What does Red Sea disruption mean for Europe's economy?

[January 19, 2024]  By Mark John

(Reuters) - Weeks of attacks by Iranian-backed Houthi militants on vessels in the Red Sea have disrupted shipping in the Suez Canal, the fastest sea route between Asia and Europe carrying 12% of global container traffic.

For the European economy, already skirting a mild recession as it tries to shake off high inflation, prolonged disruption would be a new risk to its outlook and could derail plans by central banks to start cutting interest rates this year.

Here are some factors that policymakers are considering as they assess the situation and its implications.

WHAT HAS BEEN THE IMPACT ON THE EUROPEAN ECONOMY SO FAR?

In macroeconomic terms, small to negligible. While Germany's Economy Ministry stressed it was monitoring the situation, it said this week that the only noticeable impact on output so far had been a few cases of stretched delivery times.

Bank of England chief Andrew Bailey concurred, telling a parliamentary hearing it "hasn't actually had the effect that I sort of feared it might", while acknowledging the uncertainties remained real.

No impact from the attacks has yet turned up in Europe's main economic indicators - including December inflation numbers, which ticked up slightly across the region on a mix of largely expected statistical effects, some one-offs and some pressure on prices for services.

That might change - watch next Wednesday's preliminary PMI readings for activity in European economies in January, and Feb. 1's first estimate of euro zone inflation for the same month. ECB President Christine Lagarde may well broach the subject in her news conference after next Thursday's rate-setting meeting.

BUT WHY ISN'T IT FEEDING THROUGH TO THE ECONOMY YET?

The main reason is probably that the global economy as a whole is still performing below par, which means there is plenty of slack in the system.

Take oil prices, the most obvious channel through which Middle East troubles could hit economies in Europe and beyond.

They haven't taken off yet because, as International Energy Agency executive director Fatih Birol told Reuters this week, supplies are solid and demand growth is slowing.

"I don't expect a major change in the oil price because we have an ample amount of oil coming in the market," he said.

German logistics giant DHL said it still had available air freight capacity - not an option for everyone - because the global economy was "not really pumping yet"

A Houthi fighter stands on the Galaxy Leader cargo ship in the Red Sea in this photo released November 20, 2023. Houthi Military Media/Handout via REUTERS/File Photo

This subdued economic picture also makes it harder for companies to pass onto consumers any increases in costs they are encountering, for example by having to re-route around Africa. Many of them have rebuilt margins in the past year and accept they might simply have to suck this one up.

"Our best forecast at the minute is we're able to absorb the incremental cost that we estimate will come through and still achieve ... gross margin improvement," Poundland owner Pepco Group's executive chairman Andy Bond told Reuters.

Furniture retailer IKEA even said it would stick to planned price cuts and had the stocks to absorb any supply chain shocks. As long as that remains the case for enough companies, the disruption will not move the dial on consumer price inflation.

SO CAN EUROPEAN POLICYMAKERS SIMPLY LOOK THROUGH THIS?

No - because the longer the disruption goes on for, the more likely it is to take a toll on the wider economic picture, even if gradually.

Using an IMF estimate of the impact of freight cost rises, Oxford Economics in a Jan. 4 note estimated gains in container transport prices would add 0.6 percentage points to inflation in a year's time. The ECB is expecting euro zone inflation to fall from 5.4% in 2023 to 2.7% this year.

"While this suggests that a sustained closure of the Red Sea wouldn't prevent inflation from falling, it would slow the speed at which it returns to normal," Oxford Economics concluded. It did not see this preventing an expected pivot to lower interest rates, however.

At the margins, the Houthi attacks and wider troubles in the Middle East represent one of the "geopolitical risks" that get referred to in the minutes of central bankers' monetary policy discussions. The fear is of escalation - and that fear itself may feed into the decisions that emerge.

Finally - and we may still be some way off this - there is the possibility the situation will encourage companies to advance plans drawn up after the COVID-19 pandemic disrupted trade for alternative, more predictable supply routes.

That could involve longer but more secure trade paths and "near-shoring" or "re-shoring" to bring production closer to key markets. But whatever options are explored, the likelihood is that they all have one thing in common - higher costs.

(Writing and reporting by Mark John; Editing by Catherine Evans)

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