Eurozone: Balancing act

A confluence of politics, trade tensions with the US, and efforts to lift the bloc out of stagnation will dominate developments this quarter and the year ahead.

Firstly, the German elections held in February 2025 saw CDU/ CSU win the poll with 28.6% of the vote, and they were on track to form the next coalition government. A coalition would be necessary to surpass the 50% of the seats in the parliament. A favourable outcome would be a coalition with SPD, even if marked by internal policy differences. The far-right AfD party expanded its presence, emerging as the second most popular party. While mainstream parties have rejected cooperation with the AfD to form the next government, its strong showing might undermine investor confidence.

The political quagmire comes at a difficult time for Germany and the Eurozone amidst stagnant recovery, slow growth in key trading partners, and rising challenges from US tariffs. Passage of the French 2025 budget avoided the imminent fall of the government but involved few concessions, including a slower pace of fiscal consolidation.

Worsening relations between the US and Ukraine will require Europe to assume a bigger role in the region, de facto increasing public spending towards defence and support for Ukraine. The European Defence Agency estimated EU defence spending at EUR326bn in 2024, up from EUR 279bn the year before. A paper by four European countries that share their border with Russia called for a doubling of spending to reach the target of at least 3% of GDP. Press reports cite discussions of an immediate delivery of air defence systems and deep-precision strike missiles as part of the EUR20bn military package in the works. France and the UK are reportedly spearheading efforts for a one-month peace plan for Ukraine, while the region mulls a military coalition.

Secondly, the threat of US tariffs lingers over the Eurozone. The US was the largest destination for EU exports of goods in 2023 and the second-largest partner for EU imports. Of the proposed measures yet far, the most consequential for the zone is the upcoming 25% tariffs on cars, aluminium & steel, semiconductors, and pharma. Reciprocal tariffs in early April are also a risk, although the contours of the proposed structure and its reach are still unclear. Amongst the EU members, the Netherlands, Germany, France, Belgium, and Italy have amongst the highest exports to the US. As a % of their GDP, Netherlands, Belgium, and Ireland signal the highest exposure (see chart).

Amongst multiple proposals outlined by the US, we see the impact of sectoral action and/or non-tariff barriers (Value added Tax) as being more material than reciprocal action. Pharma, machinery & motor vehicles, and energy make up more than a third of the EU’s exports to the US. For instance, the economic consequence for the Netherlands will be significant, given the proposed action on steel and aluminium, cars, pharma, and semiconductors, with its rate differentials also wide vs. the US. As the chart shows, Ireland makes a bulk of pharma preparations exports to the US, Germany, Belgium, and the Netherlands. While the impact on sectors might be material, the risk of reciprocal tariffs is lower as the tariff differential between the US and EU is not as pronounced as it is with Asian economies.

For instance, the simple average (of the top EU trading partners) of the Most Favored Nation (MFN) trade-weighted rate on imports from the US is 1.3% vs exports to the US at 1.9%. With the Value-added Tax also being mentioned as a non-trade barrier and the EU VAT being amongst the highest in the region, that differential will be negative for the bloc.

We have trimmed our growth forecast for 2025 to 0.9% yoy, improving marginally from 0.6% yoy in 2024. Household disposable incomes are expected to fare better in the first half of the year, backed by a pick-up in real wages and a low unemployment rate. The saving rate for households, however, continues to rise, signaling underlying caution. Investment growth remained subdued, while net exports contributed to the headline. Germany faces significant headwinds, raising the likelihood of a flat growth or a recession this year.

The pace of disinflation has, meanwhile, moderated on sticky services. This is, however, unlikely to deter the ECB from further lowering rates this year. After a 125bp reduction since 2024, we expect 75bp more cuts in the deposit facility rate to 2.0% by end-2025. Neutral rates are seen in the 1.75 to 2.5% range. The deeper the economic stagnation, the greater the need to lower rates to the weaker end of the suggested neutral range.

Japan: Modest risks

We maintain our forecast for Japan's economy to grow by 0.9% this year, with modest downside risks.

Externally, Japan faces the threat of automotive tariffs from the US. Passenger cars are the largest category of imports the US sources from Japan, and Japan is the US's second-largest supplier of cars, following Mexico. From a macroeconomic perspective, passenger car exports to the US account for approximately 1% of Japan’s GDP. A 25% tariff could potentially reduce Japan’s GDP growth by 0.2 percentage points due to substitution effects arising from increased US domestic car production.

The reciprocal tariff may not be the primary challenge. Japan ranks as the US’s seventh-largest source of trade deficit in 2024, amounting to USD 68.5 billion. However, Japan’s simple average tariff rate for most favored nations was 3.7% in 2023, nearly identical to the US rate of 3.3%. Additionally, under the 2019 Japan-US trade agreement, Japan further reduced tariffs on US agricultural and industrial goods.

Japan’s consumption tax, equivalent to a VAT, is currently set at 10%, higher than the US but lower than in many European countries.

Regarding the foreign exchange rate, the US Treasury's 2024 findings indicate little evidence that Japanese authorities have intervened in the FX market to weaken the yen (here).

Domestically, consumption is expected to remain subdued in 2Q. Japan’s largest labor union, Rengo, has demanded a 5% wage increase during this year’s Shunto, which includes both the annual scheduled wage increase and base pay rise, similar to last year. Meanwhile, companies have continued to experience strong corporate profit growth in 2024, supported by a weak yen. We estimate that macro-level base wages will rise by approximately 2% this year, similar to last year’s 2.2% increase.

Inflation and core inflation are expected to hover around 3% YoY in 2Q before easing to 2% in the second half of the year. Food prices, including vegetables and rice, continue to rise sharply due to domestic supply disruptions and higher costs of raw materials, logistics, and labor. Despite the government’s reinstatement of energy subsidies, the lagging effects of yen depreciation are likely to keep imported inflation elevated in 2Q. As a result, real base wage growth is expected to remain negative in 2Q, constraining consumer purchasing power.

We maintain our forecast for the Bank of Japan to raise rates by 25 bps to 0.75% in 3Q. The results of the Shunto wage negotiations and inflation data are likely to fuel expectations for faster BOJ rate hikes in 2Q. However, the weakness in real consumption and real GDP growth will likely discourage the BOJ from acting prematurely. Additionally, the anticipated escalation of tariff threats from the Trump administration in April could further deter the BOJ from raising rates too soon.


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Radhika Rao

Senior Economist – Eurozone, India, Indonesia

[email protected]

Ma Tieying, CFA

Senior Economist - Japan, South Korea, & Taiwan 

[email protected]

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