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In Europe, Every Little Reform Counts


A funny thing happened in Europe on Feb. 15. As businesspeople from London to Lisbon were settling down to work, they were hit with some of the most unsettling economic news in months. New data suddenly showed that the German and Italian economies had actually shrunk in the last quarter of 2004, despite near-unanimous predictions of mild growth. That shocker came just days after German jobless rolls sailed past the 5 million mark for the first time since World War II ended. So how did the markets react? The euro strengthened. And euro-zone shares shot up.

Are European investors crazy? Not really. The very day that scary news was spreading, one of Germany's most respected economic institutes was broadcasting a story of a different sort. Up in Mannheim, the Center for European Economic Research, which conducts a monthly survey of the expectations of professional economic analysts, reported a 33% increase in confidence about the German economy. True, enthusiasm sagged a bit when, a week later, the Munich Ifo Institute's closely watched index of German business confidence dipped in February after two consecutive months of improvement. But economists say confidence is still good. "The [absolute] level of the Ifo index is very solid," says David Millkeker, head of industrial countries research at Dresdner Bank in Frankfurt.

The indicators may not all be marching forward in lockstep. But on balance, the numbers appear to be telling a positive story. Even the unexpected 0.2% dip in Germany's fourth-quarter output was driven largely by reduced public spending -- manufacturing and consumer spending remain on an upward trend. Nuremberg-based market researcher GfK's consumer confidence index for Germany rose to 4.1 in February, from January's 3.1.

Indeed, some suggest that the Continent could be at a psychological tipping point at which both consumers and business are feeling cautiously optimistic. That's the sort of lift Europe's slow-growth economy could sure use. "The leading indicators have been rising for several months," says Holger Fahrinkrug, senior economist at UBS (UBS) in Frankfurt. "That is leading people to look slightly more optimistically into the future."

TWEAKING

If this is the case, it's not because of any big-stroke, courageous policy moves. Rather, it may be that the cumulative weight of small reforms in France and Germany is beginning to add up to something. These range from laws to free up rigid labor markets to tax incentives designed to attract investment. "There is suddenly a reform story," says Joachim Fels, economist at Morgan Stanley (MWD) in London.

Take Germany. Economically speaking, the second half of 2004 was a write-off. Hard-hit German consumers were spooked by crises at retailer KarstadtQuelle and construction giant Walter Bau. Deutsche Bank, once the bellwether of the country's rock-solid economy, geared up for massive job cuts. Most of all, Germans were worried that Chancellor Gerhard Schröder's labor market reforms would lead to massive layoffs.

Yet when the reforms actually took effect in early January, their impact was much less severe than many had feared. Unemployment in January hit a postwar high of 12.1%, according to non-seasonally adjusted figures. But that figure was driven largely by changes in the methodology, and masked a positive trend: For the first time since 2001, the number of employed Germans has been rising. Dresdner Bank calculates some 300,000 new jobs were created last year.

It's roughly the same story in France. The center-right government of Jean-Pierre Raffarin has been quietly but steadily moving to roll back measures once considered sacrosanct. Under legislation approved in early February, France's 35-hour workweek will be largely dismantled, with most workers getting a green light to work longer hours.

Paris also is finally adopting measures to make France a more attractive to multinational companies. Until recently, factors such as the sky-high 48.9% marginal tax rate discouraged foreign companies from setting up regional headquarters in France. Japan's Toyota Motor Corp. (TM) built a major plant in northern France in the late 1990s but still bases its senior Japanese executives in Belgium to shield them from French taxes.

To fight the trend, Raffarin has unleashed a host of small measures. Effective this year, non-French executives based in France will be exempt from paying tax on income not earned in France. At the same time, the government has been pushing local authorities to simplify the procedures non-European Union citizens need to go through to be able to work in France. Currently, it can take up to four months -- and thousands of euros in fees -- to secure working papers for a non-EU graduate of the prestigious French management school Insead. "The system in France is still an absolute nightmare," says Claire Lecoq, Insead's director of MBA career services. Because of French policies, she says, a vast majority of the school's U.S. and Asian graduates head to Britain, where they can get working papers in as little as four days.

SETTING THE STAGE

In France, as in Germany, the reforms may be starting to gain traction just as companies are beginning see benefits from several years of tough restructuring. Buoyant exports, payroll slashing, and offshoring of jobs to cheaper locales in Eastern Europe -- coupled with increasingly sophisticated capital markets -- are helping pave the way for fatter profits. Although not all companies have reported 2004 results, the data thus far show that the net profits of France's top 40 blue-chip companies rose 30% last year, while the 30 companies that make up Germany's benchmark DAX stock index logged a 72% jump. "It is only this year that profits in the euro area are being restored in a way that sets the stage for expansion," says John Lipsky, chief economist of JPMorgan Chase & Co. (JPM).

Lipsky believes that economic growth in Europe is set to tick upward to 2% a year. True, that's lackluster by global standards and not enough to make a dent in unemployment. But if psychology is in fact beginning to shift in Europe, it could well make it easier for gun-shy governments to push through more meaningful reforms. Getting consumers to spend is key, and that means making it easier and cheaper to get credit. France and Germany, for example, make it almost impossible for homeowners to take out secondary mortgages. Considering that half of all household wealth in those nations is tied up in real estate, compared with just one-quarter in the U.S., there is a vast pool of resources that could be tapped. With steady-drip reforms, Europe may finally be wearing away some of the toughest obstacles to growth.

By John Rossant in Paris and Jack Ewing in Frankfurt


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