There are increasing indications of a strengthening global economic recovery during 2003. This is reflected in improved business and consumer confidence, favourable profit expectations in international equity markets and rising indicators for industrial and services activity, as emphasized in the Economic Survey of Europe just released by the United Nations Economic Commission for Europe (UNECE).
There are marked regional variations in economic growth in 2003. The United States has remained the main engine of global economic growth. But there was also a surprisingly strong rebound of economic growth in Japan and growth has also been strong in Asian emerging markets, notably China. In contrast, Western Europe is much behind in the international business cycle, though economic activity picked up somewhat in the third quarter. In Eastern Europe and the CIS, growth has remained buoyant despite the deteriorating external economic environment, which was offset by the robust growth of domestic demand.
Economic growth is expected to strengthen in all major regions of the global economy in 2004, with a continued significantly below average performance in Western Europe. Growth in Eastern Europe will continue to be considerably stronger than in Western Europe.
The sustainability of the global recovery hinges notably on an improved situation in the labour markets, for which there are currently only tentative indications. But there are other major downside risks related to the realignment of exchange rates of major currencies and the large external imbalances in the world economy.
(i) Western Europe and North America
In the United States, the recovery gained considerable momentum in 2003, driven mainly by expansionary monetary and fiscal policies and the gain in price competitiveness stemming from the depreciation of the dollar. In late September 2003, when the Survey was finalized, real GDP in the United States was forecast to increase by somewhat more than 2.5 per cent in 2003 compared with the preceding year. But against the background of the buoyant growth in the third quarter of 2003, it is now expected that the outcome will likely be some 3 per cent. The stronger cyclical momentum will carry over into 2004, when real GDP is expected to rise by some 4 per cent (table 1). Against this background, baseline forecasts assume a gradual withdrawal of the sizeable monetary stimulus in the course of 2004.
In the euro area, economic activity is expected to remain very sluggish in the second half of 2003. This reflects persistently weak domestic demand and the restraining effects on exports of the sizeable real appreciation of the euro in an international economic environment, which is still relatively weak. Forecasts of growth in the euro area have been lowered to a mere 0.5 per cent in 2003. This very modest outcome reflects not only persistent economic stagnation in Germany but also a pronounced cyclical slowdown in France and Italy and in several of the smaller economies in the euro area (table 1). Economic growth in the remaining three EU members outside the euro area should remain significantly above the euro area average. Taking into account the performance of the non-EU economies, real GDP in Western Europe is expected to increase by just 1 per cent in 2003.
Overall, the prospect is for a relatively lacklustre cyclical upturn, supported by low interest rates, the favourable impact of falling inflation on real personal disposable incomes and household spending, some inventory rebuilding, and the expected gradual improvement of the external environment. Given the weak rate of output growth, however, the situation in the labour markets will hardly improve and this will dampen consumer confidence.
Against this background, current forecasts are for only a moderate acceleration of economic growth in the euro area in 2004, to an average annual growth rate of somewhat less than 2 per cent. For Western Europe as a whole, the national forecasts add up to an aggregate growth rate of 2 per cent, reflecting the continuing stronger cyclical momentum outside the euro area.
Can the recovery be sustained?
The improved global economic outlook is dependent on the United States maintaining its role as the engine of growth for the world economy. The problem with this scenario is that it will accentuate the already huge external imbalance of the United States and increase the risks of disruptive adjustments of capital flows and exchange rates of the major currencies. This points to the need to create a more conducive environment for growth of domestic demand in the rest of the world to better accommodate the external adjustment process in the United States. While the depreciation of the dollar is part and parcel of the necessary adjustment required of the United States, the burden has so far fallen disproportionately on the euro area, given the exchange rate policies pursued in Asian economies. On the other hand, persistent weakness of euro zone domestic demand also puts disproportionate emphasis on the dollar exchange rate as a means of adjustment.
There are several other important downside risks facing the United States economy. The recovery has so far not led to any significant improvement in the labour market, and a continued "jobless recovery" could erode consumer confidence and dampen household spending, which has been the mainstay of economic growth even during the cyclical downturn. Consumer spending could also be adversely affected by a further rise in long-term interest rates, especially given the very high levels of household debt. This could trigger an end to the housing boom with concomitant downward pressure on house prices and adverse wealth effects. In any case, rising interest rates are bound to restrain consumer spending, inter alia, because of their adverse effects on mortgage refinancing, which has been a major source of additional spending power over the past few years. Rising long-term interest rates would also affect business investment, the future strength of which is in any case uncertain because of the considerable margins of excess capacity. A weaker than expected recovery would also risk frustrating the currently optimistic profit expectations, reflected in the surge in equity prices during the first three quarters of 2003, with associated risks of negative wealth effects on aggregate demand.
In the United States, both monetary and fiscal policy have responded forcefully to the progressive weakening of economic activity. The federal funds rate is now only 1 per cent and it is clear that the margin for conventional monetary policy measures to stimulate economic activity is now largely exhausted. The fiscal position has deteriorated significantly, leaving little scope for additional expansionary measures and raising concerns about its sustainability in the medium and longer term. There is also the persistent risk of adverse reactions in the capital markets to the large "twin deficits" with concomitant negative effects on interest-sensitive expenditure.
In the euro area, there is still scope for a further relaxation of monetary policy, and this is desirable in view of the moderate outlook for growth, forecasts of inflation falling below 2 per cent, and the fact that the earlier relaxation of monetary policy was largely offset by the sizeable real appreciation of the euro. As regards fiscal policy, at the current juncture it would be counterproductive to prevent the automatic stabilizers from operating fully and to enforce procyclical policies.
Although it has to be acknowledged that insufficient effort was made during the good years to bring public finances in line with the Maastricht criteria, and so provide a cushion against adverse shocks, the present is hardly an appropriate time to make up for previous sins of omission.
(ii) Eastern Europe and the CIS
Having demonstrated resilience to the global slowdown, Eastern Europe and especially the CIS are poised to remain the most dynamic parts of the UNECE region. However, the outlook for 2003 as a whole in Eastern Europe has deteriorated somewhat since the assessments made at the beginning of the year. The more optimistic expectations about the economy of the euro area failed to materialize and in some east European economies growth has fallen below expectations. Growth in many of the region's economies in 2003 was predominantly consumption-led but this may prove to be unsustainable unless the recent modest recovery in business fixed investment gains momentum and leads the way to a healthier structure of output growth accompanied by further productivity improvements and job creation. There are uncertainties about export growth in the short run in view of the dim prospects for a west European recovery and the increasingly strong competitive pressures coming from Asian producers.
According to the most recent forecasts, aggregate GDP in the east European region is expected to increase by 3.6 per cent in 2003 as a whole, compared with the 3.9 per cent forecast at the beginning of the year (table 2). This mainly reflects the lowering of forecasts in some of the central European economies, in particular the Czech Republic, Hungary and Slovenia (prompted, in turn, by their worse than expected performance in the first half of the year). Growth forecasts were lowered also in Estonia and Romania. In other countries such as Bosnia and Herzegovina and Serbia and Montenegro, GDP growth for the year as a whole is also expected to fall short of earlier forecasts. In contrast, Poland's economy (with a considerable weight in aggregate regional output) has been recovering faster than expected, and there has been a slight upward revision in the GDP forecast for the year as a whole. Similarly, the official forecasts for Lithuania and for Latvia have also been raised.
The speed of the recovery in the CIS region in the early months of 2003 has prompted upward revisions of growth forecasts. According to the latest estimates, aggregate GDP in the CIS should grow by 6.3 per cent in 2003 as a whole, substantially above the 4.4 per cent forecast at the beginning of the year (table 3). Russia's GDP is expected to grow by some 6 per cent (or even more) in 2003, which is 1.5 percentage points above the January forecast. Growth forecasts have been raised in many of the other CIS countries, in particular Armenia, Kazakhstan and Ukraine, among others. If the present rates of growth continue through the end of the year, the growth of aggregate GDP in the CIS in 2003 as a whole may well exceed these revised forecasts.
The east European forecasts for 2004 generally assume a more favourable external environment than in 2002 and 2003, and in particular a more solid recovery in Western Europe. Consequently, the rate of growth of the region's aggregate GDP is expected to rise to 4.4 per cent (table 2).
In central Europe it is expected that the strengthening of west European import demand, coupled with the positive effects of EU accession on business and consumer sentiment may well lead to stronger growth next year. The Polish forecasts for 2004 envisage an acceleration of GDP growth to some 5 per cent, based on the assumption of a further strengthening of the export-led recovery in the manufacturing sector and a notable revival of private fixed investment. In Hungary, the expected strengthening of GDP growth (to 3.5 per cent) presupposes improved competitiveness and profitability resulting from wage moderation and rapid productivity growth, leading to a stronger recovery of business investment and a revival of FDI inflows. The forecast also assumes a significant tightening of fiscal policy - in order to deal with the twin deficit problem - while rising net exports are expected to offset the expected deceleration of private and public consumption. In Slovakia solid growth is expected to continue next year building on dynamic external demand, the confidence-enhancing effects of EU membership, and structural reforms focused on improving the fiscal position and providing better work incentives. The forecast of GDP growth in the Czech Republic in 2004 is more cautious (2.8 per cent) in view of the difficult policy choices related to the threat of unsustainable twin deficits.
The forecasts for the Baltic States in 2004 are sanguine, with rates of GDP growth expected at around 6 per cent, comparable to those in recent years. Growth in south-east Europe is expected to pick up to 4.6 per cent, although differences in performance among the individual countries are likely to remain considerable.
There are, however, serious downside risks to these rather optimistic forecasts. In the short run, the most serious risk for east European growth in general would be another delay to recovery in Western Europe. In addition, if the efforts to consolidate public finances in central Europe fail to arrest the current fiscal expansion, this may provoke a tightening of monetary policy (driven by the policy effort of meeting the Maastricht targets), with negative consequences on economic activity. In the longer term, growth in the region will be decisively influenced by the progress achieved in implementing key structural reforms, particularly of the financial, labour and product markets.
In the CIS, some moderation of growth rates is expected in 2004, with aggregate GDP increasing by some 5 per cent (table 3). This reduction in the average rate of GDP growth reflects expectations of some slowdown in the region's largest economies (in the first place, Russia), which, in turn, is largely related to uncertainties surrounding the external environment. The government agencies responsible for preparing economic forecasts for Russia produced a range of scenarios for 2004, with the expected rate of GDP growth ranging from 3.8 per cent to 5.2 per cent, depending on the future of world oil prices. The latest forecasts are more optimistic, suggesting that the rate of GDP growth rate should be in the upper end of this range or even higher. Russia's public finances are expected to continue to remain in surplus (which as of next year will be allocated to a special stabilization fund), while monetary policy will remain moderately expansionary, trying to strike a balance between the policy goals of gradual disinflation, on the one hand, and the prevention of a strong real appreciation of the rouble, on the other. Real GDP in Ukraine is forecast to grow by 4.8 per cent in 2004, which - in contrast to Russia - is at the lower end of the earlier range of forecasts. Economic growth should remain strong (at around 7 per cent) in Kazakhstan, albeit below the average pace for the period 2001-2003. Rates of GDP growth ranging between 4 and 7 per cent are expected for most of the other CIS economies.
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