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Euro area
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The Euro area: the slowdown is confirmed
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Important decisions taken at the summit of European Union heads of state.
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The school year normally begins in September. Most students will have new teachers or will even start new subjects. However, those repeating the year will be able to use the same text books and will probably have the same teachers as last year. The same thing is happening with the European Union (EU) as, although it's done its homework, its marks weren't good enough to pass its September retake and it will face the same problem of handling sovereign debt as some EU Member states.
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In fact, far-reaching decisions were taken at the summit of the heads of state or government of the euro area held in July. Firstly, the second bailout plan for Greece was agreed, totalling 109 billion euros. This plan will be implemented through the European Financial Stability Facility (EFSF) as the financial vehicle for the next payout. In the same summit statement, it's calculated that, in the case of Greece's bailout, the net total contribution from the private sector will be around 50 billion euros for the period 2011-2014. Part of this aid is due to the financial sector which, voluntarily, might support Greece in order to reinforce the overall sustainability of the new plan.
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Greece's second bailout plan is approved.
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Secondly, it was decided to extend the maturity schedule for future EFSF loans to Greece from the current period of 7.5 years to a minimum of 15 years and up to 30 years, with a 10-year grace period. On the other hand, the interest rate was lowered that is required by loans close to the EFSF funding cost, without going below it.
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Lastly, authorization was given for the EFSF and the European Stability Mechanism to intervene in buying up sovereign debt in secondary markets. The only requirement is a preliminary analysis by the European Central Bank acknowledging the existence of exceptional circumstances in the financial markets that warrant such intervention, although this last measure won't come into force until the 27 EU Member states approve it in their respective parliaments.
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Proposals continue regarding reforms of the institutional architecture.
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Since the start of this crisis, two lines of action can be observed on the part of those managing European economic policy. On the one hand, the urgent solutions that must be presented given the problems diagnosed, for example a financial bailout plan or regulations in financial markets to prevent short selling, etc. On the other hand, more extensive structural reforms of the architecture and governance of European institutions have also been considered and positions taken. Of note for this last context is the Franco-German summit of 16 August in terms of pushing the European project forward.
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The second quarter's GDP figures confirm the slowdown in the economy.
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In fact, at the summit held between Sarkozy and Merkel, ambitious proposals were noted to increase European economic coordination. Firstly, a budgetary golden rule so that all countries in the euro area include a public deficit limit in their constitutions. Moreover, France and Germany undertook to apply a common corporate tax to their companies as from 2013. Lastly, the creation of an economic government for the euro area was proposed, made up of government heads and run for two and a half years by a permanent president.
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These new proposals have arisen within a context of economic slowdown, confirmed by the figures for the euro area's gross domestic product (GDP) from the second quarter. GDP grew by 0.2% quarter-on-quarter, lower than the previous figure of 0.8% and reducing year-on-year growth from 2.5% to 1.7%. The breakdown for growth is still not available but, geographically, the flat growth of France (0.0%) and the lower than expected growth of Germany (0.1%) have negatively affected data on economic activity in the second quarter. We should remember that, together, Germany and France's GDP accounts for 48% of the euro area as a whole.
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Leading indicators suggest modest growth in the third quarter.
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To some extent, a slower rate of growth was expected, as the rate recorded in the first quarter was exceptionally high. However, the slowdown has been more intense than predicted by the consensus of economists' forecasts. These figures are cause for concern as growth is the best antidote for those countries with problems of fiscal consolidation. And leading economic indicators point to very modest growth for the third quarter.
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For example, the Purchasing Managers' Index continues its downward slide started in February this year. The index is similar to a business confidence indicator. Values over 50 imply expanding economic activity whereas values under 50 suggest shrinkage. This index suggests that business confidence is still in decline and the implications for job creation are not positive.
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Business and consumer confidence indices continue to decline.
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The main macroeconomic data, such as consumer confidence, point in the same direction. The figure for July fell slightly to -11.2, a level at which consumer confidence has remained stuck since August 2010. Economic sentiment surveys also continued to fall from the peak reached in February this year. Growth in the euro area's industrial production also continues to decrease.
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On the other hand, this European economic situation is occurring within a context of lower world growth, both in emerging countries and also in the rest of the EU's main trading partners.
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This situation is important because a large part of the dynamism in Europe's current economic cycle comes from exports, whose growth levels are likely to fall over the coming months.
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The context of global economic slowdown damages European exports.
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Given the consolidated growth data for the first half of this year, together with economic indicators that point to modest GDP growth in the third quarter, our 1.9% growth estimate for the whole of 2011 in the euro area has been revised downwards by two tenths of a percentage point to 1.7%. Although the slowdown during the central part of this year is temporary, tensions in the financial markets, with the rise in risk premia for sovereign debt and the acceleration of fiscal adjustment plans, for example in Italy and France, could keep growth at a very gentle pace over the coming quarters.
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Our growth forecast for the euro area is revised downwards from 1.9% to 1.7%.
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In summary, the slowdown in the euro area's economy has been confirmed and moderate growth is expected for the third quarter of this year. And all this within a context of world economic slowdown that is damaging European exports, while the sovereign debt crisis is a subject that still has to be passed at the start of this school year in September.
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The bail-out plans for Greece, Portugal and Ireland
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Pharmacology is the study of the effects of drugs on people and its clinical application is used to diagnose and relieve the symptoms of an illness. Sometimes to start a fast treatment. Other times, when the origin of the pathology is unknown, broad-spectrum drugs are used to eliminate a wide range of factors that might be causing the illness. This is the case, for example, of antibiotics, although sometimes these treatments are harsh and cause unwanted side effects.
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An analogy can be drawn between pharmacology and the financial bail-out plans for Greece, Portugal and Ireland, as these have been tailor-made to apply their beneficial effects and thereby get the countries back on the track of sustainable growth as soon as possible. As sometimes happens in pharmacology, the remedy used has had to be quite general because, when intervention occurred, the crisis had already spread to the economy as a whole.
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In Greece, for example, the trigger to the crisis was the sharp deterioration in public accounts. After significantly revising the level of public debt in January last year, at the end of 2010 this stood at 143% of GDP. As a reference we can use the limit established by the Maastricht Treaty, namely that public debt should not exceed 60% of GDP. The austerity measures required by this situation and the increased uncertainty it generated affected private sector solvency and the economy's growth capacity as a whole, which was already quite weak. This, in turn, made fiscal adjustment even more difficult, forcing Greece into a vicious spiral from which it was practically impossible to escape without external financial aid.
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In Ireland, the origin of the crisis was the bursting of a real estate bubble combined with an overbloated financial system. For example, in 2009 credit represented 270% of GDP in Ireland while in Greece and Portugal this figure was 90% and 174%, respectively. The Irish financial system had to take on huge losses from its mortgage loans. These losses had to be nationalized, changing banking risk into sovereign risk. This year public debt, which in 2007 accounted for 25% of GDP, is expected to reach 111% according to the International Monetary Fund. In this case, economic decline in the private and public sector also ended up affecting the economy's capacity to recover as a whole, aggravating the situation for the real estate and financial sectors. Ireland therefore also ended up in a vicious circle and was forced for ask for financial aid.
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Lastly, in the case of Portugal, the low productivity of its economy and the sharp increase in wages over the last fifteen years harmed the country's competitiveness, which led to a loss of export market share and a growing current account deficit. Between 2002 and 2007, Portugal's average rate of growth in GDP was 1.0% and in 2010 the current account deficit reached 10.3%. Although public debt was at relatively lower levels than those in Greece, in 2008 this represented 71.6% of GDP, with the recession also pushing this up. The IMF expects this figure to be 111% of GDP in 2011. Given the lack of growth capacity shown over the last decade, the economy looked unlikely to recover without far-reaching reforms and doubts regarding the sustainability of public debt increased accordingly. As in the previous two cases, this also forced Portugal into a vicious circle from which the only means of escape was external financial aid.
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Each aid programme has therefore had to stress different aspects because each country has different weaknesses. At the same time, however, many of the measures recommended are the same since, ultimately, the overall economy of each country was affected. Fiscal consolidation is one objective for all of them and, therefore, all are taking measures to achieve this, although it's a particularly important challenge for Greece, as it has to reduce its fiscal deficit from 15.5% of GDP in 2009 to 2.6% in 2014. To this end, numerous painful measures are being taken to reduce public spending, such as drastically cutting the number of civil servants and their wages, cutting social expenditure and increasing revenue, eliminating several tax deductions and raising VAT. The package also includes an important company privatization plan which the government hopes will help to considerably reduce its financing needs.
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The main goals of Ireland's package are to restructure the financial system, reduce its size, recapitalize it and improve banking regulation. All these initiatives are already underway and, for the moment, are progressing satisfactorily. The central bank of Ireland is working hard to create two large banks, one based on the Bank of Ireland and the other focused on Allied Irish Banks. The recapitalization carried out has managed to give the sector a good level of solvency, as shown by the results of the stress tests published in July, as the Irish banks passed these with ease. Moreover, an aggressive divestment plan has been established to get the sector back to a sustainable size.
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Lastly, the measures agreed in the Portuguese bail-out plan particularly aim to improve the country's competitiveness, as well as strengthen its financial system and balance public accounts in the short-term. Given the impossibility of improving the country's export capacity by devaluing its currency, Portugal will carry out an internal devaluation. To this end it will lower company social security payments to reduce the cost of labour and consequently make the price of Portuguese products more competitive. At the same time indirect taxes will be increased, such as VAT, to ensure the public coffers don't lose any revenue. The Portuguese government has also proposed an ambitious liberalization and privatization plan for industrial sectors, key to improving their efficiency. Lastly, also of note are the far-reaching labour market reforms to be carried out by the country.
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In short, these bespoke economic bail-out plans are beneficial for the countries implementing them, just as some medicines are more suitable than others, depending on the patient and the illness in question. Obviously, as in medical science, a bad diagnosis will mean that the recommended drugs will not help the patient to recover. In other words, the economic policy measures proposed in the financial bail-out plans may be well designed but if the initial hypotheses are incorrect or too optimistic, these measures will be of doubtful efficacy.
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This box was prepared by the European Unit,
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Research Department, "la Caixa"
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Germany
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Abrupt halt to the German locomotive
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The meagre 0.1% growth of the German economy in the second quarter is disappointing...
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A slowdown was predicted in the German economy after an extraordinarily good first quarter. However, the initial estimate of second quarter GDP was worse than expected, providing a quarterly increase of just 0.1%. Similarly, the quarter-on-quarter rate for the first quarter of 2011 was revised slightly downwards to 1.3%.
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...although it can partly be explained by the extraordinary expansion of the first quarter.
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The second quarter's meagre growth was affected by a certain slowdown in the global economy over the last period and the foreign sector, which had made a notable contribution in the last quarter, contributed negatively as imports rose more than exports. However, part of the rise in imports was due to an increase in stocks. On the other hand, the slowdown in the second quarter can be explained by the effect of construction being brought forward to the first quarter due to an abnormally mild winter. Consumption stalled noticeably, however, partly due to higher inflation.
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In spite of the brakes being put on in the second quarter, the likelihood of the economy derailing is small, as although most of the trend indicators have weakened, the German economy shows a solid foundation that suggests this is more of a dip than actual stagnation. In fact, in year-on-year terms, which approximate the trend, the expansion in German GDP stood at 2.8%. Moreover, its level was equal to the historical peak of the first quarter of 2008, before the Great Recession.
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Our growth forecast for the German economy in 2011 has been revised downwards to 2.9%.
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At the start of the third quarter, tourism sales rose by 9.9% compared with July 2010, after a year-on-year drop in June. However, consumer confidence fell back, affected by debt crisis of the euro area's peripheral countries, albeit remaining at a high level. With regard to investment, industrial capacity utilization stayed relatively high so that, together with low real interest rates, this suggests expansion will continue, albeit at a slower rate, given the change in overall economic sentiment in the last few months.
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A similar view is provided by supply. Industrial confidence lost steam in July but was slightly above the long-term average and the order portfolio was robust. Confidence in services also lost ground but was also higher than the historical average. With regard to construction, permits to build housing increased by 27.9% in the first half of the year compared with the same period a year ago and the sector's confidence indicator showed an improvement at the start of the third quarter.
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On the other hand, the trend in the labour market continues to support consumption. After a 1.4% year-on-year rise in employment in the second quarter, unemployment fell in July, in seasonally adjusted terms, compared with the previous month. However, the BAX employment demand indicator fell slightly in July, although remaining at a high level. On the other hand, although consumer price inflation increased slightly in July to 2.4%, the sixth consecutive month above 2%, this was primarily due to energy and the phenomenon is likely to reverse.
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Because of the new macroeconomic figures, we have revised our growth forecast for the German economy downwards to 2.9%, 4 tenths of a percentage point less than before. It should be noted that there are still risks related to developments in the sovereign debt crisis of the peripheral countries of the euro area and also of a more extensive slowdown in the global economy.
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France
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French gross domestic product stabilizes in the second quarter
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Consumption performs worse than expected in the second quarter in France.
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After a pleasant surprise in the first quarter, in which the French economy posted strong growth of 0.9% quarter-on-quarter in revised figures, the initial estimate for the second quarter disappointed, recording stagnation compared with the preceding quarter. The negative effect came from household consumption, down 0.7% after a quarterly increase of 0.4% in January-March.
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Downward turn in the French GDP growth forecast in 2011 to 1.8%.
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This fall was partly due to the withdrawal of subsidies for renewing vehicles, which led to a sharp drop in car registrations. Moreover, both public consumption and total investment slowed up. The contribution of domestic demand to GDP quarterly growth was therefore -0.2 points. On the other hand, and as a positive note, foreign demand contributed 0.3 points to quarterly growth after having subtracted half a point in the first quarter. Compared with the same period a year ago, GDP growth slowed up to a rate of just 1.6%.
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Available economic indicators for the third quarter do not give much cause for celebration and have got worse in general. However, they are compatible with modest quarter-on-quarter growth. Tourism sales practically stood still in July compared with the previous month, seasonally adjusted. Consumer confidence fell below its historical average at the start of the year due to concern about a future rise in unemployment. With regard to investment, industrial capacity utilization fell slightly, as well as confidence in industry, although the level of the order portfolio was slightly higher than a year ago in terms of value. Similarly, construction confidence improved in July. On the whole, the indicator for economic sentiment weakened in July but remained above the long-term average.
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In the first six months, the government deficit fell by 0.5% compared with the same period the previous year, standing at 61.4 billion euros. Spending was 5.3% down year-on-year, in line with the forecast. For its part, revenue decreased by 1.5%, affected by changes in the tax calendar. In spite of this moderation in the public deficit, the risk premium of France's sovereign debt underwent an upswing in the first few weeks of August as rumours spread of it possibly losing its top rating within the context of the sovereign debt crisis in the periphery of the euro area. The spread between interest rates for France's ten-year bonds and German bonds went from 40 basis points at the end of the first half of 2011 to a peak of 79 on 9 August, although it subsequently eased.
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The Italian economy grows slightly more than the euro area in the second quarter but the outlook is not very buoyant.
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Given this situation, on 10 August, at an extraordinary meeting, the French government announced that it was preparing new adjustment measures to confirm the credibility of the fiscal consolidation process, which must reduce the public deficit to 3.0% of GDP by 2013. On 24 August, the French government specified its plan to reduce the public deficit by 12 billion euros between 2011 and 2012. The proposals include the creation of a special contribution from the highest income earners, the withdrawal of a tax deduction on property gains and raising the tax on capital gains, as well as on alcoholic and sweetened drinks. The French government is also continuing to promote the constitutional mandate of equilibrium for public finances, to which end it must secure the support of three fifths of the two parliamentary chambers.
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As a consequence of the slowdown in the global economy and in particular of the sovereign debt crisis in the periphery of the euro area, as well as after the national accounts figures for the second quarter, the pessimism of French consumers and tighter budgets, we have revised our 2011 forecast for France's economic growth downwards, placing it at a moderate 1.7%, in line with the euro area as a whole.
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Italy
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Economic growth revives slightly in Italy
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After coming close to stagnation in the first quarter, the Italian economy picked up again slightly in the second. GDP rose by 0.3% compared with the previous quarter, slightly above the rate for the euro area. This recovery was boosted by industry and services, as the value added of agriculture fell. In any case, the year-on-year rate fell by two tenths of a percentage point to a modest 0.8%.
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The overall situation does not look like improving in the third quarter. Automobile sales fell in July by 10.7% compared with the same month the year before. Consumer confidence weakened again given the economic uncertainty and gloomy outlook for the labour market. The fall in industrial capacity utilization does not point towards vigorous investment. Industrial and services confidence also fell in July, although it rose in the retail trade. On the whole, the indicator for economic sentiment fell in July to slightly below its long-term average.
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The risk premium of Italian debt sets a record at the beginning of August...
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Italy's central government accounts seem to have improved during 2011. However, the slow rate of expansion in activity and the high level of public debt continued to raise concern among the markets given the sovereign debt crisis in the periphery of the euro area. As a result of tensions related to its sovereign debt risk premium, at the end of June the Italian government presented a new adjustment plan and speeded up its passing through parliament, so that it was approved by mid-July.
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This package finally set the reduction in net borrowing at around 80 billion euros but relegated the main part of the adjustment to 2013 and 2014, establishing budgetary equilibrium for the latter year. Among other measures, there was the rationalization of healthcare expenditure with co-payment in some cases, various adjustments in pensions, some tax hikes such as on fuels, a reduction in fiscal benefits, as well as promoting a programme to sell shares held by the state. However, as most of the consolidation has been postponed until after the general elections in 2013, this plan was not seen as credible by the financial markets.
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Although the five Italian banks that took part directly in the European Banking Authority stress tests published mid- July were correctly capitalized, the risk premium continued to rise and, on 4 August, the spread of interest rates for ten-year bonds with their German equivalents set a record of 386 basis points. Within this context, on 12 August the Italian government passed a new package of measures that went on to be debated in parliament.
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The aim of the new plan is to bring budgetary equilibrium forward to 2013. These measures include the simplification of the central and local administrative structure with a reduction in operating costs, a wage cut for members of parliament of between 10% and 20% and the introduction of a solidarity contribution for the next three years of between 5% and 10% from the highest income bracket. Similarly, it also proposes the liberalization of professional activity as well as the privatization of local public services.
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...and its rise is only contained by the European Central Bank intervening and by the Italian government presenting a new adjustment plan.
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The European Central Bank's intervention by buying up Italian public debt and the presentation of a new adjustment plan contained the rise in the risk premium, which fell to around 270 basis points by mid-August. However, this level is relatively high and slightly exceeds that of Spanish debt. Given this situation, it's unlikely that GDP growth will exceed 1% in 2011.
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A Greek tragedy?
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If a bond has a yield of 30% it's because the debtor is very likely not to pay on time or to pay back only part of the debt. This was the approximate yield offered by the Greek government's two-year bonds at the end of June. At that time, and for many even a long time before, it was completely obvious that the bail-out programme of May 2010 was not enough to resolve the Greek crisis. In July this year, the EU Council proposed a new package of financial aid that gives the Greek economy more time to sort itself out. Uncertainty, however, persists.
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Tough, optimistic and naive are adjectives that could be used to define the 110 billion euro bail-out approved by the IMF and the EU in May 2010. Tough because it requires the fiscal deficit to be cut by 13 points of GDP between 2009 and 2014 (from 15.5% of GDP to 2.6% of GDP), with a large part of this adjustment concentrated in the first two years. Also because, originally, the aid funds were offered at a high interest rate (in the case of euro area loans, at 3.5 percentage points above the 3-month Euribor). The plan was optimistic because it underestimated the difficulties the Greek economy would face in returning to growth within a context of strong fiscal adjustment. For example, although it was forecast that GDP would fall by 2.6% in 2011, the Greek government itself now believes that this drop might reach 4.0%. Lastly, the plan was naive insofar as it supposed that Greece would be able to finance itself again in the private capital markets by 2012, even though the weight of its public debt is estimated to be equivalent to 150% of GDP at that time. The yields recently exhibited by Greek debt make it clear that Greece is far from being able to access private financing at a reasonable price. So an alternative was required to cover the more than 125 billion euros that Greece had hoped to secure from private investors between 2012 and 2014.
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The new bail-out hopes to meet these financing needs at the same time as improving the financial conditions of the official loans. This is a package totalling 109 billion euros (of which 80 billion correspond to the euro area and the rest to the IMF) which will be offered at a lower interest rate (in the case of the European funds, at the issue cost of the European Financial Stability Facility, EFSF) and over a longer term. This improvement to conditions will also be applied to the previous package, reducing interest rates to 3.5% approximately and extending payback periods from 7.5 years to 30 years. Similarly, to facilitate Greece's economic recovery, the EU has also undertaken to increase investment financed by structural funds.
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Moreover, and due to the insistence of Germany, the governments of the euro area have managed to secure from the private sector an offer to voluntarily take part in financing Greece to the tune of around 50 billion euros. This offer includes a menu of options to replace bonds maturing in the next few years with new debt at 15 and 30 years, as well as interest rates averaging 5.5%. Consequently, the private sector could contribute around 37 billion to Greek net borrowing between 2011 and 2014. On the other hand, there's also a plan to set up a fund to buy back Greek debt on the secondary market (with the private sector contributing approximately 13 billion euros to this programme). With these bond exchanges, which in some options will involve a discount on the debt's nominal value, and the buying back of bonds under par, it is estimated that Greece might be able to reduce its debt by around 27 billion, equivalent to 12% of GDP.
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On the whole, this is quite a generous package, even more so than expected. However, five weeks after the European Council's announcement, the yield on 2-year Greek bonds exceeded 40%. Why has this new plan not dispelled the uncertainty? There are several reasons: the new package is still not in operation and some countries, such as Finland, are reluctant to take part if they're not guaranteed should Greece default the EFSF (a requirement that does not reveal much confidence in the success of the bail-out plan); in spite of restructuring part of the debt, its weight will still be very high (gross debt is expected to be around 160% of GDP in 2014), so that many believe future debt haircuts will be difficult to avoid; the fiscal deficit targets haven't been altered either and are still difficult to achieve, both for political and economic reasons; and, lastly, there is still scepticism regarding the euro area's system of economic governance, which is incomplete, whichever way you look at it.
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In this respect, and together with Greece's bail-out, the European Council approved a series of measures to prevent contagion from the Greek crisis, but these haven't gone far enough to dispel doubts affecting those countries with high levels of debt or deficit. Specifically, the EFSF has been made more flexible so that it can buy up public debt from any country in the euro area on the secondary market under certain conditions (an undertaking that, at present, the ECB carries out only reluctantly) and finance the recapitalization of financial institutions, even in countries not subject to a bail-out programme. Unfortunately, the Council did not increase the EFSF's size, making these reforms less credible. Neither has it considered, for the time being, the possibility of issuing joint bonds to finance the different Member states (so-called Euro bonds). It's not difficult to comprehend the political resistance of the richer countries in the euro area to greater fiscal integration, no matter how reasonable this may be from a conceptual point of view.
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In short, the Greek crisis is far from over. There are still huge challenges facing the country and the EU's support requires a loss of fiscal sovereignty which is tough to manage politically. Further debt restructuring is more than likely to be required, with substantial relief. A more remote possibility, due to the costs both for Greece and also for the euro area as a whole, is a disorderly default and Greece leaving the euro. That would be an ending befitting a Greek tragedy.
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This box was prepared by Enric Fernández
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International Unit, Research Department, "la Caixa"
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United Kingdom
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The United Kingdom: social unrest within a complicated economic scenario
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Britain's growth figures for the second quarter are weak.
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The social unrest experienced by the United Kingdom has surprised everyone and has raised doubts as to the leadership skills of the British prime minister at a time when leadership is vital in order to redirect the course of the economy. The fact is that economic figures are still doggedly pointing towards an economic slowdown in the United Kingdom, a situation that had already been ruled out months ago by the consensus of economic forecasts.
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Even the Bank of England, in its August Inflation Report, revised the country's growth prospects downwards, while the governor of the reserve bank, Mervyn King, warned of the risk of inflation being temporarily above 5% over the coming months. For the moment, the latest data on the CPI for July remain at a stubborn 4.4%. In the minutes of the meeting on 3 and 4 August, the members of the central bank's Monetary Policy Committee stated unanimously that they would keep the official interest rate at 0.5% given the deterioration in the economic outlook. We should remember that, in previous meetings, some members had even voted in favour of a rise in the nominal reference interest rate. Something that, today, appears very remote.
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The scenario of fiscal adjustment and the deterioration in households' disposable income augur moderate growth for the remainder of the year.
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Certainly second quarter GDP growth slowed up to 0.2% quarter-on-quarter from the 0.5% of the first quarter, while year-on-year growth went from 1.6% to 0.7%. These figures reinforce the theory that the recovery will continue to be very gradual. Such slowness is weighing heavy on households and is hindering the recovery in private consumption. Whereas the sales animated the British in June, in July the figures for retail and consumer goods once again looked very weak. Moreover, the labour market is still failing to show any clear signs of improvement and unemployment actually increased slightly to 4.9% in July.
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In short, the economic situation is moving within parameters of great weakness: between tough fiscal adjustment and poor performance by the net disposable income of households due to rising unemployment and the high level of inflation, which is rising faster than wages. A complicated scenario which means that we will probably have to revise our 2011 GDP growth forecast downwards for the United Kingdom, currently at 1.6%. However, we keep to our forecast of 4.3% inflation in 2011 as, in spite of the increases in basic energy service prices, which will be passed on to consumers in their electricity and gas bills over the coming months, we believe that inflation will fall subsequently due to the disappearance of several temporary effects that have raised British prices over the last few periods.
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Emerging Europe
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Emerging Europe: towards a change of scenario?
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The loss of pace in growth becomes the most pressing concern in emerging Europe.
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At the start of the summer, three aspects of the macroeconomic situation in emerging Europe were cause for concern. Perhaps the most pressing was the drift in prices, which were threatening to push inflation to high levels. Secondly, the financial developments were being followed with some concern, accompanying the sovereign debt crisis in the peripheral economies of the euro area. Lastly, a third issue was to gauge the extent of what was, at that time, perceived as a certain moderation in activity. The events of July and August have tended to give more weight to the last of these trends, although the other two are still far from resolved.
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In the second quarter, the predominant trend is a slowdown in activity.
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Although data on Poland are not available, the economic growth figures for the second quarter have been lower than expected. While forecasts predicted the rate would speed up, the reality has been that, in Hungary, the Czech Republic and Slovakia, GDP growth has slowed down in year-on-year terms, while in the case of Romania it has maintained the weak figure posted in the first quarter. The common element lying behind this slowdown is the worsening of activity in Germany and in other economies of the European Union which concentrate the majority of exports from central and Eastern Europe.
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Growth is weaker in Romania and Hungary, the two countries going through macroeconomic adjustment.
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As can be seen in the graph, growth has been moderate in Romania and Hungary, two states that are undergoing macroeconomic adjustment and whose main source of activity is exports. However, the latest GDP flash estimate was particularly better in the Czech Republic and Slovakia, two countries that have been able to partly assuage the decline in exports with more dynamic domestic demand.
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Apart from this moderation in growth in the second quarter, what can be expected in the coming months? The few indicators available for activity in the third quarter, and particularly figures on economic sentiment for July, point to the slowdown continuing during this period. This trend is consistent with that of activity indicators in the euro area, which are also falling, suggesting there will be moderate activity in the second half of the year in those countries that share the single currency. Given this situation, it would be surprising if growth in emerging Europe accelerated appreciably in the remainder of the year.
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Inflation starts to moderate.
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The bad news of this loss in economic dynamism has been offset by two developments that can be seen in a positive light. Inflation, which last May reached levels of close to 5% year-on-year, therefore starting to threaten the achievement of the inflation targets set by the region's central banks, has fallen to the zone of 3.5% in just two months. This development is due to the slowdown in energy and food prices, two trends that are expected to continue in the coming months.
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A second front whose development is less worrying than expected a few months ago concerns the repercussions for the region of the European sovereign debt crisis. Trends in the risk premia of the five economies we usually cover in this report (Poland, Hungary, the Czech Republic, Slovakia and Romania) show that investors have only perceived an increase in public solvency risk in Hungary's case.
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There is no widespread financial contagion from the debt crisis, although Hungary's public debt is cause for concern.
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This position is based on the fact that Hungary has a slightly higher public debt than is usual in the region: equivalent to 80% of GDP in Hungary compared with values in the region of 30%-40% in the case of Romania, the Czech Republic and Slovakia, and 55% in Poland. This clear discrimination of risk by the financial markets means that we can rule out the most negative hypothesis for the time being, namely widespread regional contagion.
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In summary, emerging Europe, a region closely related commercially and financially to the central countries of the European Union, is accompanying these countries in a period of lower economic growth. For the moment, the most likely scenario is of a temporary slowdown and moderate intensity, which will fundamentally affect the second half of 2011. This depends, however, on the financial markets continuing to make a fine distinction when discriminating risk in geographical terms, as well as on Germany quickly overcoming its unexpected cyclical weakening.
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