UNUnited Nations Economic Commission for Europe

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Persistent economic weakness in euro area contrasts with robust expansion in eastern Europe and the CIS

UNECE launches its Economic Survey of Europe 2005 No. 2

Geneva, 21 July 2005 - This issue of the Survey provides an assessment of the macroeconomic situation and the short-term outlook in the summer 2005. It updates the assessment made in the Economic Survey of Europe 2005 No. 1, which was finalized in late January this year. In addition, this Survey contains a study on the issue how to sustain growth in a resource-based economy using the specific case of Russia, which was prepared for the UNECE Spring Seminar held in February.

A balancing act – global recovery continues …

In mid-2005, the consensus of forecasters is for continued robust global economic expansion in 2005, albeit at a somewhat lower rate than in 2004. World output is expected to increase by 4 per cent. The continued expansion will be supported by favourable financing conditions, with long-term interest rates expected to rise only slightly. The difference between growth in the United States and in the other major industrialized economies, however, will widen in 2005. Modest growth prospects in western Europe continue to contrast with the persistent economic dynamism of eastern Europe and the CIS.

In the United States, real GDP is forecast to increase on average by 3.5 per cent in 2005, about a percentage point less than in 2004. With the United States continuing to act as a “locomotive” for the world economy (given weak domestic demand in the other major advanced economies), the large current account deficit is set to deteriorate further. The expansion remains very dependent on household consumption spending, which will be supported by rising real incomes, a stronger demand for labour, and increased net wealth resulting from the surge in house prices. The Federal Reserve is expected to continue its gradual tightening of monetary policy towards a neutral stance, which will tend to dampen economic growth. The expansion is currently expected to continue at a rate close to trend in 2006 as well.

… but important global downside risks have not diminished.

The pattern of downside risks to this overall favourable global outlook has, however, changed for the worse during the first half of 2005 in comparison with the assessment made at the beginning of the year. These risks centre around the developments in the oil markets; the further widening of global external imbalances; a sudden and sharp reversal of the rise in house prices in many countries, where they have reached levels regarded as out of line with “fundamentals”; and a stronger than anticipated rise in long-term interest rates from their current unusually low levels.

Although the adverse economic impact of higher oil prices has so far been relatively small, the large cumulative increase over the past two years must inevitably bring them closer to a point at which the economic pain for households and end-users in industry will be increasingly felt. In any case, further rises in oil prices will increase the risk of dampening and even choking off economic growth in the oil importing countries.

A persistent challenge remains the orderly reversal of the unprecedented global imbalances, with rising current account deficits in the United States mirrored in rising surpluses in the rest of the world, notably Asia. There is still a risk that a change in financial market sentiment could suddenly trigger a sharp and sustained decline of the dollar, with concomitant upward pressures on inflation and interest rates in the United States and adverse spillover effects on other asset markets and regions in the global economy.

The strength of the dollar from the second quarter of 2005 means that exchange rates are moving in the opposite direction required for dealing with the global imbalances, which means that the risk of a sharp adjustment at a later stage could be increasing.

Euro area: The lean years

In the euro area, growth forecasts have again been lowered. Real GDP is now expected to increase by only 1.3 per cent in 2005. (In January of this year the consensus was for a growth rate of 1.7 per cent.) The continued rise of oil prices in 2005 has curbed the purchasing power of private households, at a time when consumer confidence was already low due to uncertainties about employment and the impact of intensified international competition. Exports have been held back by the lagged effects of the strong euro and the slower growth of global demand.

The recent weakening of the euro has only partially offset the large appreciation against the dollar since early 2002 and, if not reversed, will have a positive effect on economic activity.

The persistent sluggishness of aggregate domestic demand, which now has spread to all three major economies, remains the key problem of the euro area. On current forecasts, economic activity might gain slightly more momentum in 2006, but this will depend on the development of the global economy and on the price of oil.

Growth rates are set to continue to diverge significantly among the twelve economies in 2005, with the average for the euro area being pulled down by the weakness of the three major economies. Real GDP is forecast to (at best) stagnate in Italy and to increase only moderately in Germany (0.9 per cent) and France (1.6 per cent). Among the smaller economies, sluggish activity in the Netherlands and Portugal contrasts with continued solid growth in most of the other countries.

Finding the appropriate policy mix

The persistent sluggishness of economic activity in the euro area, in combination with a widening output gap and persistently high rates of unemployment point to the need for a cut in the ECB’s main official interest rate, which has been at 2 per cent since June 2003. On current forecasts, moreover, inflation will fall below the ECB’s 2 per cent ceiling in 2005 and 2006. But the euro area may now well be on the edge of a Keynesian liquidity trap.

While lower interest rates may be desirable they are unlikely to provide much of a boost to economic growth given that such a move would hardly lead to a further significant lowering of long-term interest rates, which are already at exceptionally low levels. Nevertheless, even if the additional monetary stimulus were small, it would send a signal to economic agents that the ECB is also concerned about raising growth and employment, as in fact it should be, as mandated by the Treaty of Amsterdam. There has been progress in structural reforms in recent years and much more will undoubtedly have to be done – but it is in the very nature of these reforms that their growth effects will generally appear only with a relatively long lag. Finding an appropriate macroeconomic policy mix, with a supportive role to be played by fiscal policy, is now the major challenge.

The economies of new EU member states preserve their dynamism

The short-term outlook for the new EU member states from central Europe and the Baltic region remains generally favourable. Both in 2005 and 2006 the average rate of growth of these subregions, as well as the GDP growth rates in most countries are likely to remain significantly higher that those of the old EU member states (table 1).

Restructuring and economic modernization (on the supply side) together with strong investor and consumer confidence (on the demand side) will remain the principal engines of growth in the short run. Macroeconomic policy in the new EU member states is set to remain moderately supportive of economic growth, and will benefit from the recent changes in the rules of the EU’s Stability and Growth Pact, which provide for increased policy flexibility. On the downside, the forecasts of GDP growth are subject to the risk of weakening external demand, especially in western Europe that absorbs the bulk of regional exports.

The re-appearance of high rates of inflation is unlikely in any of the EU-10 countries, but their rates are still generally higher than in the old EU member states. Large fiscal deficits are another problem, especially in the central European economies. Regardless of the desired timing of their accession to the EMU, these issues will remain the focus of macroeconomic policy in the EU-10 in the short- to medium term.

South-east Europe: the large current account deficits are in the focus of macroeconomic policy

With domestic demand outpacing aggregate output throughout south-east Europe, the external imbalances of many countries are escalating. These large current account deficits are risky for immature market economies that are susceptible to external shocks. Policy makers in south-east Europe have undertaken various measures to curb the growth of domestic demand in an effort to halt the further expansion of these deficits. However, the ongoing general tightening of macroeconomic policies may have adverse effects on the growth of domestic output in the short run.

Nevertheless, in most parts of south-east Europe, economic growth is expected to remain relatively strong, but at a slightly lower rate than in 2004. The fact that the region’s aggregate GDP growth rate in 2005 will be more than 2½ percentage points lower than in 2004 mainly reflects the slowdown from exceptionally high rates in the two largest economies, Turkey and Romania. GDP in most of south-east Europe is expected to grow at rates between 4 and 6 per cent through 2006.

Despite some slowdown, strong economic performance will prevail in the CIS

Economic growth in the CIS region is generally set to remain relatively strong through 2005 but its pace is slowing down in some economies (table 2). Commodity exporters (especially those specialized in hydrocarbons) continue to benefit from high world market prices and robust demand in some of their main markets. Current trends suggest a continuing rise in real disposable incomes, which are underpinning buoyant domestic demand. Macroeconomic policies are generally set to remain expansionary, providing further support to the growth of the output and real incomes. This, however, is also a source of downside risk, as the loosening of macroeconomic policy (which in some cases has been under way for several years) is not sustainable and has already led to rising inflationary pressures in a number of countries.

The outlook for the Russian economy hinges on the balance of divergent trends in some key industries. Thus, while rapid growth continues in some sectors of the economy, particularly in market services (underpinned by strong consumer spending), other industries, such as manufacturing, have slowed down considerably (partly as a result of the losses in competitiveness due to the persistent appreciation of the rouble’s real exchange rate). As to domestic demand, Russian consumers continue to be the mainstay of the economic expansion, whereas investment activity has weakened markedly. Macroeconomic policy in Russia remains beset with consistency problems: the monetary authorities in fact face a trilemma, as they are not only struggling to balance the mutually exclusive goals of targeting both the exchange rate and the inflation rate under the pressure of sizeable inflows of foreign exchange, but at the same time they are having to cope with the inflationary consequences of a continuing fiscal loosening.

The marked slowdown in Ukraine’s economy in the early months of 2005 will affect the average performance for the year as a whole. As the demand for Ukraine’s exports is likely to deteriorate further (especially for steel), this implies that net exports will have a diminishing influence on output growth. This shift in the sources of economic growth is expected to lead to a further deceleration in the rate of output growth for the year as a whole. As a result of the drastic deterioration in the government’s financial balance, which was associated with the 2004 presidential election campaign and has led to a resurgence of inflation, Ukraine now faces the need for a major effort at fiscal consolidation.

In contrast, economic growth is likely to maintain its momentum in the two other large CIS economies, Kazakhstan and Belarus. In Kazakhstan, strong domestic demand should continue to provide the main impetus for economic activity and GDP is forecast to grow by some 8 per cent in 2005. One of the downside risks arises from the pre-election fiscal loosening (reflected in a sizeable increase in social spending), which may lead to higher inflation and prompt a tightening of monetary policy. Rapid economic growth is also expected to continue in Belarus, with GDP forecast to grow by close to 10 per cent in 2005. Accommodative monetary policies and strong import demand in its main export market, Russia, should continue to support activity, at least in the short run.

In the Caucasian Rim, economic growth should remain strong in Armenia and, especially, in Azerbaijan, where the new Baku-Ceyhan-Tbilisi pipeline should start operating at full capacity before the end of 2005. A rapid economic recovery is expected to continue in Tajikistan, but some moderation of output growth is expected in the other central Asian CIS economies. The downside risks to the economic outlook in Kyrgyzstan have increased considerably since the beginning of 2005 due to the political turmoil in the country and newly emerging problems with gold production.

A gradual economic slowdown is likely to continue in 2006 in the CIS as a whole, as well as in some of the largest economies. While total output in the region will continue to grow at relatively high rates, sustaining these in the medium and longer run will require an acceleration in the process of systemic and structural reform.


For further information please contact:

UNECE Economic Analysis Division
Palais des Nations
CH - 1211 Geneva 10, Switzerland

Phone: +41(0)22 917 24 92
Fax: +41(0)22 917 03 09
E-mail: [email protected]
Website: http://www.unece.org/ead/ead_ese_new.htm

Ref: ECE/GEN/05/P08