1. Diverse fiscal developments
Following the estimated deterioration in 2003, the general government deficit in the euro area is expected to remain stable at 2.7% of GDP in 2004 (2.6% in the EU). With respect to 2003, the general government balance is expected to deteriorate this year in several EU countries, compensated by an improvement in Germany, Spain, France, Austria and the UK. In the case of Denmark, Sweden and Finland, the deterioration refers to a fall in the surplus.
In a number of cases this situation calls for the activation of the budgetary surveillance instruments foreseen by the Treaty and the SGP. Specifically:
In the Netherlands the breach of the 3% of GDP deficit threshold in 2003 requires the immediate preparation of a report on the existence of an excessive deficit (Article 104(3)). The implementation of the following steps of the Excessive Deficit Procedure would be decided on the basis of measures taken to adjust the situation in 2004.
In Italy the budget deficit was slightly below 2½% of GDP in 2003. According to the Commission forecast the deficit would exceed 3% of GDP in 2004. The interruption in the reduction of the debt, which at 106% of GDP is the highest in the euro area is a further source of concern. This requires the immediate activation of the early-warning mechanism so as that the authorities make the necessary policy adjustment.
In Greece the latest data reported by the government show a budget deficit rising to just below 3% of GDP in 2003. Based on these data the Commission forecast projects a deficit in excess of 3% in 2004. However, the data for 2003, are not validated by Eurostat and do not therefore provide a reliable basis for assessing the budgetary situation at this stage. A fact-finding mission is being prepared for the end of April in order to have more information about the budgetary situation in this country and decide on steps to be taken.
In Portugal, the deficit has been maintained below 3% of GDP in 2002 and 2003. Portugal has therefore complied with the terms of the excessive deficit recommendation addressed to it in 2002 (Article 104(7)). Accordingly, the abrogation of the excessive deficit is in order. However, Portugal should take the necessary measures to avoid the re-occurrence of an excessive deficit.
In the UK the latest estimates show a budget deficit of 3.2% of GDP in (calendar) year 2003. In the case of the UK the relevant measurement period for budgetary surveillance purposes is the financial year, from 1 April to 31 March. . The Commission forecast and official statements by the UK authorities indicate that the deficit in the financial year 2003-04 exceeded 3% of GDP .The Commission has therefore to prepare a report on the existence of an excessive deficit (Article 104(3)). The deficit however is expected to return to below the 3% of GDP threshold over the forecast period, both in calendar and financial year basis. Without prejudice to the eventual outcome of the EDP, this might give margins to conclude that an excessive deficit would not exist in the sense of the Treaty and therefore bring the procedure to an end.
In 2005, on a "no policy change" assumption and, hence, not including measures that may be adopted in the next budgets, a slight improvement is expected for the euro area with the general government deficit declining to 2.6% of GDP (2.4% for the EU). Under this assumption, four countries (France, Italy, the Netherlands and Portugal) are projected to exceed the reference value of 3%.
2. Buoyant world economy boosts global trade
After the weak growth in world trade in 2002, a strong rebound of 5% is estimated to have taken place in 2003. The near-term outlook is for a further acceleration to around 8% in 2004-2005.
World GDP growth is estimated to have been stronger-than-expected at 3.7% in 2003. This year, world economic activity should expand at a robust 4.5%, before levelling off in 2005. This acceleration is supported by a number of factors, including accommodative macroeconomic policies, supportive financial conditions and a return of confidence.
The regional distribution of world growth widened in 2003, with stronger than expected contributions coming from the US, the CIS, OPEC, Asia (especially China) and the acceding countries. In the US, helped by monetary and fiscal policy stimulus and solid underlying productivity growth, the recovery is expected to continue, with growth at 4.2% in 2004. Nonetheless, in view of the high general government and current account deficits, this pace of economic expansion is viewed as unsustainable, and the growth rate is expected to decline to 3.2% in 2005.
Prospects for Japan have improved markedly with a sharp upward adjustment of growth from an estimated 2.7% in 2003 to 3.4% this year. Deflation appears to be coming to an end, but the general government deficit is expected to remain above 7% of GDP in 2004 and 2005.
The economic outlook for Asia (excluding Japan) remains buoyant with growth in the vicinity of 7% in 2004-2005. During this period, Hong Kong and Korea are expected to take up the slack created by a slight attenuation of the striking growth rates of China and India. Among the other emerging regions, Latin America is expected to double its growth rate in 2004 after a lacklustre performance in 2003. Economic activity is also expected to pick up speed in Africa. In the countries preparing for accession on 1 May 2004 and the other candidate countries, continued strong growth is expected throughout the forecast period, supported by domestic demand and structural change.
3. Rising commodity prices and recovering stock markets
The global recovery has put upward pressure on both fuel and non-fuel commodity prices. While the appreciation of the euro has shielded the euro area from many of the adverse effects of this trend, its implications for the world economy are less encouraging.
The assumed profile for oil prices has been revised upwards compared to the Autumn forecasts. From an average of USD 28.5 per barrel (Brent crude) in 2003, the price of oil is assumed to decline gradually from a high of USD 31.5 per barrel in the first and second quarters of this year, yielding an average of USD 31 per barrel for the year as a whole. Some easing is foreseen during the course of 2005, producing an average of USD 29 per barrel.
After stabilising in the middle of last year, equity prices continued their upward trend into the new year, before levelling off somewhat recently. Long-term government bond yields have remained low by historical standards, despite improving global growth prospects. Corporate bond spreads have also narrowed to historically low levels. Overall, these developments, which suggest that financing conditions in the global economy have improved compared to one year ago, should be supportive of the recovery.
4. Growth re-emerged in the euro area and EU economies in the second half of 2003 …
For the euro area, the rebound in economic activity was driven by a surge in the growth of exports, while the growth-contribution of domestic demand was negative. The latter was due in particular to the negative performance of investment in the third quarter. Domestic demand took over from trade as the engine of growth in the last quarter of the year. Investment picked up considerably, breaking a prolonged downward trend. However, lacklustre private consumption provided no impulse to growth and the contribution of net exports turned negative due to a sharp rise in the growth of imports.
The recovery, which took place in the second half of 2003, was broadly in line with predictions in the Autumn forecast. However, the source of the turnaround was somewhat surprising as the stronger-than-expected growth in the third quarter was driven by external rather than internal demand. The outcome for the last quarter was closer to expectations both in terms of the magnitude and the composition of growth.
5. …and will gain momentum in 2004
Survey indicators have been sending out encouraging signals for the prospects of a recovery since the middle of last year. While the euro-area economic sentiment indicator has improved since summer 2003, capacity utilisation in manufacturing is still below its long-term average. Business sentiment in the manufacturing sector has hesitated somewhat recently, but the improvement in production expectations has been maintained.
In the services sector, confidence is still at a low ebb but demand expectations are advancing. The gradual rise in consumer confidence is based mainly on a better outlook for the economy and for the labour market. This should lead to greater optimism on the part of households regarding their own financial situation, which should in turn provide an impulse to consumer spending.
The projected recovery in business and household spending in the coming months stems in part from the particularly low real interest rates, both short-term and long-term. This has contributed to an easing of the balance-sheet constraints of households and businesses through a reduction in debt servicing costs. The rebound in stock markets since March of last year and the buoyant housing markets in some Member States have also helped to partially restore wealth lost following the bursting of the stock market bubble. Households' real disposable income has been sustained by the resilience of employment and real wage growth. The projected decline in inflation should also provide a positive stimulus to consumption.
The average growth rate in the euro area is projected to rise to 1.7% in 2004 and 2.3% in 2005 (2.0% and 2.4% in the EU, respectively), barely unchanged from last autumn's forecast. Growth is expected to be supported by domestic demand, which in turn will be sustained by an acceleration of capital formation during the course of 2004, followed by a more gradual recovery of private consumption expenditure.
6. Encouraging labour market performance and outlook
Despite the prolonged downturn, the rise in the unemployment rate has been quite moderate in comparison to previous cycles. The euro area unemployment rate stabilised at 8.8% in the second quarter of 2003, after increasing by 0.8 of a percentage point during the slowdown in the current cycle. This contrasts with a rise of over 2 percentage points to above 10% in the trough of the early nineties. On the employment side, the picture is also more encouraging insofar as job losses are concerned. No jobs were lost in net terms in the recent downturn, while more than 2.5 million jobs disappeared in the 1992-93 recession.
In line with the gradual nature of the recovery and the usual lagged response of the labour market, about half a million jobs are expected to be created this year. However, this figure should more than double in 2005 as the recovery gathers pace. The euro area unemployment rate is expected to remain stable at 8.8% (8.1% in the EU) this year, before edging downwards in 2005.
7. Headline inflation set to fall below 2% this year
Notwithstanding the economic slowdown and the appreciation of the euro, headline inflation remained sluggish in 2003, buoyed up by such temporary factors as weather-induced food and energy price hikes and rises in indirect taxes. Compared to an estimated 2.1% in 2003, headline inflation is expected to fall to 1.8% this year, as a result of the lagged effects of the euro appreciation and weak domestic price pressures. Inflation should fall further to 1.6% in 2005.
Core inflation was also rather sticky during 2003. Services sector inflation was particularly sluggish in view of the sector's relatively low productivity and less exposure to competition than the manufacturing sector. However, a reduction in the pace of unit labour cost growth, as labour productivity picks up and wage moderation continues, should also lead to a fall in core inflation.
8. Upside and downside risks to the forecast
Many regions of the world are sending out encouraging signals in support of a continuation of global growth. This reinforces the likelihood of a broad-based simultaneous acceleration of growth across the world, which would generate a mutually reinforcing growth momentum. However, long-standing macroeconomic imbalances may hold back growth in the US economy later in the forecasting period. Rising oil and other commodity prices might also put a damper on global growth. On balance, however, the international environment implies an upside bias.
A renewed sharp appreciation in the euro exchange rate could undermine activity mainly in the euro-area manufacturing sector, especially in those Member States that have recently depended on external demand to generate economic growth. On the other hand, any further appreciation would ease inflationary pressures further and, accordingly, raise real disposable income.
The protracted nature of the downturn and uncertainties related to current and future income have undermined consumer confidence, leading to the postponement of consumption plans and sluggish private consumption. Survey indicators suggest that consumers are still wary about committing themselves to purchases of larger consumer durable goods. Furthermore, although geopolitical tensions diminished in the second half of 2003, the threat of terrorist attacks continues to weigh on consumer confidence, particularly in view of the events in Madrid in early March. With the resumption of confidence, the release of pent-up demand would accelerate the return to potential growth. The rise in house prices in a number of EU countries and the contribution of the rise in stock markets to restoration of household wealth should also support spending.
Although investment is being supported by favourable financing conditions and positive developments in earnings and profitability, possible constraints posed by the incomplete adjustment of balance sheets cannot be ruled out. It should also be recalled that confidence can be positively affected by visible progress on structural reforms.
Overall, the balance of risks appears to have shifted towards the downside in recent months.
9. Acceding countries: A positive stimulus from EU integration
Despite weak growth in the EU, the economies of the new Member States are estimated to have expanded on average at a robust 3.6% in 2003 as accession unleashes favourable growth dynamics. In particular, private consumption supported growth, notably in the Baltic States, Hungary and the Czech Republic. Three factors underpinned household spending: (i) increased real disposable income, partly thanks to relatively low inflation in many countries at about the euro-area level; (ii) greater access to credit as a result of the development of the banking system; (iii) anticipated spending ahead of expected price rises in 2004 linked to indirect tax hikes.
Investment activity was weak in 2003 (except in the Baltic States), reflecting the global situation, but also as a consequence of the stalling reform process in the acceding countries. Exports did very well, notably in Slovakia, which, given weak EU demand, is mostly explained by an export basket with a higher value-added content. In Poland the depreciation of the zloty contributed significantly to the good export performance.