Geneva, 28 February 2003

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Not to be released before
4 March 2003, 00:01 GMT

The economic outlook for the UNECE region in 2003: clouded by downside risks

UNECE releases its Economic Survey of Europe, 2003 No.1

Global economic developments were disappointing in 2002. Hopes for the beginning of a sustained recovery from the recession of 2001 were frustrated. The consensus of forecasters is now for a recovery to start in the second half of 2003 and to gain further momentum in 2004. The short-run outlook for the world economy, however, remains dominated by significant downside risks stemming in particular from a possible war in Iraq and from global financial imbalances (see below).

World output growth in 2002 continued to be strongly dependent on economic developments in the United States. Economic activity in Japan and western Europe, both potential engines of growth for the world economy, remained disappointingly sluggish, partly because of self-imposed constraints on more growth-supporting macro-economic policies. In contrast, growth in eastern Europe and the CIS remained quite resilient to the weak international economic environment. (For details on the economic performance in eastern Europe and the CIS see Press Release ECE/GEN/03/P04).

Western Europe and North America

Uncertainty surrounding the short-term economic outlook is amplified by the increasing possibility of a war with Iraq. This has already contributed to the weakening of consumer and business confidence and has fostered a wait-and-see attitude with regard to big spending items. Even the available baseline forecasts, which assume that there will be no military conflict, however, suggest only a moderate strengthening of growth in the global economy in the course of 2003.

The United States is again seen as leading the global recovery. Expectations are for a limited cyclical upturn in the first half of 2003, which should gather momentum in the second half of the year. The associated strengthening of domestic demand would then stimulate economic activity in the rest of the world, including western and eastern Europe and the CIS.

Real GDP in the United States in 2003 is expected to increase by about 2.5 per cent (table 1.1.2). This outcome is based on the assumption of a faster rate of economic expansion in the second half of the year, driven by strengthening private consumption and a recovery of business fixed investment. The growth of consumer demand, however, will be restrained by the need of households to increase savings in the face of their high debt servicing burdens, the considerable loss of financial wealth stemming from the plunge in share prices, and concerns about the problems facing pension funds. The scope for higher business capital spending will similarly be circumscribed by the need to reduce corporate debt. Exports should be supported by the gains in price competitiveness stemming from the depreciation of the dollar in 2002 and the expected upturn of economic activity in other regions of the world. Changes in real net exports are expected to be less of a drag on economic growth in 2003 than in 2002. The current account deficit is forecast to reach some 5¼ per cent of GDP, reflecting inter alia the differential strength of domestic demand in the United States and the rest of the world.

In western Europe, forecasts of economic growth in 2003 have been generally lowered since the autumn of 2002. Real GDP in the euro area is now forecast to increase by 1.4 per cent in 2003, up from 0.8 per cent in 2002 (table 1.1.2). The modest expected growth rate for 2003 is pulled down by the continued sluggishness of the German economy, where real GDP is forecast to increase by less than 1 per cent for the third consecutive year. But growth will also be weak in France and Italy and many of the smaller economies.

Exports will be the most dynamic component of final demand, reflecting a stronger cyclical momentum in the global economy in the second half of the year. But the overall stimulus to economic activity will still be relatively modest, as is reflected in the expected modest acceleration in the growth of total domestic demand. This increase of domestic demand, moreover, will be accompanied by rising imports, while export growth is likely to be restrained by the appreciation of the euro. Changes in real net exports are therefore likely to be broadly neutral in their impact on overall economic activity in 2003. Output growth in the euro area will remain below trend, leading to a further increase in the output gap. Against this background, inflation is expected to fall below the 2 per cent ceiling of the ECB's target range in 2003 and unemployment can be expected to increase.

Monetary policy in the euro area shifted to a more accommodative stance in early December 2002, but the real appreciation of the euro has effectively led to a tightening of monetary conditions, offsetting the impulse from lower real interest rates. The appreciation of the euro, moreover, will tend to reduce imported inflationary pressures and this, in combination with the expected sluggishness of economic activity in early 2003, should enable the ECB to reduce interest rates again. Fiscal policy is faced with deteriorating total and structural government financial balances and the constraints on active policies imposed by the Stability and Growth Pact (SGP) (See: Press Release ECE/GEN/03/P06). On average, fiscal policy will not be supporting economic activity in the euro area in 2003, given inter alia the significant budgetary consolidation required in Germany and other large economies to meet their SGP commitments.

Outside the euro area, real GDP in the United Kingdom is forecast to grow by some 2.4 per cent in 2003, up from 1.6 per cent in 2002. There are major uncertainties, however, related to the future developments of house prices and the related strength of private consumption expenditures. Low interest rates will continue to support domestic demand.

In aggregate, real GDP in western Europe is expected to increase by some 1¾ per cent in 2003, up from 1 per cent in 2002. This is not an inspiring prospect and one, which will contribute very little to correcting the major imbalances in the global economy.

Downside risks

Leaving aside the lingering banking crisis in Japan, the major downside risks are the high levels of indebtedness of the private sector (both business and household) in major industrialized countries, and the large current account deficit in the United States and, partly related to that, low household savings and the high value of the dollar. But in addition there is now the acute risk of a military conflict in Iraq.

Military and non-military costs highly uncertain

The economic consequences of a war in Iraq are difficult to estimate and depend on the duration of the conflict (ranging from a short intervention to a more protracted conflict), the total damage caused to Iraq, and the possible extension of the conflict and instability beyond that country.

The budgetary costs for the United States (and possibly other countries) are highly uncertain, as is the broader economic impact on the global economy. The latter will depend not only on what happens to the price of oil but also on the impact of (higher) defense spending and how the outbreak of war will affect consumer and business confidence.

Consumer confidence in western Europe fell in January 2003 to its lowest level since the end of 1996, while in the United States, it reached its lowest level since the end of 1993. In the international equity markets, prices fell to six-year lows in late January 2003. These developments, however, reflect not only the threat of war in Iraq but also the bleak outlook for jobs and profits. The open question is to what extent confidence and the equity markets will continue to decline in the event of the actual outbreak of military conflict. In any case, the already low levels of confidence and share prices do not bode well for private sector spending in 2003.

Higher oil prices might cause a recession

Oil prices rose above $31 per barrel in January 2003. If maintained at that level throughout 2003, this would be tantamount to a considerable "oil tax" which would increase inflation and dampen the growth of real incomes and the global demand for goods and services. According to some estimates, a temporary (one-year) increase in oil prices by $10 per barrel would, on average, reduce total economy output by a quarter of a percentage point in the industrialized countries and raise inflation by half a percentage point. Given the weakness of the present conjuncture, however, the effect of such an increase on output might be much larger.

A sustained rise in oil prices to much higher levels could even push the western economies into recession. This might happen in the event of a conflict that is more protracted than expected, especially if combined with disruption (or threats of disruption) to oil supplies and further adverse shocks to consumer and business confidence.

The conflict could however be short and be followed by a sharp fall in oil prices, thereby boosting business and consumer confidence as well as real disposable incomes. However, the adjustment problems associated with the considerable global financial imbalances would still be present. It is therefore not certain that even a swift resolution of the Iraq crisis would actually lead to a sustained recovery of economic activity in the United States and the global economy at large.

Global financial imbalances

A major challenge remains the gradual reduction of the United States' huge current account deficit and, associated with that, a gradual depreciation of the dollar. Although the dollar was weakening significantly and in an orderly fashion in 2002 and early 2003, there is still a risk of a more abrupt adjustment in international capital flows and exchange rates. This might reflect increased concerns on the part of international investors about the persistence of large external imbalances and the associated accumulation of foreign debt in combination with the re-emergence of large government budget deficits (the so-called "twin deficit" problem).

Any accelerated depreciation of the dollar would raise imported inflation and would eventually force a tightening of monetary policy in the United States. It would, moreover, act as brake on economic growth in the euro area, Japan and other Asian economies. Such an outcome would be likely to trigger a coordinated intervention by the major central banks.

Another downside risk is that the pace of balance sheet adjustments by private households and the corporate sector in the United States could be more rapid than assumed, which would depress domestic demand growth. This might also be caused by a further sharp fall in equity prices or a reversal in the boom of residential real estate. The latter is also a matter of concern in the United Kingdom.

Deflationary risks need attention

In a context of low inflation and sluggish economic activity, a collapse of equity prices, large margins of excess capacity and interest rates already at low levels, many commentators have expressed worries about the risk of sliding into a deflationary spiral. The reason is that since official nominal interest rates cannot be reduced below zero, the room for manoeuvre of monetary policy in a severe cyclical downturn may be quickly exhausted. In Germany, where inflation was about 1 per cent in 2002 and economic activity was stagnating at a low level, there appears to be the potential for a deflationary development.

The sustained deflationary slump in Japan illustrates the point that once an economy has entered a deflationary process, it may be very costly and difficult to reverse. Compared with that situation, the costs of a temporary, excessive monetary loosening would have been more limited and more easily corrected. In Japan, the degree of monetary loosening proved inadequate and, with hindsight, a precautionary further loosening of monetary policy in the first half of the 1990s would have been justified. In a similar vein, a timely and moderate additional fiscal loosening might have been sufficient to maintain economic activity.

The general lesson is that when inflation and interest rates have fallen close to zero, active policies should not be held back by fears of an excessive stimulus, which can be reversed later through the tightening of policies.

Although the possibility of deflation still appears to be remote in most industrialized countries, the risk has increased and should not be ignored. Any prospect of deflationary tendencies can certainly be countered by the timely creation of a conducive environment for a sustained economic recovery.