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A strong but uneven rebound
of the ECE economy
UNECE launches its Economic
Survey of Europe 2004 No. 2
Geneva, 20 July 2004
- 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.
TABLE
3.1
Annual changes in real GDP in Europe,
North America and Japan, 2002-2005
(Percentage change over previous year)
TABLE
3.2
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
E-mail: [email protected]
Ref: ECE/GEN/04/P12