No. 67/03
October 29, 2003

The weak economic performance observed in the euro area and EU economies at the end of 2002 continued throughout the first half of this year. Consequently, for a third consecutive year, growth is likely to disappoint: the average growth rate is expected to be a mere 0.4% in 2003 in the euro area (0.8% in the EU). However, with accommodative macroeconomic policy conditions, continued disinflation, supportive financial conditions, progress in structural reforms and a reduction in geopolitical uncertainty, the confidence of economic agents is returning and the international environment is improving. In this context, the momentum for recovery is expected to pick up in the second half of 2003 and to gather pace throughout 2004. A rebound to average growth rates of 1.8% for the euro area and 2% for the EU is projected next year, approaching 2.5% in 2005. This is underpinned by a recovery in consumer expenditure, supported by growing external demand, and a consequent recovery in investment. Despite this projected recovery, the protracted period of sluggish growth has taken its toll on the performance of the labor market and employment growth is expected to be sluggish, registering only 0.3% in 2004 and a somewhat better 0.8% in 2005.

Incipient global recovery

After the contraction in world trade in 2001 and the weak growth in 2002, the future now looks brighter. The sluggish growth in foreign trade projected for this year is deceptive, since it is affected by the poor performance in the first half of the year. It should accelerate from around 4.4% in 2003 to between 7 and 8% in 2004-2005.

World GDP growth is projected at 3.3% in 2003, up from last year's 2.8%. It should increase to a robust 4.1% in 2004 and 2005. This acceleration is supported by a number of factors, including accommodative macroeconomic policies and supportive financial conditions partially linked to further disinflation and a return of confidence, that originates from reduced geopolitical tensions and strength in asset markets.

Looking ahead to 2004, the base for world growth is widening, with strong and rising contributions coming from Asia (particularly China), the US, Australia and the acceding countries. In the US, helped by monetary and fiscal policy stimulus and solid underlying productivity growth, the recovery is expected to continue with growth at about 2.8% in 2003, rising to 3.8% in 2004. This will bring GDP growth above potential. Nonetheless, in 2004, both the general government deficit and the current account deficit are expected to widen to 5.5% and 5.6% of GDP, respectively.

The economic outlook for growth in Asia remains buoyant with growth at 6.7% in 2004-2005. Prospects for Japan have also improved with a sharp upward adjustment of growth to 2.6% in 2003, although deflation is set to continue, albeit at a lower pace, and the general government deficit is expected to exceed 7% of GDP throughout the forecast period. After stagnation in 2002, Latin America is expected to recover moderately, benefiting from currency depreciation, a pick-up in the world economy and the gradual resolution of the financial crises, which hit several countries in the region. Growth is expected to regain momentum around the end of 2003 in Canada. Also in the countries preparing for accession on 1 May 2004, continued strong growth is expected throughout the forecast period, supported by domestic demand and structural change.

Diminishing oil prices and recovering stock markets

The oil price assumptions suggest a gradual decline from a high of USD 31 (Brent crude) in mid-October to yield an average of USD 28.3 per barrel for the year as a whole. A further easing is assumed over the next two years, to USD 25.6 per barrel in 2004 and USD 24.1 per barrel in 2005.

Since mid-June, equity prices have stabilized and government yields have bounced back fairly sharply, though the latter remain low by historical standards. With lower risk premia and accommodative interest rates, financing conditions in the global economy have improved compared to last year. This should help to promote recovery particularly by facilitating a de-leveraging of the corporate sector in both the United States and the European Union.

The euro area and EU economies failed to gather momentum in the first half of 2003

Following its poor performance in 2002, the euro area economy stagnated in the first half of 2003, while the EU registered a slight up-tick.

After a promising rise in the first quarter of this year, growth in private consumption expenditure fell back in the second quarter. Investment continued to decline during the first half of the year, while the decline in inventories tapered off. Net exports exerted a significant drag on growth for the three quarters up to the middle of 2003. Government consumption became the main contributor to growth in the second quarter of this year.

There are several reasons behind this disappointing economic performance and the delay in the recovery that was expected earlier this year. Confidence both on the consumer and business sides at a global level was undermined by geopolitical tensions linked to the Iraq war, which created uncertainties about the price of oil. For the euro area consumer, this was exacerbated by uncertainties related to future labor and pension income and the adverse wealth effects of the prolonged stock market decline. The pressure on corporate profitability stemming from the over-investment of the late '90s, the long slowdown, ongoing balance sheet adjustment and the increased cost of external funds, resulting from the stock market decline, is likely to have led to the postponement of investment plans.

Prospects of a turnaround in the second half of 2003, reaching potential growth in 2004

Survey indicators have been sending out encouraging signals for the prospects of a recovery since April of this year. According to these indicators, the services sector is leading the way. Within services, the return of confidence is more gradual in retail trade. The purchasing managers' index entered expansive territory in July and has now regained the highs of early 2002. Consumer confidence is showing slow-but-steady signs of improvement, although households remain relatively cautious where major purchases are concerned.

Indicators for manufacturing suggest that the recovery is less well established in this sector. Nevertheless, leading indicators, such as the business climate indicator and the purchasing managers' indicator for the manufacturing sector, have improved. Taken together, these indicators suggest that a recession has been avoided and that the turnaround is in progress at present.

Given low interest rates and a stronger exchange rate, the source of growth should be the domestic rather than the external side. Part of the projected recovery in household and business spending in the coming months stems from the historically low interest rates, both short-term and long-term. This has contributed to an easing of the balance sheet constraints on households and businesses through a reduction in debt servicing costs. The rebound in stock markets since March of this year and the buoyant housing markets in some member states have also helped to partially restore wealth lost, following the bursting of the stock market bubble.

The real disposable income of households has received a boost from lower inflation, which will intensify as inflation declines further. The positive real income effect is supported by the appreciation of the euro and the ensuing terms of trade effect, which should be more visible in the medium-term.

While the average growth in the euro area remains limited to 0.4% in 2003, it is projected to rise to 1.8% in 2004 and 2.3% in 2005 (0.8%, 2% and 2.4% in the EU, respectively). The upturn is driven by a recovery of domestic demand, supported by rising foreign demand, starting in the second half of 2003. This is, in turn, expected to trigger an acceleration of capital formation during the course of 2004.

A less favorable labor market performance

In the initial phase of the slow growth period, employment held up quite well and the rise in the unemployment rate remained limited. The relative stability of employment in the services sector partially explains this result. Possible additional factors include labor hoarding and more flexible labor contracts. However, with the prolongation of the downturn, a less favorable picture is emerging. In 2003, some 200,000 jobs (in net terms) are expected to be lost in the euro area, the first decline since 1994. The unemployment rate is forecast to increase to 8.9% (8.1% in the EU). Given the sluggish recovery and persisting rigidities, very little job creation is foreseen for next year. Since the growth of the labor force is expected to exceed employment growth, the euro area unemployment rate will continue to rise to 9.1% in 2004 (8.2% in the EU), before edging downwards in 2005.

Inflation is starting to ease

Despite the economic slowdown, headline inflation remained sluggish in 2003, buoyed up by such temporary factors as the pass-through of oil price increases, weather-induced food price hikes and rises in indirect taxes. Compared to 2.3% in 2002, headline inflation is expected to remain at 2.1% on average in the euro area this year, before falling to 2% next year and 1.7% in 2005. Core inflation was also rather sticky during 2003 as a result of sluggish productivity growth and the slow pass-through of the effects of the euro appreciation into production and consumer prices. However, the reduction in unit labor costs, as labor productivity picks up, and wage moderation should also lead to a fall in core inflation in the medium-term.

Further deterioration of the general government deficit in the euro area with considerable differences across member states

From 2.2% in 2002, the general government deficit in the euro area (1.9% in the EU) is expected to widen to 2.8% of GDP in 2003 (2.7% in the EU). Compared to the Commission Spring Forecast of 2.5% for the euro area, this implies a worsening of the general government position in all countries except Belgium, Spain, Austria and Portugal.

With respect to 2002, the general government balance is expected to deteriorate this year in all EU countries, excluding Belgium. Within this overall deterioration, a number of country-groupings may be distinguished. The first group is composed of two countries—Germany and France—which are expected to exceed the reference value of 3% in 2003, having already been in this position in 2002. The second group includes those countries whose deficit has deteriorated this year and/or is projected to be close to the reference value: Italy, the Netherlands, Portugal and the UK. The third group consists of those countries where the deficit is forecast to remain below 1¾% of GDP in 2003: Greece, Ireland, Luxembourg and Austria. The final group contains those countries, which are still expected to post a surplus in 2003: Belgium, Denmark, Spain, Finland and Sweden.

In 2004, a slight improvement is expected for the euro area with the general government deficit declining to 2.7% of GDP (2.6% for the EU). Three countries (Germany, France and Portugal) are, nonetheless, projected to exceed the reference value of 3%. In 2005, the deficit of the euro area is expected to remain at 2.7% of GDP (2.4% for the EU). This is a result of the expected acceleration in GDP growth, since the forecast for 2005 is carried out on the basis of a “no policy change” assumption. Bearing in mind this assumption, four countries would exceed the reference value in 2005: Germany, France, Italy and Portugal.

Balanced risks to the forecast

The North American and Asian economies are sending out encouraging signals in support of a resumption in world growth. A simultaneous acceleration of growth in all major regions of the world would establish a mutually reinforcing growth momentum. However, long-standing macroeconomic imbalances may hold back a sustained expansion of the US economy. The Japanese economy is still in the early stages of recovery from its protracted recession. Therefore, the international environment might turn out to be less benign than assumed.

A renewed sharp appreciation in the euro exchange rate could undermine activity mainly in the euro-area manufacturing sector, especially in those member states that have recently depended on external demand to generate economic growth.

The protracted nature of the downturn, the uncertainties related to the Iraq war, and the balance sheet adjustment in the corporate sector have sapped confidence, leading to the postponement of consumption and investment plans. With the resumption of confidence, the release of such pent-up demand would accelerate the return to potential growth.

Business confidence can be positively affected by visible progress on structural reforms, as well as adherence to the Stability and Growth Pact framework. Finally, while geopolitical tensions have not disappeared, they have diminished in recent months, thereby reducing uncertainty at a global level.

Acceding countries: on average growth remained relatively resilient…

Despite a difficult international environment, growth in the acceding countries remained solid at the end of 2002 and in the beginning of 2003. Growth was driven by exports and a pick-up in industrial production, while private consumption remained robust and additional support was provided by lower interest rates. Reflecting the situation at the world level, investment was weak.

Average GDP growth is forecast to be 3.1% in 2003, unchanged compared to the Commission Spring Forecasts and representing an acceleration from last year's 2.3%. This compares favorably with the disappointing growth performance of the EU, but the aggregate masks different trends at the country level. Growth has been revised downwards for many countries and is forecast to be slower compared to last year. The unchanged aggregate growth figure is mainly accounted for by Poland, which is gradually emerging from two years of slow growth. For this year, expected growth varies form 0.8% in Malta, particularly affected by a fall in tourism due to global uncertainty, to 6.6% in Lithuania, which is characterized by buoyant investment, and is expected to accelerate, benefiting from EU enlargement, but employment creation remains low.

Stimulated by the recovery in the EU and the prospect of enlargement, average growth in the acceding countries is expected to accelerate to 3.8% in 2004 and to 4.2% in the following year. This pattern is foreseen in all countries, except the Baltic States, where some slowdown from high levels is projected. Increasing exports and strong private consumption, complemented by a pick-up in investment, are the main drivers of growth.

Linked to the ongoing process of restructuring, employment is contracting in the Czech Republic, Poland and Slovenia in 2003 and employment creation was relatively low in the other countries, except Slovakia and Lithuania. Overall, the situation is set to improve, but average employment creation remains subdued at 0.6% in 2004 and 1.1% in 2005. Consequently, the unemployment rate will continue to be high at around 15% in 2005.

Subdued increase in headline inflation

Inflation, at about 2.5% on average, fell significantly in 2002 and a few acceding countries experienced even falling prices during a certain period, as a consequence of strong productivity gains. In 2003, average inflation is expected to remain close to the levels observed in the euro area, but afterwards an acceleration to 3.5% in 2004 and 3.1% in 2005 is foreseen. Driving these developments are a return to the more normal situation of rising prices, the liberalization of administrative prices and a hike of indirect taxes. Underlying inflation should remain subdued as pressures from relatively strong wage increases are compensated by productivity growth.

Current account deficits remain high

The average current account deficit is forecast to stay at around 4¾% of GDP during the forecast period. This is the combined result of the correction of a very high deficit in Estonia and Slovakia and a slightly rising deficit in Poland and Latvia. Deficits remain relatively high with little adjustment in the Czech Republic and Hungary.

Six countries are likely to have general government deficits in excess of 3% of GDP in 2003

The average general government deficit in the acceding countries is estimated to be 5% of GDP in 2003. Cyprus, the Czech Republic, Hungary, Malta, Poland and Slovakia are expected to have deficits above 3% of GDP. With the improvement of the economic situation and a tightening of fiscal policy, the general government deficit is expected to decline in 2004 in most countries. A deterioration of the deficit is expected only in Poland (to 5.9% of GDP from 4.3%), in Lithuania (to 3.1% from 2.6%) and in Estonia (to 0.4% from 0.0%). In 2005, the general government balance improves in all acceding countries.

Other candidate countries: further stabilization

The other candidate countries will see a further stabilization in their macroeconomic performance. Growth is expected to converge to around 4.5% - 5% per year in all three candidate countries [Bulgaria, Romania and Turkey] over the forecast period. For Turkey, this would mean a slowdown compared to the very strong 2002 growth performance, which was however characterized by re-emergence from the deep crisis in 2001. Hence, over the forecasting period, the growth performance will follow a more stable and sustainable pattern. The slight deceleration in Romania in 2005 follows the strong boost to growth expected in 2004, which is an election year. In Turkey and Romania, disinflation should continue, driven by the trend real appreciation in these countries, a strengthening supply side of these economies, driven by strong investment and, partly, more prudent fiscal and monetary policies. Towards the end of the forecasting horizon, inflation is seen at single digits in both countries and as in Bulgaria with already quite low, but slightly accelerating, inflation.

In all three countries, current account balances are expected to widen, driven by strong domestic demand and slightly worsening price competitiveness of their exports on world markets.

More detailed information on the forecasts is available in European Economy, on the internet at:

http://europa.eu.int/comm/economy_finance/publications
/european_economy/2003/ee503en.pdf