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EU Commission spring economic forecasts

Tue, May 15 2007, 09:53 GMT
by KBC Market Research Desk

KBC Bank

• Public finances benefit from upward revision EU Commission growth forecasts
• Strong investor’s risk appetite to keep spreads tight, despite rising yields

The EU Commission Spring forecasts highlighted the strong economic performance of the euro zone economy in 2006 and solid outlook for 2007 and 2008. Compared to the Autumn forecasts, the Commission has revised up its growth forecasts and now expects economic growth to remain above potential in the next two years.

In 2006, the economic expansion was increasingly driven by domestic demand, especially by a marked improvement in investment in equipment. Private consumption grew more moderately, but is expected to accelerate as the labour market started to improve considerably. Following the 2.7% growth pace in 2006, annual growth is forecasted at 2.6% in 2007 and 2.5% in 2008 upwardly revised from 2.1% and 2.2% in last year’s Autumn forecasts.

On the back of the economic improvement, public finances improved markedly last year with the general budget deficit falling from 2.5% in 2005 to 1.6% of GDP in 2006. This positive trend is set to continue with the euro zone budget deficit forecasted to fall further to 1% in 2007 and 0.8% in 2008. In structural terms, corrected for cyclical factors and net of one-off and other temporary measures, the budgetary adjustment in the euro area is however more muted than the nominal improvement. At the same time, the debt ratio also continued its decline that started in 2006. Between 2005 and 2008, the debt ratio is expected to fall from 70.5% to 65% of GDP.

The table (cf. below) provides an update of the new growth and deficit/debt forecasts for the individual euro zone member states. The member states are ranked in order of their projected debt-to-GDP ratio. Since the modification of the Stability and Growth Pact (SGP) in March 2005, market attention for the national budget situations has increased. The loss of credibility of the SGP resulted in a significant underperformance of mainly Italian, Greek and to a lesser extent also Portuguese bonds, as these countries faced the strongest deterioration in their fiscal position in recent years and already had the lowest rating among the euro zone member states. Last year, S&P and Fitch downgraded Italy’s rating from respectively AA- to A+ and from AA to AA-, as the new government failed to implement rigorous measures in their first budget. Since, the improvement in public finances has put Greece on a positive outlook at Moody’s and Fitch and has upgraded the negative outlook of Portugal to stable at Fitch.

From the countries under the excessive deficit procedure (EDP), the 2006 outcomes confirm that the deficit has been brought below the 3% of GDP threshold in both Greece and Germany. In Greece, the forecast is still based on the old GDP series and not yet on the ‘revised’ GDP data reported by the Greek authorities. Using the latter would lead to an upward revision of nominal GDP by around 26% per year. This would reduce the deficit to just below 2% of GDP, but as this would lead to a permanent increase of Greece’s contribution to the EU budget, the Commission estimates the budget deficit would rise again to close but below 3% of GDP.

A better than expected reduction of the deficit was also achieved for Portugal and Italy (net of a large deficit increase one-off). In the case of Italy, the budget deficit is expected to fall below 3% of GDP in 2007. In Portugal, however, the deficit is still projected to remain above the 3% of GDP throughout the forecast period. Concerning the debt-to-GDP ratio, the upward trend has reversed for all countries except Portugal, where the debt is expected to increase slightly. As such, Portugal won’t meet the requirements of the excessive deficit procedure to correct its excessive deficit by 2008 without additional measures.

Among the countries that do not have the highest credit rating in the euro zone, Belgium is still doing rather well,even while Eurostat amended the budget deficit from a surplus of 0.1% to a deficit of 2.3% of GDP in 2005 in relation to a debt assumption from the railway company. Despite the government’s commitment to publish budgets in balance, the Spring forecast project the Belgian budget deficit to widen to 0.1% of GDP in 2007 and 0.2% in 2008 from the 0.2% surplus in 2006. The debt ratio, while still the third highest within the euro zone member states, is projected to remain on a firm downward path and to fall to 82.6% of GDP in 2008.

To assess the budgetary outlook, it is also important to keep a close eye on the general trend in yields. Shortterm yields have risen quite substantially since the start of the ECB tightening cycle in December 2005. At the longer end of the curve, the rise in yields was less outspoken, as the curve flattened. The rise in yields is mainly important for countries with a high debt-to-GDP ratio like Italy, Greece and Belgium, as this may have a large influence on interest expenditures and consequently budget deficits. The outlook for the spreads between government bonds will however heavily depend on the general risk appetite. Until now, the rise in ECB rates did not spoil investor’s risk appetite yet. On the contrary, on the corporate bond market spreads are still very tight. This may keep spreads tight between euro zone government bond yields too, despite the strong improvement in public finances in for example Germany.

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Published on  Tue, May 15 2007, 09:56 GMT

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