]

The prolonged sanctions on Russia due to the ongoing war in Ukraine and increased defense spending due to security concerns are also expected to heavily pressure the EU economy. According to Bloomberg, EU countries have implemented about 150 economic sanctions from the first round in February last year to the ninth round on November 9, resulting in massive losses and costs amounting to approximately 525.5 billion euros (about 705 trillion KRW).

The direct aid from EU countries to Ukraine, including military and financial support, is estimated at about 20 billion euros (about 26 trillion KRW). This is about one-fifth of the US aid, which exceeds 100 billion dollars (about 126 trillion KRW). However, the costs incurred from sanctions on Russia and the acceptance of millions of Ukrainian refugees are putting pressure on EU countries. According to the UN Refugee Agency, the number of Ukrainian refugees who fled to EU countries is about 3 to 4 million, including 1.54 million in Poland, 1.02 million in Germany, 470,000 in the Czech Republic, and 160,000 in Italy.

Increased defense spending due to security concerns is also expected to be a significant burden on the economy going forward. According to the New York Times (NYT), the ratio of defense spending to GDP in European countries rose from the previous 1% to over 2% before and after the Ukraine war. Poland (2.2%), Lithuania (2.15%), Romania (2.02%), and France (2.01%) have raised their defense spending ratios to the 2% range, and Germany also announced plans to increase its defense budget ratio to over 2% by allocating a special defense budget of 100 billion euros.

◇Croatia joins Eurozone, possibility of a turnaround in sentiment

[Image source=Yonhap News]

This year, Croatia joined the EU, increasing the likelihood of Eastern European member states joining the EU. This is expected to expand the economic scale of the Eurozone and could serve as a turning card to change the stagnant atmosphere.

According to the Associated Press (AP), Croatia abandoned its former currency, the kuna, and adopted the euro as of January 1 this year, becoming the 20th Eurozone country. The exchange rate was set at 7.5345 kuna per euro, and both kuna and euro will be accepted until the 14th of this month. Along with this, the Schengen Agreement, which allows free movement across borders among EU member states without border checks, was also signed. As a result, citizens of other EU countries can freely travel to Croatia without passport checks or visas.

To celebrate Croatia's new membership in the Eurozone, Ursula von der Leyen, President of the European Commission, personally visited Croatia. During her visit to Zagreb, Croatia, she emphasized, "There is no place in Europe today where a new beginning and a new chapter have started more than at the border between Croatia and Slovenia," adding, "Today is a day for history books."

With Croatia becoming a Eurozone country 10 years after joining the EU, there is growing expectation that other Eastern European EU member states will also join the Eurozone, significantly expanding its economic scale. The Bulgarian government, which also aimed to join the Eurozone, plans to challenge Eurozone membership again with a target introduction date of January 1 next year. Bloomberg reported, "The Eurozone will lead Croatia to the center of the EU and provide a financial safety net. Although Croatia's economic scale is not large enough to bring immediate major changes to the Eurozone, the expansion of the Eurozone for the first time in seven years will help change the stagnant atmosphere."