UN/ECE releases its latest 1999 Economic Survey of Europe
Western market economies: outlook still weakening
In western Europe, economic activity became increasingly sluggish in the final months of 1998, according to the United Nations Economic Commission for Europe (UN/ECE) 1999 Economic Survey to be released on 4 May 1999. Industrial output fell in the last quarter and real GDP rose only slightly. Industrial confidence has continued to fall in the first three months of 1999 against the background of deteriorating order books and weaker production expectations. The marked rise in consumer confidence in 1998 petered out in February 1999 and weakened in March.
The short-term economic outlook deteriorated steadily in the second half of 1998 and current forecasts now point to an increase in real GDP of slightly less than 2 per cent in 1999, down from 2.7 per cent in 1998. This reflects essentially a weakening in the growth of total domestic demand. The deceleration in export growth is expected to continue this year, but the adverse effect on overall output growth will be partly offset by the weaker demand for imports. In the euro area, aggregate economic growth is forecast to be slightly above 2 per cent in 1999, down from 2.8 per cent in previous year. These forecasts imply that economic activity will strengthen in the second half of the year and pave the way for further cyclical gains in 2000.
The slowdown in economic growth in 1999 will mean smaller increases in employment and little, if any, further progress in reducing high levels of unemployment.
Inflation is not a problem, even if the deflationary effects of falling commodity prices will no longer be present in 1999.
The lowering of official interest rates decided by the European Central Bank (ECB) in early April 1999 is in line with the analysis made in the Survey. But the response of the ECB to the worsening of economic performance and growth prospects has come rather late and, given the long lags involved, will have little impact on economic activity in 1999. Although nominal interest rates are now quite low, there will be a need for a further easing of monetary policy if economic conditions fail to improve significantly in the euro area as a whole. This might also stem from an appreciation of the euro, which would be tantamount to a tightening of monetary conditions.
The burden on monetary policy to stabilize economic activity is increased by the fact that the scope for supportive fiscal policies in the three major economies of the euro area is virtually exhausted given the rules of the Stability and Growth Pact, and the associated stability programmes, which aim at achieving broadly balanced government budgets by the year 2002.
In the United States, the continuing buoyancy of domestic demand and output in late 1998 has persisted in the first few months of 1999. The unemployment rate fell to 4.2 per cent in March, the lowest rate in nearly 30 years, but inflationary pressures remain remarkably low. Real GDP is now forecast to increase by some 3 per cent in 1999, down from 3.9 per cent in 1998.
Altogether, real GDP in western Europe and North America is forecast to increase by some 2.5 per cent in 1999, down from 3.3 per cent in 1998.
This relatively benign scenario, however, is surrounded by considerable downside risks, the effects of which could be amplified because they are partly interrelated. Outcomes could be worse than currently forecast if the recession in Japan were to deepen in 1999 rather than bottoming out as expected or if net private capital inflows to emerging markets are significantly lower then projected, with concomitant adverse effects on their activity levels and import demand. Another important risk is the high level of share prices in many industrialized countries, notably in the United States: a major downward correction of share prices in the United States could have large negative effects on both consumer spending and business investment with significant financial spillover effects on western Europe. The projected rise in the US current account deficit to record levels and the concomitant rise in net foreign indebtedness, moreover, could eventually weaken the confidence of international investors and trigger a large-scale withdrawal from dollar denominated assets. This, in turn, would lead to a sharp depreciation of the dollar, which would affect activity in western Europe and other regions of the world economy.
It is still too early to judge the impact of the war in Yugoslavia on economic activity in the western market economies. It will depend partly on the length of the conflict and whether it can be contained. Apart from the depressing impact on exports to south-east Europe, a prolonged war would put upward pressures on government defence spending, which in view of the budget deficit targets in the euro area would need to be offset by savings elsewhere or by higher taxes. It cannot be excluded that the conflict will eventually affect consumer and industrial confidence and dampen private sector spending.
Transition economies: negative impact of strong external shocks
The overall trend of economic activity in the ECE transition economies was abruptly reversed towards the middle of 1998 when the negative impact of a strong external demand shock dominated the second half of the year. This shock resulted from the combined effect of the collapse of Russian imports, the drop in global demand for primary and intermediate products, and the weakening of west European import demand. Virtually all transition economies were negatively affected (albeit to varying degrees) by the fall in external demand. The speed at which economic developments deteriorated in the second half of the year presents a serious challenge to policy makers in the transition economies.
The rate of growth of aggregate GDP in eastern Europe in 1998 (2 per cent) was only half of what had been expected and well below the average in 1997 (2.8 per cent) which reflects a general weakening of economic activity throughout most of eastern Europe. There was a similar disappointment in the Baltic states: aggregate GDP growth in 1998 (around 4 per cent) was considerably below the impressive 7.6 per cent of 1997. Economic performance in the Commonwealth of Independent States worsened considerably in 1998: aggregate GDP of the CIS fell by 2: per cent, wiping out the modest 1.1 per cent recovery in 1997.
In 1998, output growth in the transition economies continued to be highly differentiated across countries and the growing disparities in income levels among the transition economies are becoming rather disturbing. Within central and eastern Europe the new divide is between the group of so-called leading reformers B those where institutional and market reforms are well advanced, economic growth is relatively high and sustained, and most of which are in the first wave of applicants for EU membership B and a group, mainly in south-east Europe, where a coherent programme of reforms has proved much more difficult to design and implement, which in turn has made it more difficult to achieve an improved macroeconomic performance. Similar problems have marred the course of economic transformation in most CIS countries. In these problematic groups of transition economies, the external demand shock has been amplified by the deepening of internal problems which, in turn, have reinforced the negative trends of 1998.
The Russian crisis was undoubtedly the event that attracted the most attention in 1998 due its severity and wide-ranging repercussions throughout the whole region. The August collapse of the rouble and the effective default on Russia=s domestic debt was an effective admission that a three-year strategy of juggling an unsustainable macroeconomic policy mix in the absence of adequate institutional support and microeconomic reforms had come to an unproductive end. Shock waves from the Russian crisis hit all the ECE transition economies but their repercussions were especially damaging to the neighbouring CIS countries. Apart from the negative impact on trade and output performance, these economies were also greatly affected by the devaluation of the Russian rouble which triggered a series of currency crises among CIS countries.
The unexpected weakening of output growth has had a bad effect on the labour markets in the ECE transition economies. This was especially pronounced in the second half of the year when unemployment started to increase rapidly throughout the whole region: between June and December the average rates of unemployment in eastern Europe increased from 11.6 to 12.6 per cent; in the Baltic states from 5.9 to 7.3 per cent; and in the CIS from an average 7.7 to 8.5 per cent.
In general, disinflation continued in 1998 in eastern Europe, in the Baltic region and in some of the CIS states; in many countries the inflation rate was significantly lower than expected. This outcome was largely due to lower import prices, a result of the large fall in the prices of commodities and other tradables. At the same time, contagion from the global financial turmoil in 1998, and especially from the Russia crisis, resulted in increased financial and macroeconomic turbulence in a number of transition economies; the most visible consequence was the series of currency crises leading to sizeable depreciation of the exchange rates. As a consequence, strong inflationary pressures re-emerged in a number of transition economies, mainly in the CIS, in the second half of the year.
The value of the foreign trade of the east European countries increased by some 8-9 per cent in 1998, more than in 1998 (6 per cent). However, most of the increase occurred during the first months of the year; trade performance weakened considerably in the second half. Despite the apparently strong export performance for the region as a whole, individual exporters in many countries suffered substantial declines both in value and volume, mainly because of the weakening of import demand in the CIS countries, and especially in Russia.
The aggregate value of the foreign trade of the CIS declined in 1998: during the first three quarters of the year, the dollar value of total exports declined by some 14 per cent, while the value of imports fell by 5 per cent. All CIS countries are relatively specialized in the export of primary commodities and these falls in value reflect to a large extent the collapse of world commodity prices.
In most countries current account imbalances worsened throughout 1998, accelerating in the last quarter as the full impact of falling external demand and in some cases appreciating exchange rates began to be felt. In general, the deficits reported in the last months of 1998 were larger than had been expected even under the more pessimistic projections made earlier in the year. As a result the aggregate current account deficit of eastern Europe continued to rise, to an estimated $17 billion (4.5 per cent of GDP), while in the Baltic states the average deficit rose to over 11 per cent of GDP in January-September. The imbalances would have been even greater but for the considerable drop in import prices of commodities and intermediate goods. In several countries current account deficits were constrained by the tight international financing conditions affecting all emerging market economies.
Outlook for the transition economies: possible recession
During the first few months of 1999 the downside risks surrounding the outlook for 1999 have increased considerably, and economic performance in 1999, on average, is likely to be considerably worse than in 1998. Preliminary data for the first quarter confirm the continuing weakness of economic activity in many transition economies. It is virtually certain that in some of the major CIS economies, such as Russia, Ukraine and possibly Kazakhstan, GDP will continue to fall in 1999 and this is likely to lead to a further decline in the aggregate output of the CIS. The weakness in the CIS region will continue to have a negative impact on the rest of the transition economies. Moreover, if the deterioration in western Europe=s economic performance continues in 1999, as well it might, then a number of east European transition economies, including some of those that have been growing rapidly in recent years, could move into recession.
Kosovo crisis adds to the already unfavourable environment for many transition economies
The outbreak of war between the NATO Alliance and Yugoslavia has added a new dimension to the already unfavourable external environment for many transition economies, worsening further their short-term economic outlook. The war-related economic damage already incurred is quite substantial. Neighbouring countries (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Romania, The former Yugoslav Republic of Macedonia) have lost important markets as well as traditional suppliers in Yugoslavia. Transport links to and from the south-eastern part of Europe have been severely damaged: navigation along the Danube has been paralyzed by the destruction of bridges in Novi Sad and all traffic through Yugoslavia (ground, rail and air) has been brought to a halt. The negative consequences are especially severe for the trade flows between western Europe (the main trading partner) and the countries locked in the Balkan region (in particular Bulgaria, Romania and The former Yugoslav Republic of Macedonia): as the available transport alternative routes are of limited capacity, the result is simply destruction of important trade flows. In addition, the blocking of the Danube will have a pan-European impact as it is causing costly interruptions in shipments for all the countries through which it flows.
The war has undoubtedly increased investors= perception of risk throughout the whole area surrounding the zone of conflict and this will both restrain access to international financial markets and raise the cost of borrowing for the affected countries which, in general, are those which are most badly in need of fresh finance. There have already been some repercussions of this sort in the financial sphere. (Even Hungary, one of the best credit risks in the region, chose to delay a large, $750 million bond issue in March; when it finally went ahead in April, its size was substantially reduced (to $500 million) and the costs had increased). The inflow of FDI to this region B an important driving force of economic restructuring as well as a balance of payments support B is also likely to weaken. The 1999 financial plans of many south east European countries were relying heavily on privatization revenues and other sources of FDI to finance budget and current account deficits. The fact is that the negative economic impact of the war will be greatest for the countries of south-east Europe, most of which were already in a precarious economic state before it started.
The problems facing the south-east European transition economies are complex and long-standing. The regional economy had already been destabilized by the break-up of the former SFR of Yugoslavia, and by the wars in Croatia and Bosnia and Herzegovina before the Kosovo war. Regional trading links have been broken or weakened and there are now many barriers to their restoration, a factor which discourages significant amounts of FDI. All of these economies have long been in need of large amounts of investment in order to restructure their economies and lay the basis for sustained growth, and it is clear that a great part of this will have to come from abroad. But it has also been clear for some time that the latter is unlikely to be forthcoming without significant progress in institution building (for market-based activity) and improved security in the region. Without substantial support from outside, the national authorities will find it very difficult to create the "breathing space" and the political support required to implement such a programme; but without a carefully designed programme and a broad measure of popular domestic support, private foreign investment is unlikely to be forthcoming. Coming on top of these chronic problems, the consequences of the war in Yugoslavia could lead to serious economic and political instability in these countries. To prevent an already serious situation getting worse there is an urgent need for western Europe and other members of the NATO alliance to provide south-east European transition economies with emergency support, especially for sustaining their balance of payments.
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