10 November 2011

European Commission Economic Forecast - Autumn 2011

The outlook for the European economy has taken a turn for the worse. Sharply deteriorating confidence and intensified financial turmoil is affecting investment and consumption, while urgent fiscal consolidation is weighing on domestic demand, and weakening global economic conditions are holding back exports. Real GDP growth in the EU is now expected to come to a standstill around the end of this year, turning negative in some Member States. Only after some quarters of zero or close-to-zero GDP growth, a gradual and feeble return of growth is projected in the second half of 2012.

The aggravation of the sovereign debt crisis and the deteriorating outlook for the global economy triggered global financial market turmoil amid a generalised re-assessment of risk. Equities tumbled worldwide, but most strongly in Europe. While bond yields of the euro area Member States with vulnerable fiscal positions increased, the yields of bonds considered as safe havens fell to record lows. Uncertainty about the exposure of banks to euro area sovereigns resulted in a freeze-up of inter-bank lending and a sharp deterioration of the banking sector's funding conditions. While the predicaments of banks differ, banks are now expected to accelerate the strengthening of their capital buffers.

As a result of the domestic and external weaknesses, GDP in the EU is projected to stagnate towards the end of 2011. This deterioration of the outlook is supported by the accelerated decrease of leading indicators in recent months. GDP is expected to recover very gradually from the spring of 2012 onward, returning to modest growth later in the forecast period. This outlook for a gradual recovery is in line with an assumption of declining uncertainty and financial market stress, which is, however, conditional on appropriate policy action.

Expected GDP growth is revised down for the second half of this year as well as for 2012; for 2013, a return of modest growth is projected. Mostly due to the strong GDP growth in the first quarter of this year, annual GDP growth for 2011 remains close to the values projected in the spring forecast, at 1.6 per cent in the EU and 1.5 per cent in the euro area. Growth for 2012 is revised down substantially, by 1¼ percentage points to ½ per cent in both the EU and the euro area. For 2013, annual growth is projected at 1.5 per cent in the EU and 1.4 per cent in the euro area. In terms of quarterly profile, growth is expected to be nil in the fourth quarter of 2011. On account of a gradual return of confidence and abating external drag, quarterly GDP growth is then expected to increase slowly to around 0.4 per cent in both the EU and the euro area by the fourth quarter of 2012. This modest level of quarterly growth is forecast to be maintained throughout 2013.

The present forecast heavily relies on the assumption that policy measures to combat the sovereign debt crisis will eventually prove effective. It is assumed that the uncertainty related to the sovereign debt and financial market crisis will dissipate gradually towards mid-2012, and that this will lead to a reduction of financial market volatility and gradually release deferred investment and consumption. Indeed, many important decisions have already been taken, not least in late October 2011. They cover a large spectrum of measures to ensure or restore debt sustainability, repair the financial sector and strengthen the policy rules within EMU.

The main downside risks of the GDP forecast stem from fiscal sustainability, the financial industry and world trade. Ensuring fiscal sustainability remains a challenge across Europe, but also in major advanced economies outside the EU. Lack of credible progress in addressing the sustainability challenges could lead to even stronger financial stress. The banking sector, rather than increasing capital to improve balance sheets, might resort to divestment and lending restrictions, potentially producing a credit crunch as of early 2012, which would obviously depress domestic demand.

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