May 27, 2009 / 2:30 PM / 10 years ago

ANALYSIS - Inventory bounce may boost Europe's economy

PARIS (Reuters) - A record contraction in Europe’s economy in the first quarter of 2009 showed the region mired in its worst recession since World War Two. But the very speed of the drop may lead to a tentative recovery in coming months.

Worried companies have idled production lines and laid off workers so rapidly that much consumer demand is being satisfied by running down inventories of unsold goods.

This “destocking”, most noticeable in sectors such as car and cellphone making, may have neared levels where it would be hard for inventories to go much lower, even if demand stays weak. So firms may bring output back up, at least partially.

“The first phase of the recovery is likely to be driven by an end of the inventory rundown and a possible inventory build-up,” Credit Suisse bank’s economics team said in a research note.

Even if companies do not resume building their inventories, gross domestic product may now increase if the pace of destocking merely slows, the European Central Bank said in its monthly bulletin for May.

Such hopes explain why bullish European stock markets reacted calmly to news this month that the euro zone’s first-quarter GDP sank a worse-than-expected 2.5 percent from the last quarter.

An inventory-led rebound already seems to have started in Asia, where China’s industrial output climbed 8.3 percent from a year ago in March and 7.3 percent in April, after rising just 3.8 percent in the first two months of 2009. South Korean factory output expanded a seasonally adjusted 4.8 percent in March from February.


European inventory data is not as timely as data in major Asian exporters such as South Korea, making it harder to gauge whether Europe is in for a similar recovery.

The European Commission’s April survey of companies was not encouraging. The balance describing their stocks of finished goods as excessive, at 20 percent for the euro zone, remained twice as high as its long-term average and not far from the record 23 percent seen in December.

But there is evidence in the last few weeks that Europe may be following the same trend as Asia.

Monthly corporate surveys by research firm Markit show the “new orders” index for the euro zone, an indicator of the strength of demand, decreased at its slowest pace in nine months in May, with a preliminary reading of 42.0. A number above 50 suggests expansion while a number below 50 implies contraction.

Meanwhile, stocks of finished goods posted the largest fall in Markit’s records, which date back to 1996; that index came in at a preliminary 41.1.

This caused the ratio of new orders to inventories — a gauge of pressure on companies to raise production — to climb to 1.022, its highest level since February 2008, before the economic crisis became severe.

“The ratio of orders to inventories rose to a 15-month high...raising the likelihood that manufacturing output could return to growth within the next three months,” said Chris Williamson, chief economist at Markit.

The low for the ratio in the euro zone’s current downturn, 0.522, came in December. In Britain, the low of 0.659 was hit in December and the ratio rose back above 1.0 in March, suggesting British business may be some two months ahead of continental Europe in the inventory cycle.


An inventory-led rebound in the European economy would not necessarily mean a steady recovery to near growth rates seen before the recession.

A Reuters poll of economists, published in mid-May, gave a consensus forecast of a 3.7 percent drop in euro zone GDP this year and growth of only 0.4 percent in 2010.

Daniel Gros, economist director of the Centre for European Policy Studies in Brussels, said weak house prices would remain a drag on the economy for some time, with a huge impact on countries such as Ireland and Spain over five years or so. The impact will be softer but last perhaps five or 10 years in countries such as France, Gros added.

JP Morgan economist David Mackie noted that banks and other companies still needed to clean up their ravaged balance sheets, which could prevent a sustained rebound of the economy.

And the European Union’s latest forecasts, delivered in early May, estimated 9.5 million people would lose their jobs this year and next in the 27-country EU, further hurting consumer demand.

But Gros argued that generous unemployment benefits and other social transfers in Europe, plus lower oil prices compared to last year, would soften the blow for households and put a floor under demand.

That could help to avoid any large, major drop in the new orders/inventories ratio, preventing a further fall of production on the scale of the slide seen in the first quarter of this year.

Additional reporting by Nigel Davies in London

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