Academic journal article National Institute Economic Review

Euro Area Recovery Falters

Academic journal article National Institute Economic Review

Euro Area Recovery Falters

Article excerpt

Following a strong acceleration of growth in the first quarter of the year, the Euro Area recovery hesitated slightly in the second quarter, with growth slowing to 0.5 per cent from a rise of 0.7 per cent in the previous quartet. The Euro Area was held back by a contraction in the Netherlands, while domestic demand declined in Italy and Austria and stagnated in Spain. Nonetheless, Germany, which has persistently underperformed the Euro Area average since 1995, recorded a modest improvement in the second quarter with growth of 0.5 per cent. We expect Euro Area growth to remain stable at about 0.4 per cent per quarter in the second half of the year, with any further acceleration in growth postponed until 2005. On an annual basis, output in the Euro Area is expected to rise by 1.8 per cent this year and 2.1 per cent in 2005. By 2006, we see growth rising above trend, to 2.6 per cent, allowing the Euro Area output gap to close by the middle of the year.

Growth in the Euro Area remains heavily reliant on external demand, and if the global economy decelerates more sharply than currently forecast this would seriously jeopardize our projected recovery. Euro Area export markets, and in particular those of Germany, are highly exposed to oil exporting nations. As such, the recent rise in the oil price should support the purchasing power of oil producers and boost external demand for the Euro Area. However, as discussed in Barrell and Pomerantz (2004), this buoyancy depends on the speed with which oil exporters recycle revenues. Our projections assume that oil revenues will be recycled quickly, at a rate similar to that seen in the 1990s. Net trade should, therefore, make a small positive contribution to growth going forward, after the sharp negative impact in 2003, when net trade reduced GDP growth by 0.7 percentage points.

The reliance on external demand is predominantly due to the persistently poor performance of domestic demand in Germany, which remains 3 per cent below its peak level in 2000. However, we saw a strong acceleration of domestic demand growth in France in the first half of 2004, with domestic demand rising by 2.2 per cent relative to the previous 6-month period. Domestic demand in Spain has remained a mainstay of economic growth in the Euro Area throughout the recent downturn, and we expect the pause seen in the second quarter to be a temporary one, driven by a one--off drop in stockbuilding. However, consumer expenditure in Spain has been supported by strong growth in house prices for several years, and a sharp downturn in global house prices could jeopardize our projected recovery of Euro Area domestic demand. Investment growth in the Euro Area is expected to pick up in the second half of the year, supported by rising profit growth, low real interest rates and improving corporate balance sheets. We expect domestic demand growth to accelerate to 2 per cent in 2005. However, if real interest rates rise significantly on the back of the recent oil price rise, the investment recovery may be more gradual than currently forecast.

European prospects outside the Euro Area remain somewhat brighter, and we forecast growth in the EU-25 of 2.1 per cent this year and 2.4 per cent in 2005. Accession to the European Union seems to have brought benefits to the new member states already, with equity prices rising since joining, transport links improving to allow more cross-border trade, and a number of foreign firms establishing new service centers in the new member states. We forecast growth of 4 per cent in the new member states this year, and 5 1/4 per cent in 2005. Output growth in the EU and the Euro Area will return towards trend levels of around 2 1/2 per cent per annum over the medium term. According to ECB estimates, each of the approximately four extra working days in 2004 compared to 2003 would add about 0.05-0.1 per cent to unadjusted annual GDP, or about 1/4 percentage point to the annual growth rate in 2004. …

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