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24 February 2004, 00:01 GMT
Recovery is under way but can it be sustained?
UNECE launches its Economic Survey of Europe, 2004 No.
1
Geneva, 20 February 2004 - Economic growth in the ECE region is forecast
to accelerate in 2004, but there are significant differences in the expected
growth performance of the major countries and subregions. Forecasts are for
robust and strengthening growth in North America and eastern Europe and even
for a continuing boom in the CIS. This contrasts with only moderate growth
prospects for the aggregate of western European countries, especially the
euro area.
But the outlook remains clouded by important downside risks.
These are largely related to the persistence of a very large current account
deficit in the United States, which in combination with a sizeable government
budget deficit could trigger abrupt changes in the direction of capital flows
and accentuate the fall of the dollar witnessed since early 2002. There are
notably concerns that a further marked appreciation of the euro could act
as a brake on the fragile recovery in the euro area.
The main challenge for governments, therefore, is how to
ensure both a sustained global recovery and a steady and progressive correction
of the United States current account deficit and the corresponding surpluses
of its trading partners.
A global recovery is underway, led by the United
States...
There is increasing evidence that a global recovery finally
took hold in the second half of 2003. The recovery is being led by the United
States, where economic activity accelerated in 2003, supported by robust domestic
demand, largely reflecting a very expansionary economic policy. Real GDP rose
by 3.1 per cent in the United States in 2003 compared with the preceding year.
Additional support for the global recovery has come from the cyclical upturn
in Japan and the continued strong growth in Asian emerging markets, notably
China and India. In the United Kingdom, moreover, economic growth has regained
strong momentum and continues to be more closely aligned with the United States'
growth cycle rather than with that in continental Europe.
...but economic activity in the euro area remained
sluggish in 2003
The forces for a recovery still look fragile in the euro
area, where domestic demand has remained weak and the impact of the sharp
appreciation of the euro on exports has been offsetting the stimulus from
an easing of monetary policy. Economic activity has been particularly sluggish
in France, Germany and Italy, the three major economies of the euro area.
The aggregate fiscal policy stance in the euro area was slightly restrictive
in 2003.
In the euro area, which remained the principal "weak spot"
of the global economy in 2003, real GDP rose by only 0.5 per cent. For the
European Union as a whole, real GDP rose by 0.8 per cent in 2003, slightly
more than for the euro area because of the resilient United Kingdom economy.
For western Europe, the aggregate annual rate of economic growth was 0.9 per
cent in 2003, down from 1.3 per cent in the preceding year (table
1).
The disappointing overall performance of most of the current
EU member States contrasts with the strong economic growth in the ten countries
that will be joining the Union in May 2004. Real GDP in these ten countries
combined rose by 3.6 per cent in 2003, up from 2.5 per cent in 2002 (table
1). Had these countries already been members in 2003, annual growth of real
GDP in the enlarged Union would have been 1 per cent, i.e. 0.2 percentage
points higher than for the EU-15. This small improvement reflects the relatively
small economic weight of the accession countries, which currently account
for only some 5 per cent of the nominal GDP of the enlarged EU.
Growth in eastern Europe strengthens...
Aggregate GDP growth in eastern Europe accelerated to 3.8
per cent in 2003, almost one percentage point more than a year earlier (table
2). This was largely due to the recovery in eastern Europe's largest economy
Poland: after two years of near stagnation, growth in Poland gained momentum
during the year and GDP rose by 3.7 per cent.
For the region as a whole, domestic demand remained (as in
2001 and 2002) the principal source of growth; with very few exceptions, net
exports pulled down the growth of output. Thanks to the ongoing restructuring
of the east European economies and the expansion of their productive capacity,
domestic suppliers were able to benefit from the strong domestic demand. Improved
financial intermediation and an expanding credit market, a consequence of
successful banking reforms, also contributed to the general strengthening
of economic activity in the region.
... and CIS economies are booming
After some deceleration in 2002, economic activity in the
CIS region surged in 2003, led by rapid growth in Russia. Aggregate GDP in
the CIS grew by 7.6 per cent, making it one of the fastest growing regions
in the world. A combination of favourable external conditions (especially
higher export prices for oil and gas) and a continuing strong recovery in
domestic demand contributed to this outcome. The enduring buoyancy in domestic
demand - reflecting growing consumer and investor confidence in many of the
CIS economies - is a sign that the difficult reforms in these transition economies
are finally starting to bear fruit.
The average rate of growth in the CIS reflects the strong
performance of the region's largest economies, Russia, Ukraine and Kazakhstan,
where GDP increased by 7 to 9 per cent (table 2). Apart from the factors outlined
above, the strong upturn in Russia was also underpinned by an expansionary
monetary policy. There were also signs of a deeper and more extensive restructuring
of the Russian enterprise sector, partly in response to growing competitive
pressure.
The short-term outlook is for higher economic
growth in western Europe and North America but cyclical growth forces continue
to differ significantly
World economic activity is expected to strengthen further
in 2004. World output growth is set to exceed 4 per cent, up from 3¼
per cent in 2003. This should be accompanied by a marked acceleration in the
volume growth of world merchandise trade to some 8 per cent, twice the rate
in 2003.
In the United States, economic growth is forecast to accelerate
to an average annual rate of about 4.5 per cent in 2004 (table 1). The recovery
should continue to be supported by the strong growth of domestic demand and
an accommodative economic policy. Exports are expected to grow briskly supported
by the depreciation of the dollar and a broadening global recovery. These
external influences on GDP, however, are likely to continue to be more than
offset by the strong growth of imports. The Federal Reserve is expected to
keep its target for the federal funds rate at 1 per cent until there are firmer
indications of a self-sustaining recovery. Fiscal policy will probably remain
expansionary, but the fiscal impulse should diminish significantly, given
that most of the output gap is likely to disappear in 2004 and in view of
the significant deterioration of the medium-term fiscal outlook.
In the euro area, recovery is expected to gain some momentum
in the course of 2004. Real GDP is currently forecast to rise by 1.9 per cent.
This reflects a pick-up in export growth and a strengthening, albeit moderate,
of final domestic demand growth, partly due to a slight upturn in business
fixed investment. Continued weak growth of private consumption expenditures
remains a major factor behind the moderate prospects for overall economic
growth. Exports should benefit from the stronger growth in world trade, which
should help to offset the dampening effects of the recent appreciation of
the euro in real effective terms. Changes in the volume of net exports, however,
are likely to have a broadly neutral effect overall as a result of the stimulus
to imports from the stronger euro.
Monetary policy is assumed to remain broadly accommodative
in view of the restraining effects of the real effective appreciation of the
euro and the favourable inflation forecast. In view of the strong appreciation
of the euro, which is unlikely to be reversed in 2004, a lowering of interest
rates would now appear to be necessary to avoid a further tightening of monetary
conditions let alone to provide a monetary relaxation. This is all the more
necessary, because fiscal policy is set to be broadly neutral in 2004.
Growth in eastern Europe and the CIS is set to
remain buoyant in 2004
Eastern Europe and the CIS are poised to remain the most
dynamic parts of the ECE region in the short run. While GDP growth in eastern
Europe is expected to accelerate to some 4.5 per cent, in the CIS it is set
to slow down to 5.7 per cent in 2004, a rate similar to that in 2001 and 2002
(table 2).
In 2004, growth should accelerate in most east European economies.
These generally optimistic forecasts reflect expectations of a strengthening
recovery in western Europe, which is their main export market. The new EU
members should also benefit from positive effects of EU accession on business
and consumer sentiment. The acceleration of FDI-led restructuring in some
of the south-east European countries has strengthened the supply side of their
economies, and this provides a basis for a sustained recovery in the coming
years. Most countries in eastern Europe are relying on stronger demand for
their exports in 2004 (than was the case in the previous two years) not only
to support domestic activity but also as a way to revert to a more balanced
pattern of growth: a shift towards export-led growth should help to reduce
the existing external deficits.
In the CIS, some moderation of growth is expected in 2004,
reflecting expectations of a slowdown in the region's largest economies. Economic
activity in Russia should generally remain buoyant in 2004 but GDP growth
is set to slow down slightly, to some 5-6 per cent, mostly due to a more moderate
expansion in the oil sector. A similar pattern is also expected in other CIS
economies but despite the deceleration, output growth should generally remain
robust throughout the region. Strong domestic demand will continue to be an
important source of growth for the CIS economies.
But there remain important downside risks to
the short-term outlook in the ECE region...
Although the baseline forecast is for a sustainable global
recovery in 2004 and its continuation in 2005, the short-term economic outlook
remains, nevertheless, vulnerable to important downside risks.
A major source of uncertainty is the sustainability of the
recovery in the United States, given its strong impact on economic growth
in the rest of the world. Downside risks continue to be associated with the
persistently high level of private household debt and the ongoing boom in
the housing market, which helped to sustain personal consumption growth. Another
uncertainty is the currently much weaker link between economic growth and
employment compared with previous recoveries, at least so far. If new job
creation continues to be lower than expected, it could dampen consumer confidence
and spending propensity. Persistently large fiscal deficits could, moreover,
trigger a rise in United States long-term interest rates, which would probably
spill over to the euro area and Japan, with adverse consequences for interest-sensitive
expenditure items.
... largely related to the considerable United
States current account deficit...
A persistent source of worry is the large current account
deficit, which now corresponds to 5 per cent of GDP, the highest level on
record. Concerns in international financial markets about the sustainability
of the current account deficit are reflected in the pronounced weakening of
the dollar since early 2002. In the face of a persistently large current account
imbalance, therefore, the risk of sudden and disruptive capital flows and
the associated changes in exchange rates (especially an accelerated weakening
of the dollar) cannot be excluded.
The problem is that the weakness of the dollar has occurred
at a time when the recovery in both the euro area and Japan is still fragile,
and when both, to a large extent, are relying on an initial strong impulse
from foreign demand. A dilemma is that the adjustment of the United States
current account imbalance cannot be brought about by the exchange rate alone.
What is also required is a stronger rate of growth of domestic demand in the
rest of the world and a sustained increase in the United States national savings
rate.
Persistent weakness of domestic demand in the rest of the
world puts disproportionate emphasis on the exchange rate as a means of adjustment.
There is therefore a risk that the dollar depreciation will overshoot in 2004
and choke off the recovery in Europe and Japan, via its adverse impact on
exports, profits and business investment.
In western Europe, the successive downward revisions of (already
moderate) growth forecasts risk having a negative effect on long-term growth
expectations in the business sector, with attendant negative effects on productive
investment and the growth of potential output. The ambitious goals of the
EU Lisbon strategy now look increasingly elusive and are likely to be even
more out of reach after enlargement. While the need for supply-side reforms
is undisputed, they need to be complemented with a coherent macroeconomic
policy framework that is conducive to economic growth.
The euro area needs a more flexible fiscal policy
framework
It is therefore important that the envisaged reform of the
Stability and Growth Pact finds an appropriate balance between the need to
ensure fiscal sustainability over the medium and longer term and sufficient
flexibility for fiscal policy to support economic growth (see below). A broader
mandate for the ECB - emphasizing the importance of giving due attention to
both inflation and the growth of employment - would also be helpful.
In the euro area, apart from the concern that a stronger
euro could choke off the recovery, business investment could be held back
by the lingering balance sheet problems in the corporate sector in several
countries, especially France, Germany and Italy. Another uncertainty is how
far households' spending propensities will be affected by the long-standing
discussions about future pension entitlements and the funding of rising health
care costs. There has also been a sizeable increase in household debt in recent
years, largely related to a surge in house prices in several countries (notably
Greece, Ireland, the Netherlands and Spain). As in the United Kingdom and
the United States, there is a risk that rising interest rates could trigger
a fall in house prices with adverse effects on consumer spending.
Macroeconomic imbalances need to be corrected
in eastern Europe...
The most serious external risk for eastern Europe is the
presently lacklustre west European import demand that, if it fails to improve,
could disappoint east European hopes of robust export growth. The existing
macroeconomic imbalances are another important source of downside risks: policy
makers are under increasing pressure to take action to correct large and sometimes
growing current account deficits. In addition, if efforts to consolidate the
public finances in central Europe fail to reduce the large fiscal deficits,
a further tightening of monetary policy may be the prospect. In the short-run,
such policy responses are likely to have negative consequences for economic
activity in the countries involved.
... and in the CIS
Apart from the uncertainties surrounding world commodity
markets, there are also additional downside risks to the short-term outlook
for the CIS economies. Macroeconomic imbalances in some of them may prompt
governments to tighten macroeconomic policies (after a general relaxation
in 2003), and this could lead to some moderation in growth rates. Some of
the more indebted CIS economies may encounter balance of payments constraints
that could further weaken their growth. Finally, if Russia's growth falls
below expectations, there will be negative repercussions for all the other
economies in the region.
*
* *
Selected policy issues
(i) The Stability and Growth Pact must be reformed
The causes of the current crisis concerning the fiscal rules
of the Economic and Monetary Union (EMU) can be traced in part to the sins
of omission in good economic times a few years ago, when some countries failed
to exploit the available scope for fiscal consolidation. But the current crisis
has also to be seen against the background of a persistent controversy surrounding
the EMU's fiscal rules ever since the adoption of the Stability and Growth
Pact in 1997. This controversy is not so much about the need for fiscal rules
in a monetary union, but rather about their specific design.
A major problem is that EU member States differ significantly
in their economic structures, and this in turn affects their longer-term economic
potential. The economic rationale for imposing a one-size-fits-all fiscal
policy framework thus appears highly questionable. Such an approach will become
even more difficult to justify after the enlargement of the EU in May 2004,
which will lead to a further increase in the heterogeneity of economic structures
across the EU membership.
The major elements that an envisaged reform should include
can be summarized as follows:
-
A regular assessment of long-term sustainable debt
levels including implicit government financial obligations (such as pay-as-you-go
pension entitlements);
-
The creation of an effective mechanism for controlling
the growth of government debt beyond a certain agreed limit (as a per
cent of GDP);
-
A shift in the focus of the budgetary surveillance
process from annual budget deficit targets to multi-annual (e.g. five-year)
targets;
-
A review of the too restrictive definition of "exceptional
circumstances" that allow the 3 per cent budget deficit threshold to be
exceeded (if the latter is to be upheld);
-
A waiver of the 3 per cent budget deficit ceiling
for countries with low and clearly sustainable levels of debt;
-
The introduction of the golden rule, i.e. to allow
borrowing for the financing of public investment;
Allowing automatic stabilizers to operate freely in a cyclical downturn;
-
The control of fiscal profligacy in periods of strong
growth;
-
A mechanism for ensuring non-partisan assessment of
compliance (or non-compliance) with the fiscal rules.
The main requirement of any reform of the SGP is to create
a coherent set of fiscal rules that combine sufficient flexibility for fiscal
policy to stabilize economic activity in the short run with a mechanism that
prevents an excessive growth of government debt in the medium and longer term.
Reform of the SGP should aim for a more flexible framework that, to the greatest
extent possible, should allow for the differential treatment of countries
based on commonly agreed principles and transparent fiscal sustainability
criteria. To ensure broad political support for the reformed fiscal framework,
considerable efforts must be made to explain its rationale and functioning
to the wider European public.
But the ultimate test is not whether governments can be held
to the rules but whether the rules can ensure - or ease the way to - better
economic performance and improved levels of welfare. If they are seen to obstruct
such improvement - and this will be especially important for the new EU members
- then the framework will lose legitimacy and eventually collapse.
(ii) The countries acceding to the EU face new
challenges
EU membership entails major new policy responsibilities for
the acceding east European countries. One of the key challenges in the area
of macroeconomic policy lies in their preparation for EMU accession, which
requires that the applicants comply with the Maastricht criteria. Progress
by the acceding countries in meeting these has been mixed. In particular,
large fiscal deficits are a major problem for most of the central European
countries. The Maastricht criteria also require participation - without severe
tensions - for at least two years in the EU's exchange rate mechanism ERM-2
prior to EMU entry. However, this type of monetary regime carries potential
risks for the economies that join it. The combination of a fixed (although
adjustable to some extent) exchange rate and the absence of capital controls
leave local financial markets vulnerable to volatile movements of speculative
capital. This was clearly demonstrated by the experience of Hungary (a country
that runs an exchange rate regime similar to ERM-2) in 2003. The choice of
policies towards EMU accession remains one of the most debated issues in the
acceding countries. While initially a number of acceding countries were aiming
at fast EMU accession, most of them now envisage a further preparatory period
of some four to five years after accession to the EU.
The policy debate over the strategy for joining the euro
area also raises the question as to whether the Maastricht criteria in their
present form should be applied to the new EU members. Thus the presence of
higher inflation, which is related to a productivity catch-up and is not rooted
in lax policy, could justify a reinterpretation of the Maastricht inflation
criterion. Another relevant issue is that the acceding east European economies
still suffer from poor infrastructure and hence more public investment could
improve considerably their growth prospects. In turn, this would justify a
reinterpretation of the required deficit target for these economies in terms
of the "golden rule" of public finance, that is, the allowed deficit should
be net of debt-financed public investment.
(iii) Towards closer economic integration in
the CIS
In September 2003, the Heads of State of the four largest
CIS economies, Belarus, Kazakhstan, Russia and Ukraine, signed an agreement
stipulating the establishment of a Single Economic Space (SES) among them.
The framework agreement envisages broad ranging economic integration: establishment
of a free trade area among the participating countries (free movement of goods,
services, capital and labour); unification of internal technical norms and
standards; harmonization of macroeconomic policy; harmonization of all legislation
and regulations related to the functioning of the SES in the member States.
SES is the most ambitious initiative for economic integration
(compared with several previous ones) among the CIS countries. For the first
time, it spells out clearly the goal of establishing a common economic area
that has all the essential features of an economic union. The main unknown,
however, is to what extent this agreement will actually be put into effect
and how fast the four countries will be willing and able to move towards closer
economic integration. The lessons from past similar attempts (as well as from
the EU's rich experience in advancing economic integration) suggest that policy
makers in the founding members of the SES should carefully define their joint
economic interests and focus their initiatives along these common interests.
The successful creation of a functioning free trade area will probably be
a necessary first step before the member States can turn to more advanced
levels of integration.
For further information please contact:
UNECE Economic Analysis Division
Palais des Nations
CH - 1211 Geneva 10, Switzerland
Phone: +41(0)22 917 20 84
Fax: +41(0)22 917 03 09
E-mail: [email protected]
Web site: http://www.unece.org/ead/survey.htm
Ref. ECE/GEN/04/P08