Eurozone & Japan: Better times ahead

While the Covid situation remains fluid, Eurozone and Japan are expected to continue narrowing the output gap.
Radhika Rao, Ma Tieying16 Nov 2021
  • Eurozone growth is likely to be underpinned by improving consumption and investment
  • Firm inflation might be transitory but not short-lived
  • Rise in Covid-19 cases is under watch
  • Japan benefits from the turnaround in its Covid situation, release of pent-up demand,
  • …. and post-election political stability/policy continuity
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The Eurozone economy expanded by a slower 3.7% yoy in 3Q21 from 14.2% yoy the quarter before, but the sequential momentum was firm at 2.2% sa qoq (vs 2.1% in 2Q). Amongst the four largest countries, France and Italy exceeded expectations, while Germany and Spain underwhelmed. Consumption drove much of the improvement as restrictions eased and contact-intensives services reopened.

The Covid situation was largely under control in 3Q, but the case count has begun to turn up in recent weeks. In Germany, the seven-day case incidence rate was at a record high in early November, as vaccination rates have stagnated at ~70%, necessitating fresh curbs on unvaccinated people especially in indoor areas. With few other countries also witnessing a renewed increase in cases, the WHO warned that Europe was again the ‘epicentre of the pandemic’. The growth momentum is likely to moderate into 4Q, as the bulk of the reopening gains and peak improvement in mobility are behind us, besides fading base effects.

Into 2022, while the Covid situation remains fluid, authorities will steer clear of reimposing large-scale restrictions, preferring to undertake a more nuanced approach in tune with the ‘living the virus’ dictum. Consumption is expected to display a mixed trend as the unemployment rate might tick up in the short term as emergency short-term work compensation schemes are unwound and real incomes come under pressure due to high inflation. But the jobless rate is expected to resume its fall in 2H on the broader pickup in economic activity, just as inflation also cools on base effects.

Investment growth and industrial output are poised to maintain their strong run on higher construction activity and impact of the EUR750bn worth Next Generation EU (NGEU) fund outlays, which will peak next year. The supply bottlenecks and jump in energy prices that hurt production trends and stoke inflation in the short term might iron out into 2022.

We recalibrate our 2021 GDP growth projection to 4.9% yoy and maintain 2022 at 4%. The chart in the right column shows the Eurozone trailing the US in returning to pre-pandemic levels.

The Eurozone-wide fiscal deficit is likely to stand at 7-7.2% of GDP this year, stable from last year. Next year, an unwinding in stimulus programs might narrow the deficits to 4-5%, but the impulse will still be expansionary as fiscal budget rules stay suspended. Outlays under the NGEU funds will be ramped up (0.5-1% of GDP), which will support growth if spent towards investments but will not add to the fiscal strain (spending stands above-the-budget line).

Nonetheless, countries that entered the pandemic crisis with high debt and deficit levels will find it difficult to materially narrow the shortfall in 2022, beyond scaling back the cyclical gap. With the Eurozone-wide deficit nearing 100% of GDP, we will watch for any indications on the reimposition of the EU fiscal rules ahead of the 2023 budgets.

For inflation, the balance of risks is tilted to the upside, with the rise to prove transitory but not short-lived. Inflation accelerated from an average 1.1% yoy in 1Q21 to 4.1% in Oct21 from cost push factors including high energy costs, temporary factors (tax changes), base effects, a re-weighting of the price basket, as well as a return in the demand impulses and high service sector pressures as economies reopened.

Headline inflation is expected to peak by end-2021/early-2022 but only return to sub-2% beyond 2H22. A narrowing output gap and pass-through of higher input prices is likely to underpin price pressures in 2022, even as base effects point to a slight softening in next year’s annual average at 2.3% yoy.

Even as the output gap narrows, the European Central Bank views elevated inflation as transient, expecting it to ease as supply bottlenecks adjust and energy prices abate next year.

At its review in December, the ECB might signal its intention to end the Pandemic Emergency Purchase Program (PEPP), by gradually reducing purchases from January 2022 and wind down by March. To avert a sudden fall-off in purchases, the regular monthly Asset Purchase Program (APP) might continue of EUR20-40bn alongside increased flexibility, for next 3-4 quarters. Even as markets price in rate hike expectations, the ECB will continue to persuade participants to push back to avoid any premature tightening in financial conditions. Rate hikes are not on the cards until 2023, in our view, with the ECB expected to lag the US Fed in policy normalisation.


The Japanese economy contracted more than expected by 3.0% QoQ saar in 3Q, according to the preliminary figures released on Nov 15th. We expect the sequential growth to rebound strongly in 4Q but trim the annual 2021 forecast to 2.0% from 2.2%. Looking ahead, we now project a faster growth rate of 2.5% in 2022, compared to the previous estimate of 2.0%. Real GDP will approach the pre-pandemic levels and the output gap will continue to narrow next year. Yet, underlying inflation pressure will remain benign and monetary policy will remain accommodative.

Japan’s intrinsic growth outlook is expected to improve next year. New Covid infections plummeted to 100-200 per day in early November from the peak of 20,000 in August. The government has lifted emergency measures which led to a substantial improvement in mobility data. Experts attributed the turnaround to rapid vaccination rollout, behavioural changes and some unknown factors. A rebound remains possible in the coming months as the vaccine efficacy gradually wanes. Nonetheless, optimism is emerging that the worst may be over as antiviral drugs become available amidst a more resilient response system. Domestic private consumption is poised to return to the pre-pandemic levels in 2022 but will be a tad slower than the peaks before the 2019 sales tax hike.

New prime minister Fumio Kishida is likely to forge ahead some of his pledged reforms next year. Despite losing some seats, the ruling Liberal Democratic Party (LDP) retained its majority at the lower house election in October.

This victory will ensure the political status quo into the upper house election in July 2022. During the recent election campaign, Kishida proposed the concept of “new capitalism” to reduce income disparity and redistribute wealth, such as raising wages, providing more subsidies for the young and working families, and hiking the capital gains tax. His government wants to increase spending on social welfare programmes via the FY21/22 general and supplementary budgets.

Raising capital gains tax is unlikely near term. Apart from contradicting the pro-growth policy stance of the conservative LDP supporters, this plan also triggered an adverse reaction in the stock market.

Meanwhile, Kishida is likely to follow the former administrations on the key industrial policies. These include strengthening the domestic supply chains for essential goods, enhancing technology capabilities, promoting free trade, and achieving carbon neutrality by 2050.

The previous government has successfully lobbied Taiwan’s TSMC to build a 22-28nm chip plant in Kumamoto Prefecture by offering up to half of the USD7bn investment. Construction of the plant will begin in 2022 and production is expected to start in 2024. Regarding decarbonization, Kishida has said at the latest COP26 climate summit that Japan will boost investment to transform fossil-fuel-fired thermal power into zero-emission thermal power and develop the next-generation batteries and motors that are critical for electric vehicles.

The Bank of Japan (BOJ) is expected to keep monetary policy accommodative. Unlike the US and many emerging economies, inflation is benign in Japan. The surge in energy prices and the disruptions in global supply chains have pushed up upstream costs for Japanese producers. But this could not be easily passed onto downstream consumers due to soft domestic final demand (CPI: 0.2% YoY in Sep).

We expect the BOJ to keep the short-term and long-term policy rates unchanged through 2022, at -0.1% and 0%, respectively. But the pandemic-related special loan programme may be gradually phased out after the March 2022 deadline.

Against faster monetary policy normalisation by the Fed and other major central banks, Japan’s policymakers might tolerate a weak yen amidst moderate domestic inflation and nascent economic growth.


Ma Tieying 馬鐵英, CFA

Economist - Japan, South Korea, & Taiwan 經濟學家 - 日本, 南韓及台灣
[email protected]

Radhika Rao

Senior Economist – Eurozone, India, Indonesia
[email protected]

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