A strong but uneven rebound of the ECE economy
There are increasing indications for the global economic upswing to continue at a brisk rate in the second half of 2004 and in 2005, as emphasized in the Economic Survey of Europe just released by the United Nations Economic Commission for Europe (UNECE).
The average annual growth rate of world output in 2004 should be broadly the same as at the peak of the previous cycle in 2000, namely, 4.7 per cent. Among the G7 economies, the recovery is mainly driven by the United States, Japan and the United Kingdom. In contrast, the weak cyclical momentum in France, Germany and Italy is dampening the average growth rate of the euro area, which is lagging behind in the international growth cycle. The emerging markets in Asia, the CIS and eastern Europe continue to be important dynamos of global economic activity. At the same time, however, there are lingering concerns about important downside risks associated with the necessary adjustments of global external imbalances, high levels of public sector debt and, in some countries, bubbles in housing markets.
A major feature of economic developments in the first half of 2004 was the surge in international commodity prices, especially crude oil prices. While higher oil prices will tend to restrain economic activity somewhat in the course of 2004, there has so far been no noticeable adverse effect on the pace of the global recovery. Given their greater dependence on oil imports and their lower levels of energy efficiency, net oil importers among the emerging market and developing economies will be more affected by the rise in oil prices than the advanced industrialised countries.
Robust growth in the United States and the United Kingdom, moderate cyclical momentum in the euro area
In the United States, the recovery is expected to be increasingly self-sustained, with output growth forecast to remain above trend. This should lead to further improvements in the labour markets, and the closing of the output gap in 2005. Real GDP is set to increase by some 4.5 per cent in 2004, supported by strong domestic demand and exports. The pace of expansion is expected to slow down in the course of 2005, but the annual growth rate should still be close to 4 per cent.
In the euro area, the recovery is likely to remain lacklustre in 2004 and 2005. Real GDP is forecast to increase by some 1¾ per cent in 2004 and by 2 per cent in 2005. These modest rates of growth will not lead to any significant improvements in the labour markets. The upswing will continue to be led by exports, which are buoyed by favourable growth in other regions of the world economy. In fact, the strength of exports has been offsetting the dampening effects from the rise in oil prices. Private household consumption is expected to expand only moderately, reflecting depressed consumer confidence and small gains in aggregate wage incomes due to the weak demand for labour. Consumer confidence is currently well below its long-term average, reflecting uncertainty about labour market prospects and longer term concerns about the outlook for pensions and health care. Consequently, the savings propensity in the euro area is very high. The strengthening export performance, in combination with low interest rates, is expected to stimulate business investment in machinery and equipment, which should therefore gather some momentum in 2005.
Outside the euro area, real GDP in the United Kingdom should increase by some 3 per cent in 2004, above the trend growth rate of 2.5 per cent a year. The recovery is driven by the strong growth of private consumption and government expenditures, but exports are expected to pick up in 2005.
For the member states of the European Union as a whole (EU-25), real GDP is forecast to increase by 2.2 per cent in 2004 and by 2.4 per cent in 2005. This modest average masks a significantly better performance in the new EU member states (see below). For the wider aggregate of countries in western, central, and eastern Europe (WECEE) the average growth rate will be the same as that for the EU.
The new EU members maintain rapid rate of growth
In the early months of 2004, economic growth in the new EU members accelerated further, led by a strong economic upturn in Poland and a continuing surge in economic activity in the Baltic region. The new EU members are expected to continue to benefit from the general improvement in both global and western European import demand. Taken as a whole, in 2004 as well as in 2005, the aggregate GDP of these economies is set to grow by some 4.5 per cent, a growth difference of some 2 percentage points above that of the EU-15.
GDP growth in Poland is set to remain high both in 2004 and 2005, driven by strong exports. In Hungary, the rate of GDP growth in 2004 is likely to be in the range between 3.5 and 4 per cent. The projected acceleration of growth in Slovakia in 2004 and 2005 reflects the expected recovery of domestic demand; strong export growth should also continue to support economic activity. The three Baltic economies are set to remain the fastest growing region in Europe in both 2004 and 2005 thanks to a combination of strong exports and robust domestic demand. GDP growth in the Czech Republic and Slovenia will be somewhat lower: around 3.5 per cent in both 2004 and 2005. In the Czech Republic, the relatively subdued economic activity partly reflects the efforts of the government to reduce the public sector deficit to more sustainable levels.
Strong growth continues in south-east Europe…
Economic growth in south-east Europe is set to remain fairly strong in the short-run. Some of these countries have become attractive sites for inward FDI (not least in view of their expected membership of the EU) and this has contributed to the strengthening of their economic performance. GDP growth in Bulgaria and Romania is expected to continue at close to 5 per cent both in 2004 and 2005, supported by strong domestic demand and export growth. The strong economic recovery in Turkey reflects sound economic fundamentals and rising consumer and investor confidence after the successful adjustment efforts, which followed the financial crisis. GDP growth in Turkey in 2004 may reach up to 7 per cent. In Croatia, GDP growth is expected to be around 4 per cent and to be largely export-led, as the envisaged cuts in public spending will have a negative impact on GDP growth in the short run. After a slowdown in 2003, economic activity in Serbia and Montenegro has been picking up in the early months of 2004 and this is set to continue throughout the year thanks to a strong recovery of domestic demand.
… and in the CIS
The recent surge in world commodity prices and, especially, in the prices of oil, has given a considerable boost to the economies of the commodity exporting CIS countries and to the CIS region as a whole. During the first few months of the year economic growth in the region was considerably above the expectations and this prompted in many cases the raising of growth forecasts. In the short run, the external environment is likely to remain favourable for commodity exporters and consequently economic growth in the CIS economies will remain high through 2005.
Russia has benefited considerably not only from high oil prices but also from the strong global demand for oil, and these have been the main factors behind the acceleration of growth from the beginning of 2004. The consensus forecast is that Russia’s GDP should grow by close to 7 per cent in 2004 as a whole; a slowdown to 5.7 per cent is expected for 2005. As in Russia, economic growth in Ukraine during the first half of the year turned out to be much stronger than initially expected thanks to favourable world market conditions for its major exports, steel and chemicals. GDP growth is expected be in the high single digits, several percentage points above earlier estimates. In Kazakhstan, another major commodity exporter, GDP growth will to be close to 10 per cent in 2004 and should remain fairly high in 2005 as well. In Belarus, the strong export-led upturn in manufacturing should also contribute to solid GDP (6-7 per cent) growth in 2004 as a whole. Among the smaller CIS economies, economic growth is expected to remain high in the commodity exporting countries, with GDP growing in most cases at rates in the high single digits in 2004. In contrast, rates of GDP growth in most of the countries that are not specialized in commodity exports (such as Armenia, Georgia, the Republic of Moldova and Uzbekistan) will generally remain below the CIS average in the short run.
MACROECONOMIC POLICY ISSUES
A gradual withdrawal of monetary policy stimulus in the United States…
In the United States, the stance of monetary policy remained very accommodative in the first half of 2004. The target for the federal funds rate had been fixed at only 1 per cent since late June 2003, the lowest rate in 46 years. But the setting for monetary policy started to change in the second half of 2003, when the recovery was gaining strong momentum. In May 2004, with more evidence confirming sustained strong output growth, a pick up in hiring and a moderate rise in inflation, the FOMC started to prepare markets for a reversal of the sharp fall in interest rates since mid-2001. In fact, the Federal Reserve did raise its target for the Federal Funds Rate by one quarter of a percentage point, to 1.25 per cent, on June 30th. This is a key turning point for monetary policy in the United States and, indeed, the global economy. But real short-term interest rates have remained negative. In view of the forecast robust expansion in the remainder of 2004 and in 2005, the Federal Reserve will have to progressively raise interest rates to move monetary policy back to a neutral stance. The neutral level of short-term interest rates is estimated to be around 4 to 4.5 per cent.
…. but also the US fiscal policy stance has to be adjusted.
Fiscal policy in the United States is expected to remain accommodative through 2004 although the stimulus to economic activity will be much less than 2003. Household incomes will receive another boost from tax refunds, which, however, will fade in the second half of the year. The general government budget deficit rose to 4.8 per cent of GDP in 2003, up from 3.3 per cent in 2002. Only a small reduction in of the budget deficit is currently projected for 2004. Most of this deficit is estimated to be structural, i.e. it will only be partly reversed in a cyclical recovery. This is a pointer to the need for a stringent and coherent medium-term fiscal consolidation strategy.
Monetary policy can remain on hold in the euro area…
In the euro area, the recovery is still relatively fragile relying, as it does, largely on the stimulus from foreign demand. Against this background and in view of the moderate rates of actual and expected inflation, monetary policy should remain on hold until the recovery is more broadly based, a process, which requires a sustained strengthening of domestic demand. The surge in oil prices has translated into a general rise in average domestic price levels due to the subsequent rise in the prices of energy products. What monetary policy should be concerned about, however, are the so-called indirect, or second-round, effects of higher oil prices, i.e. the impact on costs of production, especially labour costs, which could trigger an upward inflationary spiral. As in the United States, there is so far no evidence for this kind of pass-through process, which, in any case, given the labour market situation, ample margins of spare capacity and intensive international competitive pressures, can be expected to be very limited in extent.
… while fiscal policy should focus on medium-term consolidation.
In the euro area, the impact of fiscal policy is likely to be neutral in 2004, as indicated in the projection of an unchanged cyclically adjusted budget balance. But six countries (Germany, Greece, France, Italy, the Netherlands, Portugal) will have excessive deficits, i.e. deficits in 2004 that exceed the 3 per cent threshold of the Stability and Growth Pact. France and Germany will breach the 3 per cent budget deficit ceiling for the third consecutive year in 2004.
The crisis surrounding the implementation of the Stability and Growth Pact in 2003 has led to an intensive discussion about possible ways to reform it. As yet there are no firm official positions in this matter, a reflection of a lack of consensus among EU member states. But the European Commission has recently outlined the main elements of a possible strengthening and clarification of the Pact, which, at the same time, would increase the flexibility of the rules. The current fiscal position in several euro area member countries, especially the three larger ones, suggests that the room for manoeuvre of fiscal policy has now been virtually reduced to the operation of automatic stabilizers. The main challenge is to design fiscal consolidation strategies that will ensure fiscal sustainability in the medium- and longer term without limiting the operation of automatic stabilizers.
The euro area needs a supportive policy mix
It is important to stress that macroeconomic policies and structural reforms are complements and not substitutes. There is evidently a need to put more emphasis on innovation, to raise investment in human capital, boost basic research and reform labour markets further in order to lift the rate of growth of potential output. But all this can be done much more effectively in a context of sustained economic growth, supported by conducive macroeconomic policies. The plans for a more flexible interpretation of the Stability and Growth Pact therefore go in the right direction. The important issue in the short-run is whether the export-led recovery will broaden by spilling over to domestic demand. Given that fiscal policy will be focused on the need for consolidation, this points to the important role of monetary policy in ensuring a supportive policy mix.
Inflationary risks prompt a monetary tightening in the United Kingdom
In the United Kingdom, monetary policy was further tightened in the first half of 2004. This reflects the concerns of the Monetary Policy Committee of the Bank of England about the risks of failing to meet the government’s medium-term inflation target in view of projected output growth above trend and the associated pressures on productive capacity and prices. A major concern of monetary policy remains the continuing rise in house prices, which is generally seen to have turned into a speculative bubble. Household debt has risen to high levels (come 100 per cent of GDP or 120 per cent of disposable incomes). There was a significant deterioration in the government’s finances in 2003, the result of a large increase in government spending, which supported economic activity and thereby helped to offset the cyclical downturn of 2002. The actual budget deficit amounted to 3.2 per cent of GDP, twice the level of 2002. Fiscal policy is forecast to be neutral in 2004, and the actual budget deficit should fall back below the EU’s 3 per cent limit.
The new EU members set convergence targets…
After accession, the new EU members automatically assumed the obligations of the EU’s Stability and Growth Pact (SGP), including the rules and norms of the EU’s fiscal policy framework. They are also required to submit to the European Commission stability and convergence programmes which set out the course of action they intend to take in order to meet the SGP targets.
One of the most challenging policy targets for some of these economies will be the required fiscal consolidation. In 2003 the general government deficits of four central European countries – Slovakia, Czech Republic, Hungary, and Poland – exceeded the EU’s reference value of 3 percent of GDP. According to their medium-term policy programmes, these economies aim at eliminating the “excessive” budget deficits by 2006-2008. However, the consolidation will require some painful adjustment efforts, which – with the exception of Poland – are already underway.
Given the fact that many of the new EU members are still undergoing major structural adjustments, the European Commission seems to have taken a more flexible position with respect to their current fiscal deficits. It appears likely that the new EU members that are considered to be facing serious structural challenges may be granted (albeit informally) a certain grace period for meeting the stringent rules of the SGP. However, such a tacit deviation from the general EU fiscal rules highlights once again the difficulties of enforcing these rules, which, at least partly, arise from their excessive rigidity. A more appropriate solution would be to modify the SGP rules to allow greater flexibility to national policy makers in dealing with both cyclical and long-term structural adjustment.
… and prepare for EMU entry
Three countries – Estonia, Lithuania and Slovenia – joined the EU’s exchange rate mechanism ERM-2 already in June 2004, immediately after their accession to the EU. While these economies might be ready to adopt the euro in late 2006 or early 2007, other new EU members appear to have abandoned their earlier ambitious timetables for EMU accession. Thus, the Czech Republic and Hungary now seem to be contemplating joining ERM-2 only in 2008 and adopting the euro by 2010. The National Bank of Poland has also reformulated its official target date for euro zone entry from “2007” to “as soon as possible after 2007”; the government is taking an even more cautious view on the possible accession date. Latvia and Slovakia seem to be targeting EMU accession in 2008.
The CIS: coping with risks of overheating …
The current economic boom in the CIS region, which has been highly beneficial for these economies, is at the same time posing some new policy challenges. Rapid growth in some cases has been accompanied by growing inflationary pressures and thus increasing concerns about overheating. In some cases the inflationary risks are compounded by an ongoing surge in capital inflows, mostly related to high export revenues. This requires a cautious and balanced policy approach. For example, raising interest rates in such circumstances could lead to even larger capital inflows thus aggravating the macroeconomic situation. A more coherent policy response to the combined risk of overheating and exchange rate appreciation is to address them through fiscal policy, for example by tightening the fiscal stance while the monetary stance remains neutral.
… and risks of “Dutch Disease” in Russia
While Russia’s economy as a whole undoubtedly benefits from the windfall revenue gains related to the rise in oil prices, its central bank at present is faced with some serious macroeconomic policy dilemmas. Thus the symptoms of the “Dutch Disease” are becoming quite visible in Russia and the trend towards real exchange rate appreciation has intensified in the last two years. The appreciation of the rouble has now reached the point where it can seriously damage the competitiveness of local manufacturers and is obviously becoming a burden for the economy as a whole.
Russia’s recent attempts to address this problem highlight the complexity of the policy issues, especially in an environment of immature and relatively shallow financial markets. In the first half of 2004, Russia’s central bank continued its massive purchases of foreign exchange in an attempt to prevent an even faster rate of appreciation of the real exchange rate. However, the large injection of liquidity into the domestic money market has had detrimental side effects not only in terms of its pro-inflationary impact but also with respect to the efficiency of macroeconomic management per se, in particular, the central bank’s interest rate policy.
There is no easy fix for the problems associated with the “Dutch Disease”. One of the macroeconomic policy targets should be to prevent a possible overshooting of the real exchange rate, since an excessively high rate may destroy jobs and firms that would otherwise be viable at the equilibrium rate. In addition, to remain competitive local firms must restructure and adjust in order to raise their productive efficiency and profit margins. But this requires the establishment of a market environment that will make firms responsive to market signals. In particular, it implies reducing the barriers to competition in, and increasing the flexibility of, the domestic product, labour and capital markets. The long-term solution requires reducing the dependence of the economy on the exports of natural resources through diversification. The realization of Russia’s long-run growth potential thus hinges on the acceleration and deepening of systemic and structural reforms.
Addressing all these issues should thus be given high priority in Russia’s policy agenda. A broader, stronger and competitive manufacturing base would reduce not only the Russian economy’s reliance on the oil and gas sectors but also its vulnerability to fluctuations in the international prices of natural resources. To varying degrees, these issues (and the related policy implications) are also relevant for other CIS countries – such as Azerbaijan, Kazakhstan, Tajikistan, Turkmenistan and, to some extent, Ukraine – seeking ways to reduce their dependence on commodity exports.
DOWNSIDE RISKS AND UNCERTAINTIES REMAIN IMPORTANT
Oil prices retreated from their peak in early June 2004, when they rose to somewhat less than $40 p/b (spot price of Brent crude). The average monthly oil price was $33.7 in June 2004. The average monthly oil price for the first half of 2004 was $33.7 p/b, up by some $5 p/b from the same period in the preceding year. Assuming a similar increase for the year as a whole, then the impact of higher oil prices on global economic growth would be relatively small and swamped by the strong underlying cyclical momentum. Uncertainty remains, nevertheless, about possible terrorist attacks on major oil networks in the Middle East, with subsequent upward pressure on prices, including risk premia.
Another risk is a stronger than expected rise of inflationary pressures as a result of the rapid closing of the global output gap, which could lead to a more pronounced tightening of monetary policy than anticipated, especially in the United States. Interest rates in the United States are generally expected to be raised at a measured pace. This assumes that inflationary pressures will be held in check, in part by the higher trend of productivity growth. A faster than expected tightening of monetary policy in the United States would risk having adverse effects for the US equity, bond and real estate markets, with negative repercussions on household net worth and domestic financing conditions. There would also be adverse spillovers to the financing conditions available to emerging markets, reflected in widening spreads, and dampening effects on economic activity.
A more general upward pressure on long-term interest rates in the international bond markets could emerge from the increasing awareness that it may prove to be very difficult for governments of the major economies to reverse the recent deterioration of their public finances, even in an environment of sustained and stronger growth. In the absence of determined efforts to ensure fiscal sustainability, bond yields may rise in response to a higher risk premia, with dampening effects on private sector investment.
The main downside risk, however, remains the huge current account deficit of the United States. It is generally accepted that this imbalance is not sustainable and will therefore need to be reduced to “normal” levels over the medium-term. Current economic conditions, however, are not favourable for this process to make significant progress, if any, in 2004 and 2005. The basic requirement for the current account correction is a substantial depreciation of the dollar to reduce domestic absorption (i.e. a switch in expenditures from foreign to domestic products) in the United States in combination with a stronger growth of foreign demand for United States products. The recent adjustment of the real effective exchange rate since early 2002, however, has been partly reversed in the first half of 2004. The major adjustment burden has so far fallen on Europe, given the exchange rate policies pursued in the Asian economies. The growth of domestic demand in Japan and the euro area, moreover, is expected to remain weaker than in the United States. Against this background, major disruptions in the pattern of exchange rates cannot be excluded: these could be triggered by sudden changes in market sentiment and investor confidence with concomitant adverse implications for the recovery in Japan and the euro area.
Annual changes in real GDP in Europe, North America and Japan, 2002-2005
(Percentage change over previous year)
Annual changes in real GDP in south-east Europe and the CIS, 2002-2005
(Percentage change over previous year)
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