Hamish McRae: Why Europe matters more to the UK economy than Asia or the Middle East

Let's switch the focus back to Europe. There has been a stream of data from the US suggesting that the economy there may slip into recession, with the weakest period looking to be next spring. We'll have to see whether mooted interest rate cuts in America make much of a dent to this increasingly sombre outlook.

By contrast, there has been a countervailing string of stories about the buoyancy of the Middle East and Asia, including the self-confident purchase by Abu Dhabi of 5 per cent of Citigroup, America's largest bank. But from a practical point of view as far as the UK economic outlook is concerned, Europe matters more.

Continental Europe remains the UK's largest export market for physical goods, though not for invisible earnings. If, as I think it will, the UK avoids recession over the next couple of years, part of the thanks for that will be down to demand from our nearest neighbours across the Channel. So what is happening?

Well, it is tremendously interesting, for the continental economy is on a tightrope. For the moment all is well, but the risks of tipping off either into a slump in demand or into rather higher inflation are uncomfortably high. On the positive side, activity is slowing but not nearly as quickly as might be feared. On the other hand, the ability of the European Central Bank to boost demand, should activity slow too sharply, appears very limited by high inflation. The good news first.

It is really encouraging that despite the high euro and flat domestic demand, the German business community remains upbeat. The respected Ifo survey of business opinion, out this week, rose unexpectedly and remains well above its long-term average. German businesses are very positive about current business conditions, though rather less so about the six-month outlook. This suggests that the present burst of growth will continue well into next year.

Couple this with similarly positive opinion among French businesses and it is really quite hard to see the eurozone economy slowing seriously until the second half of next year. That positive view of German demand is notwithstanding flat consumption, for the poor Germans have not had any significant improvement to their standard of living for five years.

If German industry is confident, the ECB is worried. On Tuesday it was revealed that German consumer inflation in the year to October had reached 3.3 per cent and the markets now expect inflation for the eurozone as a whole to be close to that, perhaps 2.9 per cent. This is alarm-bell territory, particularly since market forecasters such as UBS think both the German and the eurozone inflation rates will remain around or even above 23 per cent through to next spring. Nor is there any sign of better news on the horizon, for the money supply figures, which the ECB watches closely, are rising at more than 12 per cent a year. That is despite effective interest rates at their highest level since 2000. The three-month euro interbank rate is a better indicator of credit conditions than the official ECB discount rate. During the past few days there has been a widening of the gap between official rates and the three-month rate for the dollar, the euro and most notably sterling.

There is a bit of a puzzle here. Why are European companies borrowing so much at these rates? Consumers are not, for they have started to pull in their horns since early last year. BNP Paribas notes that the strong corporate lending is partly the result of the chaotic market conditions. There is a shift away from more risky assets into official ones that count towards the money supply figures. But I don't think the ECB should stop worrying about this because much of the rise occurred ahead of the bumpy summer. A confident business community will increase its borrowings and, to generalise, European business remains confident.

So what will happen and what are the implications for the UK?

My guess is that the eurozone economy, taken as a whole, will not slow much through the winter. There will be pockets of distress; indeed there are already such pockets, for example in the property market in Spain and Ireland. But these will remain isolated and will not contaminate the eurozone economy as a whole. On the other hand the ECB will neither be willing nor, given inflation, be able to cut interest rates through the winter unless there is some exceptional case for doing so. Such a case might be a co-ordinated rescue of the dollar or a co-ordinated rescue of the global banking system but it would have to be something pretty big.

If that is right, then the euro will remain strong, maybe even stronger against the dollar. But sterling, while it appears strong because we think in terms of the dollar rate, has been quite weak against the euro and may become weaker yet. That is good news for UK plc. It is a very crude rule of thumb but British industry tends to buy in dollars and sell in euros. In other words, most imported commodities are priced in dollars, so a strong dollar rate cuts the cost to us, while most exports are priced in euros, so a weak pound against the euro helps export profits. For once the exchange rate works in our favour.

Will this be enough to counteract any fall in domestic demand? The honest answer to that is: it depends. It depends crucially on how fast domestic demand declines. You have to remember that consumption is nearly 70 per cent of total demand. Exports have to rise by about a five-to-one ratio to offset any weakening of domestic demand: a 1 per cent decline in consumption needs a 5 per cent rise in exports to counteract its impact. Fortunately domestic demand has historically been very solid. It takes a lot to make people cut their standard of living. Of course a house price crash would hit people's consumption but the recent evidence from the US (where home prices are falling sharply) suggests that consumers have maintained their spending there despite the housing market, at least so far.

So assuming eurozone demand holds up through the winter it is possible to paint a cautiously optimistic outcome for the UK until well into 2008 or at least it is in terms of overall growth. The problems we will face stem from excessive public spending and borrowing, for despite present growth of around 3 per cent a year, the public accounts seem to be getting worse and worse. Government borrowing seems already to be running above the levels predicted in the pre-Budget report, themselves far worse than at the time of the Budget itself. But the longer growth continues reasonably strongly, the greater the time the new Chancellor has to try to correct the mistakes of his predecessor. So we should all hope that the Continental economy holds up for as long as possible.