The European industry has had a rough couple of years. The EU industrial production index fell by 1.8% in 2023, and we expect it to fall a further 2.4% in 2024. Monthly data suggests it is yet to bottom out. We expect a modest cyclical recovery to bring growth in 2025 – the risk of a global trade war is a clear near-term threat to this. However, there are deeper issues with the sector which may not be easily overcome, and have led to fears of ‘de-industrialisation’ in Europe.
The current slump is a result of cyclical and structural issues
The decline over the past two years has partially resulted from cyclical factors, which may not represent long-term weakness. Input cost inflation, driven by high energy prices, global supply-chain disruption and labour shortages, combined with dampened demand and high interest rates, have constrained European growth. In contrast to the US, fiscal policy has tightened, especially in Germany.
More concerning are the structural problems Europe is facing. The EU’s aim to transform Europe into the world’s first net zero continent has led to fossil fuel disincentives such as the Emissions Trading System, caps on ICE vehicles and individual member-state restrictions.
However, renewable energy still made up only 18% of the industrial energy mix in 2022, compared to the 71% from fossil fuels. In 1990, these figures were 4% and 83%, respectively. Although the EU has significant market share in many green technologies, it has fallen behind China in EVs and batteries, and behind the US in self-driving technology. The automotive sector – a traditional European strength – is facing huge challenges. More generally, the EU is over-regulated, over-taxed and under-investing compared to key competitors such as the US and China (Figure 1).
The European industry is heavily dependent on imported raw materials. The EU runs a trade deficit of €29.4 bn in energy and €2.8 bn in other raw materials. Europe, and particularly its largest economy Germany, has traditionally been a big exporter. The global turn towards economic nationalism is therefore a major threat to the European industry. Perhaps most worryingly of all, China is increasingly competing in more advanced market segments such as capital goods and transportation equipment where Europe has traditionally enjoyed comparative advantage. However, exports have been more resilient than Industrial production, while imports have seen a deeper fall – suggesting that weak domestic demand has a also played a crucial role (Figure 2).
Cyclical factors should improve in 2025
We expect a modest recovery next year as a range of cyclical factors improve. Although natural gas prices have recently increased due to weather patterns and geopolitical risks, we are unlikely to experience the kind of volatility seen in 2022. Trump is highly likely to reverse Biden’s decision on pausing new LNG export terminal approvals. If new capacity goes ahead – which will depend on the commercial case – this could lead to significant extra LNG capacity over the next few years and lower prices in Europe.
The ECB’s main refinancing rate is projected to continue to fall throughout 2025, reaching 3% by the year-end, which will boost demand for interest-sensitive sectors such as construction, autos, capital and durable goods. We expect inflation to remain around the ECB’s 2% target, which together with modest wage growth will mean consumers continue to see real income growth and can increase their real spending without stretching balance sheets.
There are some signs of structural improvements as well. The European Investment Bank has dramatically increased investment across the EU, with approved projects averaging double the capital in the 12 months to October 2024 as the same period in 2021 (Figure 3). This comes as implementation of the EU’s Green New Deal and Future EU Covid-19 recovery packages continue to drive additional funding into sectors critical for manufacturing. Much of this investment is into growth-driving infrastructure, with transport and energy projects comprising 29% and 15% of approved projects, which have not yet started.
Following the Draghi report, the European Commission has pledged to reduce regulation to encourage growth. Recent revisions to green reporting rules have slashed the data-gathering responsibilities of individual firms, while delays to deforestation legislation give businesses more time to prove that the providence of their products is compliant.
Germany is likely to have a new, CDU-led coalition after Federal elections in February. Although Germany’s Debt Brake is unlikely to be scrapped, there is now widespread support for finding a compromise that would allow deficit-financed investment.
Structural problems will not be easy to solve
Europe’s structural issues are deep and not easily solved. The proportion of people aged 65 and over has grown from 18.4% in 2013 to 21.3% in 2023, and will continue to grow, while inward migration has become politically unpopular, meaning finding labour will continue to be difficult.
Competition for manufacturing from China and other emerging economies will grow, while Europe’s approach to decarbonisation – which pushes much of the cost onto industry – will continue to undermine competitiveness compared to the US, China and South Asia. The Trump administration’s instinct will be to deregulate, potentially further widening Europe’s ‘regulation gap’. High debt levels (with the exception of Germany) and increasing demands on fiscal space – from ageing populations, higher defence spending and climate change – will make it hard for governments to either invest in infrastructure or cut taxes.
Most immediately, trade frictions might grow significantly over the next two years. During the presidential campaign, Trump proposed 10% tariffs on all imports of goods, including those from the EU. However, he has not (yet) mentioned tariffs on EU products directly. If US tariffs against China and other Asian countries rise by more than tariffs against the EU, the European industry could even benefit. During Trump’s first term, the EU gained market share in US imports, as China’s share fell (Figure 4).
Trends to watch in 2025 and beyond
As set out above, we expect a modest cyclical recovery in 2025. There are also some structural trends which are potentially supportive. Although decarbonisation has raised the cost of energy in Europe, the global energy transition will stimulate huge demand for green technology products. Depending on the speed and ambition of decarbonisation, climate mitigation spending could boost global IP by $350–700bn per year. Europe is well placed to capture a significant share of this spending, having an established ecosystem of firms in green tech sectors. Spending on climate change adaptation could also boost IP, although to a lesser extent. European spending on defence has grown 14.7% in the past year, with Von der Leyen calling for even greater investment. While BEV demand has slowed this year, we expect carmakers to ramp up production and deliveries next year in order to meet emissions standards. The EU has pledged €1.4 bn of investment in 2025 into advanced technology, such as AI and bio-technology.
In the medium term, we expect growth to be relatively stronger in Eastern and Central Europe (CEE) than in Western Europe. Over the last two decades, industrial output has grown dramatically in CEE countries, especially Poland. Of the aforementioned EIB investment, Poland and Romania received the most – both getting over double Germany’s allotment, while average hourly industrial labour costs for the countries amount to €14.1 and €11.8 respectively, compared to the EU average of €32.2. Germany is the fourth most difficult EU country to start a business in due to regulation, which is generally lighter in CEE countries. Hungary is achieving considerable success in attracting inward investment from China in the battery and BEV sector. However, CEE countries – particularly Hungary and Czechia – are heavily exposed to the auto sector. They also have higher than average concentration in capital goods, which is an area facing increasing competition from China.
To sum up, some of the factors which have hurt the European industry in 2024 will abate next year. This will lead to manufacturing growth, particularly in Eastern Europe. We expect IP to grow by 1.5% in the Eurozone and 1.8% for the EU as a whole. However, there are clear downside risks to the European industry – in the near term from trade wars, and in the longer term from deep structural problems.
If you are keen to hear more about our views on Europe and the global economy, please refer to CRU’s Global Economic Outlook.
With additional contribution from Tom Wescott, Intern
