Еconomic Review of Euro Zone in 2007

The shadow of the US credit crisis.

The market financial crisis, the highly oil price and the deceleration of American economy should weight on the European growth during the year 2008, estimate the European commission who review hopes a fall as.

During the autumn forecast, the European commission has slightly upward its waiting concerning the growth for the year 2007 of 2.6% against 2.5% before for the euro zone. Nevertheless she review the fall has their forecast of 2.2% for the year 2008 against 2.5% hoped, and give a first forecast rather modest for the year 2009 at 2.1%.The horizon is clearly darkened because of turbulences on financial market during the last summer,

The American deceleration and prices increasingly higher oil price. Consequently the economic growth become more moderate and the risks weighing on the prospect clearly increased, but the negative impact should be limited because of the world growth is still strong and fundamental economic solids.

Globally household consumption became the main engine of growth during the beginning of this year, and thus should improve in euro zone with the retreats of unemployment. The commission count on creation of eight millions employment on European union during the period of 2007-2009, what should bring back unemployment of 7.1% in 2007 to 6.6 % in UE in 2009.

Another source of satisfaction: The finance public. The commission is waiting for a falling on budget deficit in the euro zone and the EU for the year 2007 on its level low since many years. He should reach an average of 0.8% of GDP, after 1.5% in 2006 in euro zone.

By country, the situation remain however contrasted. After a surplus of 0.1% this year, Germany should know a light deficit, of 0.1%, next year but less than the 0.3% forecast before.

On the other hand, France fact appears a bad student. The commission forecasted a deficit of 2.6% of GDP in 2007 like in 2008, against a prognostic of respectively of 2.4% and 1.9% previously.

The increase of the price on euro zone is another source of concern for the commission, who said herself more worried than two months ago. The risks in this sector are increase clearly.

In November 2007 the inflation thus exceed for the second consecutive time the objective of the European Central bank who would like inflation nearly around 2% or below on the medium term.

The central bank has let their principal rate a 4%, but she make state of risk of inflation pressure in the Euro zone, an indirect way of hold up the weapon for higher interest rate.

Brussels has increase their inflation forecast for the year 2008 at 2.1%, against 1.9% before, taking into account increases in the basic commodities, primarily the rises of energy prices and the foods products.

The ECB have already raise their principal rate during eight times since December 2005. It was then at 2%.

In particular, the prices of fuels for transport have raised of 8.9%, those of milk, cheese and eggs of 7.6% and those of breads and cereals of 5.4%.

Subjacent inflation except price of energy and not processed food rose at 2.1% against 2.0% in September 2007.

This year’s economic growth is expected at 2.8% in the EU and 2.5% in the euro area, a downward revision of 0.1 compared with the spring forecast that reflects mainly a weaker-than-expected second quarter. The forecast is derived from an update of the outlook of real GDP growth and inflation for France, Germany, Italy, the Netherlands, Poland, Spain and United Kingdom. Together these seven countries account for more than 80% of the EU’s GDP.

Commission forecasts moderating growth for 2007-2009, The European Commission forecasts economic growth in the European Union to continue albeit at a moderating speed. This growth will contribute to further job creation in the EU, while the widespread budgetary improvement this year is set to come to a halt in 2008-2009.

Growth is moderating but still healthy. In its most recent economic forecast the commission expects growth to decelerate from 2.9% in 2007 to 2.4% in both 2008 and 2009 in the EU (from 2.6% to 2.2% in 2008 and 2.1% in 2009 in the euro area).

The new forecast for 2008 is 0.3 point lower than six months ago for both areas.

Chart 1:

GDP in the EU and the euro area showing limited downward revision in 2008, despite headwind from turbulence in financial markets; high oil prices etc.

Impact of financial crisis limited so far

After a solid first half of 2007, the moderation going forward is partly explained by the impact of the turbulence in the financial markets. The EU economy entered 2007 in a relatively good position to weather the financial distress that began during the summer. It will take some time for markets to back to normal.

The Commission’s baseline forecast assumes that the turbulence out gradually, although it has clearly Reduced investor’ appetite for risk and tightened financing conditions. Notwithstanding clear downside risks, the Commission sees the economy growing at around potential in the two forecast years.

The current distress was triggered by a rapid increase in defaults in the US sub-prime mortgage market, which is a small segment of the overall US mortgage market. However, as these sub-prime loans have been passed on the other banks/ institutions, which subsequently mixed them with different loans or receivables into complex and quite opaque financial products such as collateralized debt obligations (CDOs), these risks have been distributed around the global financial system. For instance, some European institutions without any apparent connection to the US mortgage market were severely hit in recent months.

Market participants became reluctant to engage with counterparties until the location of these losses became clearer and their own liquidity needs were fully assessed. While some markets have recovered (at least to a degree), crucial segments of the credits market, such as inter-bank lending, remain seriously disrupted. Even though major intervention by the central Banks to inject liquidity has helped to stabilize the markets, the turmoil has clearly titled the balance of risks to the downside in particular as regards the outlook for the US.

Economic activity is also supported by a positive, albeit small, net contribution from the external sector this year in the euro area. The international environment is expected to remain supportive, as a more marked slowdown in the US is largely offset by buoyant growth in the emerging markets. World GDP growth (excluding the EU) should ease slightly from 5.6% this year to 5.3% in 2008. before accelerating again to 5.4% in 2009.

Word trade growth (excluding the EU) is set to decline somewhat from around 8% in 2006 to 7.75% this year, reflecting the global slowdown in the manufacturing sector. With world GDP growth sustained above 5% per annum, world trade is expected to remain robust at 7-7.5% in 2008-2009. The slowdown in the US economy appears sharper than expected this spring.

Oil prices have reached new record highs during this autumn, with the cost of a barrel of Brent crude oil Exceeding 84-US dollar at the time of the cutoff date (i.e 24 October). Compared to mid-January, oil prices have risen by 65% ( or 49% expressed in euro). Notwithstanding the fact that oil prices had already more than doubled in the preceding three years. A continued tight oil market, suggest that spare capacity and stock levels could remain under pressure.

Consequently, oil prices, between 75 and 81 US dollar per barrel, corresponding to an annual increase of 6.6% this year and 11.7% in 2008 before easing somewhat in 2009. Since the cut-off date for the autumn forecast, oil prices have continued to rise and reached 90 US-dollar on 2 November, recent developments in the markets would imply that the oil price assumptions would have been around 6 US- dollar higher per barrel next year (or almost 4 euro more per barrel also taking into account the further strengthening of the euro). Using the multipliers from Commission’s global macroeconomic model QUEST as a rule of thumb, this would have lowered GDP growth by almost 0.2 point next year and increased consumer price inflation by 0.1 point.

Most non-fuel commodity prices also continued to rise this year, especially food commodities and metals. For example, wheat prices have doubled the last year as a result of adverse weather conditions in e.g Europe, Africa and Australia. Under the assumption that weather conditions normalize and conditions in metal markets ease somewhat, non-fuel commodity price inflation could start to recede in the course of 2008.

Looking ahead, survey data for the EU have started to decline in recent months. According to the Commission’s most recent business and consumer surveys, economic sentiment has weakened in all sectors besides the construction sector. However, the economic sentiment indicators remain well above their long-term averages. National business surveys also have declined in recent months, though almost all remain at elevated levels.

This would suggest relatively firm real GDP growth in the coming quarters, broadly in line with potential. Against this background, both hard and soft data suggest that the peak of the current business cycle is behind us, although data may partly be distorted by special factors (e.g the impact of the VAT increase in Germany on the quarterly profiles at the turn of this year).

For the year as a whole, real GDP growth is expected to ease only marginally to 2.9% in the Germany on the quarterly profiles at the turn of this year). For the year as a whole, real GDP growth is expected to ease only marginally to 2.9% in the EU and 2.6% in the euro-area economies (thus unchanged from the spring forecast).

Growth rates continue to vary across EU Member States. This can be partly explained by the ongoing catching-up process in the recently acceded Member States, but there are also sizeable differences among the euro-area countries. However, this follows exclusively from the impact of the smaller Member States as the dispersion among the five largest countries remains unchanged.

Private consumption picked up again in the second quarter of this year, thereby becoming the main engine of growth- as is to be expected in a maturing business cycle. The initially weaker development of private consumption compared to previous recoveries mainly reflected sluggish employment growth at the start of this upturn on top of rather subdued wage growth. On the back of the turnaround in the labor market situation since early 2006, consumer confidence firmed and consumption growth gradually strengthened (although this trend may have been partly overshadowed in 2006-2007 by the temporary impact of the budgetary measures in Germany).

With a still favorable employment outlook, a key question is to what degree consumer confidence in the retail sector declined sharply in September 2007 (as regards both the present and the expected business situation). The savings rate is expected to broadly stabilize in the EU, suggesting that private consumption would grow at around 2.25% in the coming two years in line with disposable income.

Although the slowdown of growth in the US economy affects exports in the EU, especially in countries such as Ireland and the United Kingdom, the external sector remains supportive to growth this year. The impact of the appreciation of the euro on euro-area exports should be offset by a broadening of world growth and its ongoing shift in the geographical composition in favor of Asian and oil-exporting economies. Moreover, taking into account the developments in other key currencies, the gains in nominal effective terms have been markedly more moderate (about +3% vis-a-vis +8.5% in the bilateral US-dollar/Euro rate until end-October).

Following a slight deterioration next year, European exports are forecast to benefit from the acceleration of world growth and world trade growth in 2009.

Strong job creation this year.

Turning to the labor market, employment growth accelerated to 1.5% in the euro area in 2007 (whilst remaining unchanged at 1.5% in the EU), reflecting the lagged response of employment to GDP. This corresponds to 3.6 million new jobs in the EU this year (of which 2.3 million in the euro area). The improvement appears broad-based across all sectors as well as various types of work arrangements (e.g part-time, full-time, permanent and fixed-term contracts). Employment growth also seems to be largely balanced across Member Sates this year, although not always accelerating and with Hungary being an exception with declining employment.

Going forward, a deceleration in employment growth to around 1% per year is expected in both EU and the euro area as the business cycle matures. It follow, in particular, from a marked slowdown of fob creation expected in Germany, Spain, and Poland among the larger Member States. However, this is still equivalent to 4.5 million new jobs being created in the EU in 2008-2009 (3.2 million in the euro area) and is expected to bring the employment rate to above 6.6% of the working-age population in the EU by 2009.

The unemployment rate fell to its lowest level in more than fifteen years at 7% of the labor force in the EU in the early autumn of 2007. The unemployment rate is expected to continue to decline gradually, albeit at a clearly slower pace, to reach 6.6% in the EU in 2009 (7.1% in the euro area). Although the cyclical upswing is the main factor behind the improved labor market situation in recent years, a decline in the estimated structural unemployment rate has also contributed to lower unemployment.

With unemployment declining, labor shortages are becoming more common in both the manufacturing and services sectors, especially in Bulgaria, Denmark, the Netherlands and Poland. This tightening of the labor market situation is expected to put some upward pressure on nominal wage growth. Compensation of employees per head is therefore forecast to accelerate from 3% this year to 3.6% in 2008 in the EU, before easing somewhat in 2009. Similarly, euro-area wage growth is set to pick up from 2.6% in 2007 to 3.1% in 2008 before moderating to 2.8% in 2009.

An easing in 2009 may appear somewhat counterintuitive, but is above all explained by the impact of contract renewals, one-offs and catching-up measures in 2008, particularly in Germany, Italy and Finland, which, at least in the German case, followed several years of wage restraint.

Sustained labor productivity growth is expected over the forecast horizon that, at 1.3% in 2009 in the euro area and 1.6% in the EU, hovers around their long-term averages. This limits the rise in unit labor cost over the forecast period across most Member States. After several years of low actual productivity growth in the 1990s, the decline in trend labor productivity growth seems to have come to a halt, although at this stage there is no robust evidence of a pick-up in the underlying trend.

Contained inflation so far this year.

Inflation has remained relatively contained during the first three quarters of this year. Headline HICP inflation decelerated to 2.1% on average in the EU and 1.8% in the euro area. Indeed, euro-area consumer prices remained below the 2% threshold for the twelve month in a row until September this year, when energy prices pushed the inflation rate above 2% again. The main reason behind this development is the strong increase in oil prices during 2006, which caused favorable base effects in energy price inflation (YoY) during the first three quarters of this year.

Core inflation (which excludes energy and unprocessed food), on the other hand, continued to drift up. The gap between headline and core inflation that has been observed over the last two years has therefore been closed. Indirect and second-round effects of high oil prices still appear to be relatively limited, as the pick-up in core inflation reflects, in particular, the impact of the German VAT hike by 3 pps at the start of this year as well as strong increases in primary commodity prices.

Going forward, euro-area inflation is expected to rise to 2.4% in the fourth quarter of this year reflecting base effects turning unfavorable and commodity prices on the rise, while unit labor costs remain relatively moderate. Consumer price inflation is expected to come back to around 2% in the second half of 2008 for the remainder of the forecast horizon on the back of an assumed easing of oil prices. A similar pattern is expected in the EU as a whole, albeit at a slightly higher level. This corresponds to a certain upward revision of annual consumer price inflation to 2.3% this year and 2.4% in 2008 in the EU, before easing slightly to 2.2% while accelerating from 2% this year to 2.1% in 2008 in the euro area, before decelerating somewhat to 2% in 2009.

The current account is broadly in balance for the EU and the euro area, but varies across Member States. In some of the recently-acceded Member States, a sizeable deficit may be linked to a catching-up process where external savings, especially in the form of foreign direct investment could play an important role supporting income convergence. Indeed, most of these countries also display buoyant investment growth and an annual labor productivity growth of 5% or more.

However, persistently large (and in some cases growing) deficits and external debts could raise some concerns about sustainability and vulnerability. This may reflect, for example, difficulties in financing large external deficits in an environment of shifting risk preferences in the global markets, or problems in adjusting the external position once the upswing of a strong credit boom has run it course.

Unexpected revenue gains improve the budgetary outlook this year.

Public finances are set to improve further this year. The general government deficit is expected to decline from 1.6% of GDP in 2006 to 1.1% in 2007 in the EU (and from 1.5% to 0.8% in the euro area). This follows, in particular, from stronger-than-expected revenue growth in the euro area, which has bees revised up to 4.9% from 4.2% in the spring forecast. However, pats of these windfall gains have been used for additional expenditure this year and next in some of the Member States. Expenditure growth in the euro area is now forecast at 3.1% in 2007 (up from 2.8% in the spring forecast). For 2008, a slight deterioration in the deficit expected to 1.2% of GDP in the EU and 0.9% in the euro area, also taking into account the moderation in economic activity. Based on the usual no-policy-change assumptions, the deficits are forecast to broadly stabilize in 2009 in both areas.

At the Member State level, the budgetary developments are more diverse than forecast this spring. While the outlook is for an improved budgetary position in most euro-area economies, a worsening is now expected for Ireland throughout the forecast period as well as, although to a lesser extent, for Belgium and Greece this year. The deterioration anticipated for the Netherlands this year is expected to be largely made up for over the coming two years. Conversely, the outlook for 2007 has improved particularly for Germany and Italy, even though the fiscal consolidation projected in the spring for the latter country was slightly higher.

A significant improvement is also foreseen for Portugal with the deficit falling below the 3% of GDP threshold in 2008. As regards the four Member States outside the euro area that are currently subject to the deficit procedure (EDP), the budgetary position improve significantly in Hungary, with the deficit falling from 6.4% this year to 4.2% in 2008., the Czech Republic and Slovakia, while the deficit is set to rebound in Poland above the threshold in 2008 on account of an expansionary budget. Outside the countries currently in EDP, the deficit in Romania is expected to widen significantly and could reach 3.9% of GDP in 2009.

Fiscal consolidation comes to a halt.

Taking into account temporary measures and cyclical factors, the estimated structural deficit is also declining this year (from around 1.5% to 1% in the EU and from about 1% to 0.75% in the euro area). However the decline is less pronounced than for the nominal balance, reflecting a slowdown in fiscal consolidation. On the basis of the usual no-policy-change assumption and the information from the 2008 budgets available at the time of the forecast, no further improvement in the structural balance is expected for 2008 and 2009.

The general government gross debt ration is maintaining its decline from the 2005 peak. It is expected to decrease by more than 5 pps, between 2006 and 2009 to 63.4% of euro-area GDP. As for the EU as a whole, the debt is forecast to gradually decline, falling below to 60%-of-GDP reference value already in 2007.

Downside risks on growth prevail

Summing up, the economic outlook in the EU and the euro area is for a moderation of GDP growth to around potential during the forecast period. Consumer price inflation is expected to temporarily accelerate to 2.4% in the fourth quarter of 2007 in the euro area, before coming back to around 2% in the third quarter of 2007 in the euro area, before coming back to around 2% in the third quarter of 2008 for the remainder of the forecast horizon. However, there are several risk factors to both the growth and the inflation outlook. The balance of risks for economic growth is now clearly titled to the downside and to the upside for consumer price inflation.

The major downside risks relate to the recent turmoil in the financial markets and a sharper and/or more protracted slowdown in the US economy. While most financial markets have returned to a broadly normal functioning, significant disruptions persist in crucial market segments, signaling a continued lack of confidence affecting credit and liquidity provisions. The lack of transparency of market participants exposure to the underlying risks could imply that the confidence effect may last for a protracted period of time. In that event credit conditions and credit availability could be more seriously affected than assumed in the forecast. This could affect inter alia housing markets adversely, especially in the US, but also in the EU, thereby deepening and prolonging the ongoing corrections. The impact of a further tightening of lending conditions and reduced credit availability would affect Member States in different ways Countries having had a housing boom in the recent past, with high external debt or a high share of debt at variable interest rates are likely to be more exposed than others.

Further downside risks relate to disorderly unwinding of global imbalances in general, even if the current outlook already predicts a certain reduction of the US current-account deficit. Moreover persistent large current-account imbalances could enhance the risk of protectionist measures. Other downside risks relate to adverse developments in oil prices. On the other hand, there are a number of upside risks. Commodity prices could well decrease over the forecasting period or the growth momentum in emerging markets could surprise on the upside.

The dynamics in the labor market may also have been underestimated, giving an additional boost to labor income and consumer confidence. This could facilitate a return to a trend decline of the savings rate following the temporary rise after the burst of the dot-com bubble at the start of this century-thereby yielding further support to private consumption. Risks appear to have increased also as regards the inflation outlook.

This follow, in particular, from the rise in commodity prices where the up-tick in food prices might have boosted inflationary expectations and pressures recently. Indeed, the strong increase of consumer price inflation expected for October (up to 2.6% YoY) from 2.1% in September according to Eurostat’s flash estimate, released after this forecast’s cut-off date) seem to suggest a more pronounced impact from food and energy prices. However, the marked increases in oil prices (in US-dollar) have had a relatively muted impact in recent years, owing to competitive pressures of globalization, a decline in the inflation of other goods and the appreciation of the euro , which partly offset the effect of higher oil prices on domestic inflation. Nevertheless, it cannot be exclude that there may be nonlinearities at play, possibly implying that oil prices above a certain threshold could influence domestic inflationary pressures to a greater extent.

Uncertainty about future course of financing conditions.

The current forecast is characterized by higher than usual uncertainty, due to ongoing problems in the functioning of several key financial markets and the resulting uncertainty about the future course of financing conditions. The turmoil, which has persisted over many weeks, is increasingly likely to impact on the real economy through a tightening in credit tightening will ultimately depend on how long it takes for normality to be restored in the affected financial markets which remains an open question.

The trigger for problems in financial markets has been the deterioration in the US housing market, as reflected in accelerating rates of defaults on higher risk or sub-prime mortgage loans. While the associated financial losses are small relative to the size of the international financial system, they have triggered a generalized collapse of investor confidence in those securities and institutions with potential sub-prime exposure. These effects have not been confined to the United States. European financial markets have also experienced problems of disruption and dislocation, even though sub-prime mortgage lending is much less prevalent in Europe.

Problems in the US sub-prime lending have impacted on the international financial system because of the way in which the associated credit risks have been managed. Although the sub-prime mortgage loans were originated by US mortgage lenders and retail banks, they were sold on to other financial institutions in the secondary market.

These institutions securitized the loans and bundled them together with other securities-based on prime mortgage loans or loans raised by companies-to create marketable securities known as collateralized debt obligations (CDOs). CDOs were then sub-divided into section, with risk categories ranging from very high risk (junk) to very low (AAA). Each section was assessed by a credit rating agency and sold on this basis to investors, including hedge funds, pension funds, insurance companies and banks. In this way, the credit risk associated with US sub-prime mortgage loans was distributed around the global financial system.

Money markets have been among most disrupted by the loss of investor confidence. Central banks have been required to intervene on many occasions to support the smooth functioning of these markets by providing emergency liquidity. Moreover the financial turmoil has impacted on the stance of monetary policy. The Federal Reserve has lowered both the discount rate (the rate at which bank borrow from the Federal Reserve) and the target for the federal funds rate (the rate at which banks borrow from each other) in response to growing concern about the implications of the financial turmoil.

Both the ECB and the Bank of England, which until the summer were widely expected to raise interest rates, responded to uncertainty in financial markets by holding their policy rates unchanged, while signaling a continued vigilance as regards inflationary developments.

Money markets particularly disrupted

The financial-market turmoil has led to a typical flight to quality, although some calm has been restored to markets in recent weeks. During the initial flight to safety, interest rates on most liquid government paper and sovereign bonds declined sharply, leading to an increase in spreads across sovereign issuers with similar ratings but less liquid markets. The increased risk aversion has been also visible in a sharp rise in investor perceptions of default probabilities and wider spreads on corporate and emerging market bonds. Recently, though, a partial relaxation can be observed. Equity prices initially fell sharply, but recovered in the wake of expected and then realized US interest rate cuts. However, sentiment in equity markets remain volatile and the recovery in prices has not been uniform, with large multinational corporations generally outperforming smaller firms. Several key financial markets are still not functioning properly. In the interbank markets, interest rates for maturities longer than a few days remain at elevated levels.

Problems in the functioning of the interbank market reflect a combination of perceived counterparty risk related to sub-prime exposures and, particularly more, reluctance among, market participants to make multi-day loans because of concerns about future liquidity needs. As a result, interest-rate spreads, e.g . between 3-month interbank lending rates and the respective average risk-free rate on euro-area government bills, have widened significantly.

Credit conditions have tightened.

The abrupt re-pricing of risk sparked by the financial turmoil has led to a tightening of credit conditions, which is likely to persist going forward. The precise extent and duration of such tightening is, however difficult to predict.

The sharp decline in the value of some financial assets held by the financial sector since end-July can be seen as a balance-sheet shock for banks and the financial system overall, which is likely to reduce the ability and willingness of institutions to provide credit. In addition, a reduced scope to transfer credit risk via securitization implies higher lending interest rates and tighter lending standards. In turn, lower levels of lending activity will reduce bank profits.

Tighter credit conditions are visible in the results of the latest ECB bank lending survey. The survey of changes in bank lending standards made during the third quarter of 2007 indicates that a net 31% of all euro-area bank tightened their credit conditions vis-a-vis corporate borrowers (31% of all banks tightening and none easing) and 28% of banks expected standards to tighten in the fourth quarter. A net 12% of banks also indicated a tightening of lending standards on mortgage lending in the third quarter (22% tightening and 10% easing) and a net 15% of banks expected to further tighten in the fourth quarter. The survey also revealed that banks have not yet tightened standards on other household sector loan categories, but expect to tighten them in the fourth quarter.

Negative but uncertain impact on economic sectors.

Due to the strong profitability of recent years, corporate balance sheets seem well placed on average to withstand the tightening credit conditions. However, external financing demand has risen sharply in the past two years with lending to the non financial corporate sector in the euro area at record high levels. This has partly reflected a corresponding expansion in investment activity. The aggregate growth rate of bank credit to the corporate sector hides considerable differences between Member States. In August 2007, lending was up by about 30% year-on-year in Ireland, Spain and Slovenia. In contrast bank lending to corporations was only 4% in Germany. In the face of these continuing high financing demands in some countries, corporate debt ratios have risen to record levels with the ratio of euro area corporate debt to GDP exceeding 80% compared to around 60% in 1999.

Some catching-up EU economies might be vulnerable.

The financial turmoil has not had a significant impact on catching-up economies, possibly due to their lower exposure to sophisticated financial products. Some of the Member States in Central and Eastern Europe were affected by the initial phase of the turmoil experiencing currency depreciation, widening risk and declining equity prices. However, most of these effects eased subsequently. Nevertheless, the durable tightening in credit conditions, which is likely to follow the current financial turmoil, increases the risks for these economies. Those Member States with larger external financing needs (which in some cases rely extensively on short-term capital inflows) are particularly vulnerable. Any sharp reduction in access to external financing would directly affect housing markets and consumption (directly via reduced availability of credit and indirectly via wealth effect).

Bulgaria tight labor market fuelling wage pressures.

Real GDP growth accelerated to 6.4% in the first half of 2007, up from 6.1% in 2006, mainly driven by strong domestic demand. Fuelled by continued strong FDI inflows and re-acceleration of credit growth, investment demand was particularly buoyant, expanding by close to 30%. High wage increases and strong employment growth also boosted private consumption, which grew by close to 7%. In contrast, public consumption remained almost unchanged in real terms compared to 2006. Real export growth decelerated to 7.4% whilst import growth remained strong at close to 12%.

Economic growth has thus become increasingly unbalanced in the first half of 2007. The weak export performance is partly explained by lower energy exports following the partial closure of Kozloduj nuclear power plant at the end of 2006 and the ongoing economic restructuring in certain sectors. It may also reflect an underreporting of intra-EU trade flows following changes in the reporting methodology after accession. In line with a growing trade deficit, the net borrowing of the economy widened to around 18% of GDP (up from 15% in 2006). Economic activity should decelerate slightly in the second half of the year, with real GDP expending by around 6.25% for the full year.

Prospects for 2008 and 2009.

A certain rebalancing of economic activity is expected in 2008 and 2009. Economic growth will, however remain robust reflecting underlying trends and the continuing catching-up to the Bulgarian economy.

Real GDP growth is thus projected to decelerate slightly in 2008. on the back of somewhat weaker domestic demand, and to return to close to potential in 2009. Investment growth is expected to decelerate to more sustainable levels as a result of tighter international credit conditions triggering a certain slow-down in FDI inflows. In addition, higher wage growth is compressing profit margins, and hence also dampening investment demand. Moreover, investment activity currently driven by the need to adopt EU standards in certain industries will gradually fade out in the coming years. At the same time, increased public investment associated with the absorption of EU Structural Funds should ensure that investment growth still remains well above 10% per year.

Private consumption growth will slow down moderately as nominal wage growth decelerates and high inflation together with lower employment growth also limits growth in disposable incomes. On the external side, lower domestic demand growth should be reflected in a further cooling down of import growth in 2008 and 2009. At the same time, export growth is expected to recover from the slow down in 2007 as high capital accumulation in recent years should strengthen the export potential of the Bulgarian economy.

The negative contribution to growth from net exports should thus decrease noticeably. Together with an improvement in the terms of trade and increasing EU transfers, this will entail a gradual reduction in the net borrowing of the economy to around 16% of GDP in 2008 and 2009.

Labor market, costs and prices.

The Bulgarian economy has been showing signs of overheating in 2007 with mounting wage pressures, rising inflation and a widening of external imbalances. Buoyant employment growth and a strong decrease in unemployment have led to a considerable tightening of the labor market, with growing shortages especially for high-skilled labor. Consequently nominal wage growth has accelerated sharply since the end of 2006 to over 17% in the first half of 2007. Given the sustained decline in the working-age population and somewhat weaker labor demand due to rising wage costs, job creation is projected to slow down to around 1% by 2009. Wage pressures will remain strong over the forecast period although nominal wage growth may decelerate from the currently high levels.

Even though productivity growth is expected to increase to around 5% in 2009, this would still entail substantial increases in nominal unit labor costs, reducing companies profit margins HICP inflation decelerated to around 4.5% in the first half of 2007, mainly because of base year effects due to an increase in excise duties at the beginning of 2006. Since July 2007, however, inflation has started to accelerate sharply, largely on the back of drought related increases in food prices, although core inflation has also picked up noticeably, reflecting increasing demand-side pressures. In view of sustained wage pressures, inflation is expected to remain at around 6-7% throughout the forecast horizon.

Public finances

Thanks to very strong revenue growth, the general government budget surplus is expected to reach around 3% of GDP in 2007, which is clearly above initial budget projections. The revenue over performance is largely due to stronger economic activity, with particularly buoyant domestic demand growth generating higher revenue, and to substantially higher inflation than originally expected. In addition strong growth of corporate income tax revenue- despite a 5pps reduction in the tax rate at the beginning of the year-suggests that improved tax compliance and a successful reduction of the informal economy also play a role.

At the same time, nominal expenditure growth has remained broadly in line with original budget targets, implying a slight drop in the expenditure-to-GDP ratio. The general government surplus in 2007 also reflects a one-off, expenditure increasing foreign debt cancellation to Libya of around 0.1% of GDP. Based on a no-policy-change assumption, a comparable general government surplus to 2007 is expected in 2008 and 2009. Together with strong nominal GDP growth, this would imply a further decrease in general government gross debt to below 15% of GDP.

The world economy: Global growth is withstanding the US slowdown

The outlook for the global economy remains largely positive, but the downside risks have clearly increased. This is mainly due to a sharper housing downturn in the US, which has triggered distress in the credit markets. However, the slowdown of the US economy is anticipated to be largely offset by the strong expansion of other regions of the world, in particular Asia. All in all, world GDP growth is projected to ease gradually to 5.1% this year and 4.7% next year, before picking up slightly to 4.8% in 2009. The main uncertainty of these projections lies in the magnitude of the US slowdown, which has proved to be sharper than expected in the spring forecast.

The steep fall in residential investment has depressed growth to below trend, with spillover effects on employment. It has also triggered a re-assessment of risk on the financial markets, initiated by rising defaults in the sub-prime mortgage market. While a certain decoupling between the US economy and the rest of the world has been observed so far, some economies are particularly dependent on US imports and would therefore be affected by a shaper and longer-lasting reduction of consumption growth in the US. In the same time a worsening of the situation in the credit markets would lead to a further tightening of financing conditions which could affect confidence and the global economy.

GDP growth is supported by emerging economies.

As discussed, the recent developments in the global economy have shown a decoupling between the US and the rest of the world. While the underlying growth rate of the US economy is now clearly below potential, many emerging economies have accelerated more than expected in the spring forecast. They are likely to sustain high rates of growth next year, thus putting a floor under the moderation in global growth expected for 2008. In 2009, the rebound of US GDP growth should lead to a slight acceleration in global activity. Due to weaker US import growth , would trade growth has moderated in the first half of 2007.

The global manufacturing PMI indicator, which is normally a reliable indicator of world trade growth suggests a further decline in the second half of the year. Therefore, growth in global imports of goods and services (excluding the EU) is projected to decrease to 7.8% in 2007 and 7.1% in 2008, before edging up to 7.7% in 2009.

The decline in import growth is particularly strong for the US, whose contribution to world trade growth is now expected to world trade growth is now expected to be about 1pp below that of 2006, at about 0.6pp in 2007 and 0.5pp in 2008. This slowdown should have knock-on effects on other economies, thus explaining the moderation of trade projected in other regions. However, in terms of robustness of the global economy, it is a noteworthy fact that several poles are taking over as drivers of world growth, with some of them particularly resilient to the US slowdown. Apart from Asia (especially China and India), the most outstanding cases are the MENA( Middle East and North Africa) and CIS (Commonwealth of Independent States) countries, whose contributions to world trade growth should remain above 1 pp in 2007 and 2008.

However, the resilience of these economies to a long-lasting and sharper-than-expected downturn of the US may be questioned. First, a stagnation of US imports of emerging economies (especially in the non-oil producing CIS countries) and, therefore, lead to a marked depreciation of their currencies. Second, the banking systems of these economies are still fragile and could be affected by their exposure to the US situation, with possible repercussions on domestic consumption and investment. In terms of global current account imbalances, however, the slowdown of US imports, together with strongly rising exports, is having the positive consequence of reducing the deficit in US external accounts.

The domestic counterpart is a rise in the household saving rate which should more than offset a projected increase in the fiscal deficit of general government. Nevertheless, the US current account deficit, even though decreasing, is projected to remain above 4% of GDP throughout the forecast period.

…But is threatened by the turmoil in the credit market

A widespread re-pricing of risk started on the credit markets during the summer. It was triggered by a rapid increase in defaults in the US sub-prime mortgage markets. Due to the complexity of new financial instruments, such as securitization derivatives, risk has become increasingly difficult to assess for investors, leading to a loss of confidence. As a result, financing conditions have begun to tighten globally. On inter-bank markets, the spreads between key interest rates and short-term rates have increased due to a rise in the perceived default risk.

The spread between the euro-area key interest rate-the minimum rate of submission to the main refinancing operation- and the EURIBOR 3 months reached 75 basis points in October, reflecting heightened nervousness. The same phenomenon was observed on the US market. The repeated injections of liquidity by the ECB and the US Federal Reserve in order to abate tensions have not deterred banks from hoarding excess liquidity, therefore pushing the short-term interest rates higher than usual.

Despite 50-bps-cut of the key policy rate in September and expectations of further reduction, the US 3-month rates are only 25 basis points lower than six months ago, at about 5.10% on 24 October. In the euro-area, they are about 75 basis points higher than their spring level, due to both the monetary tightening of the ECB and an increased spread stemming from the higher counterpart risk. On 24 October, they stood at about 4.65%. On the bond markets, a general flight to quality cased US interest rates to decrease. This started in mid-July, in conjunction and the monetary policy loosening. On 24 October, the 10-year benchmark rate had declined to about 4.35%. In the euro area, due to different growth scenarios, the developments were somewhat less pronounced. On 24 October, the 10 year rate stood at 4.15%, close to its spring levels.

At the same time, the yield spreads between corporate and government bonds have increased on all the ratings, due to a sudden reassessment of counterparty risk. In and historical perspective, these yield spreads remain at low levels. However, a further tightening cannot be ruled out. In parallel, banks could also respond to the financial turmoil by a quantitative restriction of credit. While the annual growth rate of loans to the private sector increased to 11.2% in August (and following the cut-off-date, to 11.0% in September), the ECB Bank Lending Survey for the third quarter of 2007 expects a deterioration of credit conditions. If this were to become a global phenomenon, it could weigh appreciably on world growth.

However, stock markets overcame the turmoil…

Global equity prices also registered a correction in August 2007. This stemmed from a worsening of the situation on the US sub-prime mortgage markets, and subsequent decisions by major banks to temporarily close some funds. While this closure was purely technical, it triggered fears of an extension of the crisis to other markets. The correction of equity prices was particularly severe for the banking sector. After the emergence of a shortage of liquidity on the money market, and the subsequent intervention of both the ECB and the Fed, banking shares lost up to 20%. However, they started to rebound on 17 August when the Fed announced a cut in its discount rate by 50 bp. Since then, losses have been mostly recovered . Stock markets have been buoyed by the Federal Reserve’s monetary policy easing as well as the status quo stance of the ECB. However, after the crisis of mid-2006 and that of February-March 2007, this last episode signals an increased nervousness of investors to any adverse developments in global economic conditions.

…And oil prices are still on the rise

After having eased to almost USD 50/bl in January 2007, oil prices have started to increase again. They are now about 40% higher than at the beginning of the year, oscillating around the level of USD 90/BL. In euro terms, however, the increase is more limited. This increase comes from both supply-side and demand-side factors. From the supply side, geopolitical tensions are strong, especially regarding the Iran nuclear programmed. In addition, US stockpiles of crude oil are decreasing, while bottlenecks persist in the refinery process. From the demand side, world oil demand is expected to continue to rise in the medium term, in connection with the buoyant GDP growth of emerging economies.

Against this background, oil prices are assumed to remain high over the forecast period. Contracts in the futures market indicate that oil prices may range from USD 75 to USD 81 per barrel in the near to medium term. Based on such contracts, the forecast assumes the price of a barrel of Brent to average USD 70.6 per barrel in 2007, USD 78.8 in 2008 and USD 76.0 in 2009

At the same time, the real exchange rate of the euro has continued to appreciate

The euro reached an all-time high against the US dollar, trading above 1.40 USD in October .This is an outcome of the relative downward revisions in expected GDP growth, which have been more significant for the US than for the euro area. In addition, the monetary policy loosening by the US Federal Reserve has reduced the interest rate differential between the two regions. Finally, the unwinding of yen carry-trades has also played a role although a smaller one than what might have been expected from a US downturn. However, gains in nominal effective terms have been markedly more moderate, with an appreciation of about 3% on one year.

Although the Japanese economy has recovered from the last recession, deflation persists and nominal key interest rates are still very low. As a result, the euro reached a new all-time high against the yen in July, before losing some ground after the start of the financial market crisis. With the recovery of the stock market and the disappointing outturn for Japanese GDP growth in the second quarter of 2007, the euro has edged up and is oscillating close to its historical high against the yen at about 160 JPY.

While the weakness of the US dollar is improving US trade, thereby lowering the US current account deficit and global external imbalances, a continuous slide, particularly in isolation from other adjustment in other parities, would have knock-on effects on the EU economies. Furthermore, the widening of the trade balance between China and both the EU and the US suggests that exchange rate misalignments persist.

Outlook by region.

World GDP is expected to ease slightly in 2007 and 2008 to respectively 5.1% and 4.7% before edging up to 4.8% in 2009.Compared to the 2007 spring forecast, which stems essentially from better-than expected growth in Asia (excluding Japan), Latin American and the CIS countries. However, the moderation of world GDP growth next year will be more pronounced than projected in the 2007 spring forecast, the discrepancy coming from the sharper than expected slowdown of the US economy. In line with this scenario, world trade growth is also expected to gradually decelerate, from an estimated annual rate of around 9% in 2006 to around 7.8% in 2007 and 7.1% in 2008, before rebounding to 7.7% in 2009.

After three years of rapid expansion, the US economy shifted to a growth path below trend last year. Between the second quarter of 2006 and the second quarter of 2007 real GDP increased by 1.9%. The slowdown has been concentrated in the housing sector with declining residential investment subtracting 1 pp from GDP growth. Although house prices have started to decline and negative wealth effects are likely to materialize in the near term, consumer spending has so far continued to expand at a solid rate. GDP growth should still reach 2.1% in 2007.

However, the housing downturn has turned out to be more pronounced and more protracted than previously expected. This has led to a significant downward adjustment of projected GDP growth for next year to 1.7%. The main reason is sharply lower consumer spending growth, as the fall-out from the housing correction takes hold. Business investment should also remain subdued, partly because of tighter credit conditions. The housing recession is expected to bottom out in the second half of next year, which should allow the economy to recover slowly towards potential, resulting in annual growth of 2.6% in 2009.

The Japanese economy should continue to grow at a moderate pace, decreasing to 1.9% in 2007 and 2008 from 2.2% in 2006. While private consumption has proved to be rather strong, especially given the still decreasing nominal wages, business investment fell unexpectedly in the second quarter of 2007, leading to a contraction of GDP. However, private investment is expected to pick up rapidly, against the background of high corporate profits and a rising external demand, especially from the rest of Asia.

At the same time, private consumption is projected to be supported by a moderate rise in household income, as wage growth is expected to gear up over the forecast horizon. For 2009, GDP growth is set to edge up to 2.3%. Economic growth is the other Asian economies is expected to continue on a strong footing over the forecast period, although the aggregated regional growth figures mask variations across the different economies. On the one side, China and India are experiencing annual growth rates from 7% to 11%, while on the other side, the countries of South-East Asia are registering growth rates of about 5%. In 2007, GDP growth in the whole region is set to reach 8.8%, before decelerating modestly to 8.4% in 2008, and to 8.2% in 2009.

China’s economic growth continues to exceed expectations, with a revised GDP growth rate of 11.1% in 2006. After a slight deceleration at the end of 2006, the Chinese economy reaccelerated in the first six months of 2007. Key factors behind this performance remain outstanding growth in net merchandise exports and investment spending. While the deceleration in US imports should induce a slight deceleration in Chinese exports, they are still expected to expand by about 20% in 2007 and about 15% in 2008. As a result, GDP growth should remain almost unchanged in 2007, before easing slightly to 10.3% in 2008. Such a projection assumes that the monetary and administrative measures undertaken by the government to cool the economy might at last have an impact, and that the slight appreciation of the effective terms will continue. If so, GDP growth for 2009 should be contained at below 10%.

Growth in India is also projected to moderate somewhat over the forecast period, from 9.2% in 2006 to 7.6% in 2009. This gradual easing reflects the impact of previous monetary tightening and the recent appreciation of the rupee against the US dollar. In the rest of Asia, economic growth is expected to decrease slightly to below 5% in 2007 and 2008, except in Indonesia, whose growth rate is set to reach 6%. While divergences exist across countries, the general tendency is, for the contribution of domestic demand to GDP growth, to decline somewhat while exports remain buoyant. This is particularly the case for Korea, which could thus suffer more if the slowdown in the USA were to be sharper-than-expected, with some repercussions on its neighbors.

However, Asian emerging economies seem to be weathering the US slowdown quite well up to now. The EFTA countries continue to enjoy strong growth. In Norway, GDP growth is forecast at 2.9% in 2007 and should increase to 3.1% in 2008, before moderating to 2.2% in 2009. Domestic activity should continue to be the driver of growth, supported by strong private consumption. In Switzerland, GDP growth is expected to slow gradually in a context of tighter monetary policy and less buoyant international environment. The economy should expand at 2.3% in 2007, before softening to 2.1% in 2008 and 2.0% in 2009.

Economic growth in Turkey reached about 6% last year, but is expected to decrease to 5.1% in 2007. This moderation reflects the impact of the financial turbulence last year. However, activity is forecast to reaccelerate gradually to 6.5% in 2009, in line with potential growth. In Croatia, strong domestic demand, partly fuelled by some pre-election spending, is likely to increase growth to 6% in 2007, before moderating to 5-5.5% in 2008-2009. In the former Yugoslav Republic of Macedonia GDP growth continues to increase, from 3.1% in 2006 to an expected 5.0% in 2007, 5.5% in 2008 and 5.3% in 2009. The CIS region is the second-fastest-growing region after developing Asia with economic growth expected at 8.3% in 2007, 7.5% in 2008 and 7.1% in 2009. Economic growth in Russia reached 6.7% in 2006 and the forecast for 2007 has been revised upwards, to 7.7% compared to 6.8% in the spring forecast.

The growth in domestic demand is still robust, as investment spending and consumption continue to accelerate. Furthermore, oil prices have rebounded after the softening observed at turn of this year, boosting a still large current surplus projected at 7.5% in 2007. For 2008 and 2009, GDP growth is expected to remain buoyant at about 7%. In the other CIS countries, economic growth rebounded to 9.5% in 2006, reflecting the strong performance of its biggest economy, Ukraine whose GDP growth is projected at about 7% in 2007 and 6.3% in 2008-09. Economic growth in Latin America continued to be strong in the first half of 2007 and is now expected to reach 5% for the year as whole.

The economic expansion has benefited from favorable external conditions, but is increasingly gaining support from domestic demand, on the back of lower real interest rates, strengthening labor markets and generally expanding credit. In line with the expected moderation in the world economy and emerging capacity constraints in some countries, GDP growth in the region is, however expected to decelerate to 4.4% in 2008 and 4.2% in 2009. While most economies in those economies that are most exposed to the US economy is likely to be lower than what was expected in spring.

This is notably the case for Mexico. GDP growth in the MENA region reached 6.2% in 2006, with most oil-importing countries performing better than the oil-exporting countries, as they reap the fruits of previous structural reforms. For 2007 real growth in the region is expected to reach 5.2% and remain over 5% in 2008 and 2009. In Saudi Arabia and the United Arab Emirates, domestic demand is expected to remain underpinned by oil export revenues, which are financing significant increases in public spending.

Buoyant foreign direct investment should also continue to stimulate growth. In Sub-Saharan Africa, annual GDP growth is expected to reach 6.9% this year, after 5.8% in 2006. Domestic demand is accelerating markedly and is expected to contribute over 8 pps to growth, supported by high oil revenues but also a dynamic non-oil sector. However, the external sector contribution remains negative, as imports are boosted by domestic demand. In 2008 and 2009, GDP growth is expected to fall back to about 6.5%, as domestic demand decelerates due to the tightening of both monetary and fiscal policies.

Статията е публикувана в бр.4/2007 г. на сп. „Финанси“

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