European Services, Manufacturing Contract Further

By Fergal O'Brien

Sept. 23 (Bloomberg) -- Europe's manufacturing and service industries contracted at the fastest pace in almost seven years in September as the credit-market seizure intensified and companies scaled back production in response to slowing orders.

Royal Bank of Scotland Group Plc's composite index dropped to 47, the lowest since November 2001, from 48.2 in August. Economists had forecast a decline to 47.8, according to the median of 21 estimates in a Bloomberg News survey. The index is based on a survey of purchasing managers by Markit Economics in London and a reading below 50 indicates contraction.

Banks are hoarding cash as they struggle with the yearlong credit crisis that has claimed financial institutions including Lehman Brothers Holdings Inc. and with an economic slowdown that is curbing loan growth. Cooling demand is also hitting Europe's biggest manufacturers, with Germany's BASF SE last week announcing it will slash production of polystyrene in Europe.

``The flash PMI data for September make grim reading, showing recession-consistent activity data pretty much across the board,'' said Ken Wattret, an economist at BNP Paribas in London. ``Manufacturing has taken over from services as the main driver of weakness, reversing the pattern in the early stages of the downturn. This is linked to Germany's switch from boom to bust.''

The continued contraction in manufacturing and services industries suggests Europe's economy isn't recovering after shrinking in the second quarter for the first time in almost a decade. The European Central Bank on Sept. 4 cut its 2008 growth forecast to about 1.4 percent. The European Commission also lowered its outlook this month and predicts recessions in Germany and Spain, the region's largest and fourth-largest economies.

Manufacturing Index

Markit's manufacturing index fell to 45.3 this month from 47.6 in August, below economists' forecasts, while the services index fell to 48.2 from 48.5.

European government bonds rose after the data were released, with the yield on the two-year Germany security dropping 11 basis points to 3.92 percent as of 10:04 a.m. in London. The euro extended declines, falling 0.5 percent to $1.4700 against the dollar.

A separate report today showed industrial orders in the euro area rose 1 percent in July from the previous month and were up 1.6 percent from a year earlier. Excluding the volatile transport category, orders fell 1.4 percent on the month and dropped 2.1 percent over the year.

Frozen Lending

To ease the credit crisis that has frozen lending and shaken stock markets, the European Central Bank and the Federal Reserve joined with counterparts last week to inject $180 billion into the financial system. Over the weekend, U.S. Treasury Secretary Henry Paulson unveiled a $700 billion proposal to use public funds to buy devalued mortgage investments.

In the past 10 days, Lehman Brothers collapsed and the U.S. government took over American International Group Inc. In Europe, HBOS Plc, Britain's biggest mortgage lender, was acquired by Lloyds TSB Group Plc last week after it lost 37 percent of its market value over three days.

European car sales tumbled 16 percent last month from a year earlier, the European Automobile Manufacturers' Association said on Sept. 16. Sales at Paris-based PSA Peugeot Citroen fell 19 percent, while Germany's Volkswagen AG, the No. 1 European carmaker, suffered a 9.5 percent drop.

``We are gloomy on the European economy; we think it's probably heading into a mild recession,'' James Shugg, an economist at Westpac Banking Corp. in London, said in an interview on Bloomberg Television. The drop in the purchasing managers' index may have been ``exaggerated a little'' as the surveys were taken ``at the time all the chaos was going on in financial markets,'' he said.

Germany, France

In Germany, manufacturing shrank more than economists forecast in September and services unexpectedly contracted, according to separate data today. Manufacturing in France also shrank faster than expected this month.

The economic slowdown has prompted economists to bring forward their forecasts for interest-rate cuts by the ECB, which in July raised its benchmark rate to a seven-year high of 4.25 percent to tackle inflation.

Citigroup Inc. on Sept. 19 said the central bank will cut the rate in December of 2009 rather than next year's second quarter. BNP Paribas this month forecast three rate cuts next year, revising an earlier prediction that the ECB would keep rates on hold.

Target Rate

Inflation in the euro area eased to 3.8 percent in August from 4 percent in July, double the ECB's target rate. Oil prices, which reached a record close to $150 a barrel in July, have dropped to around $107 today.

Measures of cost inflation within the manufacturing and services industries eased this month, today's survey showed. The gauge of prices charged by companies also declined.

``This suggests that companies' pricing power is now being diluted by markedly weaker demand and activity,'' said Howard Archer, chief European economist at Global Insight in London. ``Input prices also rose at a significantly reduced rate, thereby easing pressure on companies to raise their prices charged.''

To contact the reporter on this story: Fergal O'Brien in Dublin at fobrien@bloomberg.net.