That sinking feeling

Despite weakening growth rates in recent months, the EU economy has not yet caught the violent cold that has afflicted the US. In the final quarter of last year, growth in Europe was significantly better than in America, which suffered a sharp slowdown.

There has been no Europe-wide equivalent of the US real estate bubble and subprime disaster. But European financial institutions and markets have still been hit by contagion and the prospects do not look good for certain economies in the region.

Real estate bubbles have been growing in the likes of Ireland and Spain in recent years, and they now look like bursting. The UK, for so long the star of the class among the major EU economies, now looks close to following the US into a post-real-estate-bubble slowdown. Germany and France, the twin motors of the Eurozone, have shown signs of weaker growth. Italy, the region’s most anemic of recent times, is weakening further.

However, unlike in the US, there is no debate yet over whether or not Europe has entered a recession.

Chinese concerns
The big question for Beijing is whether any slowdown in Europe will reinforce the effects on the Chinese economy of events on the other side of the Atlantic. The most obvious impact would be exports.

During 2007, there was a rapid deceleration of Chinese export growth to the US, from 19.4% in the first quarter to only 7.1% in the last. The American slowdown can’t wholly be held accountable for this, but by the end of the year, China’s exports to the US were growing at their slowest rate since 2001, when there were two quarters of negative growth.

So far, there has been no similar rapid deceleration of exports to Europe.

The weakness of the US dollar in recent years has resulted in the EU taking on the role as the main absorber of China’s export growth. Even China’s clear policy of accelerated renminbi appreciation against the dollar in place in recent months has made little impact against the euro. Just when it seems the dollar cannot sink any lower, it manages to hit yet another record low against the euro.

As current Chinese exchange rate policy is likely to continue, what happens to the dollar will have an important impact on Chinese trade with Europe.

Much of the dollar weakness in recent months is tied to fears concerning America’s economic problems, but interest rates are another key factor. While the US Federal Reserve has been desperately slashing interest rates, the European Central Bank has stood firm in its anti-inflationary stance. This has drawn considerable criticism from some European political leaders, such as French President Nicolas Sarkozy.

If that stance should weaken as a result of a clear slowdown in the Eurozone and interest rates fall, then we may see a change in the outlook for the euro against the dollar. Without the cushion of a strong euro, Chinese exports to Europe may really begin to struggle.

China is far from wholly dependent on exports for its growth, but a serious slowdown in its two major markets will have a strong effect on the export sector.

Political ramifications
The potential impact of economic turmoil on the EU-China economic relationship has not received a great deal of attention in Europe, as events across the Atlantic remain in the spotlight.

Yet there is a growing awareness in Europe that the major economies are closely intertwined. Europe, the US and China are facing economic turbulence of kind that has not been experienced since the PRC emerged as a major modern economic power. One problem is that there is no real mechanism though which they can all sit down to coordinate their policies together.

America may be at the center of the toxic cloud of problems in the world economy but China and the EU are still at risk, both directly and bilaterally. At their summit in November, the two sides agreed to establish a High Level Economic and Trade Mechanism, which will address major economic issues, along the same lines as the strategic economic dialogue between the US and China.

The traditional areas of discussion, like intellectual property and market access, will no doubt be on the agenda. But there may also be talks on  a collaborative damage limitation exercise that offers protection for both sides in the rapidly deteriorating international economic climate.