The Eurozone economy is growing at a much slower pace than expected at this stage of a recovery with GDP estimated to increase by only 1.5% this year and 1.7% in 2012, according to Ernst & Young's Spring Eurozone Forecast (EEF).
The Forecast for Bulgaria
Despite its currency board system and sound financial policies, Bulgaria experienced a deep recession in 2009, when GDP fell 5%. But after a further sharp decline in Q1 2010, GDP picked up through the rest of last year - with quarterly growth of 1.7% being posted in Q4 - as the strong German economy helped to lift activity and exports. However, despite the strong end to the year, GDP only grew 0.3% in 2010 overall.
The tentative recovery last year was driven almost entirely by exports, with little sign of investment starting to pick up in response to more robust external demand. But the recovery momentum has now started to shift towards domestic demand, improving prospects for 2011. Both investment and consumption rose strongly in the final months of 2010, with domestic demand contributing positively to growth in Q4 for the first time in two years. Although this pick-up is likely to contain a considerable element of correction after the previous large declines, it is nevertheless encouraging, particularly regarding household spending as even big-ticket purchases picked up at year-end. But consumer confidence remains low and with the unemployment rate still quite high at close to 10% and inflation expected to stay around 4.5%, thereby eroding real incomes, household spending will be slow to recover. Ernst&Young's experts forecast private consumption growth of just 1.3% this year after declines of 4% or more in the last two years.
Given the expectation of slower growth in the Eurozone, the impetus to growth from exports will fade somewhat this year. But with domestic demand likely to continue to rise as investment picks up after two years of decline, the experts now forecast growth of 3.3% in 2011 before a stronger pick-up to around 4.5% in 2012. Our 2012 forecast is lower than before as fiscal policy is being tightened faster than expected - the 2010 budget deficit was equal to 3.9% of GDP, well below the official target of 4.6% and the government is now confident enough about the strength of the economy to try reduce the deficit this year to 2.5%.
GDP growth in the Eurozone this year, as with last, is expected to be mainly accounted for by exports, with world economic performance likely to remain robust, driven by both emerging markets and the US. Assuming that the nuclear situation is brought under control, the recent disasters in Japan are unlikely to have a significant impact. However, rapidly rising inflation is causing concerns, breaking the 2% barrier in December 2010, the first time since late 2008, and increasing further to 2.4% in February.
Unemployment across the area is also likely to remain stubbornly high. Even in 2015 EEF forecast unemployment to be around 14 million, still well above 2007 levels.
"Although we still expect a muted recovery for the Eurozone over the next 12 months that could easily be blown off course by global economic events or an escalation of the Eurozone debt crisis", Marie Diron, Senior Economic Advisor to the Ernst & Young Eurozone Forecast says.
"Despite a pick up in the global economy, the Eurozone continues to face a challenging combination of concerns over sovereign debt, political instability and rising prices. Such an uncertain economic environment is continuing to put the brakes on business investment by corporates and subsequent job creation", Mark Otty, Area Managing Partner for Europe, Middle East, India and Africa, Ernst & Young says.
Raising interest rates would be a mistake
Despite the rise in inflation, EEF believes an interest rate rise later this week, with subsequent rate rises later this year to try and dampen down the level of inflation, could potentially endanger the fragile economic recovery in the Eurozone. This is despite the fact that energy, raw material and food inflation are likely to remain high for some time. EEF forecast oil prices to only gradually decline from their current levels of around $110-$115/ barrel towards $95/barrel by the end of 2011.
"We do not believe inflation is a medium or long term concern as there is plenty of slack in the Eurozone economy and raising rates as a response to commodity-driven headline inflation is a policy mistake that risks impacting on GDP growth. We see no need for the ECB to make such a move as our forecast assumes that in 2012, as oil prices start to fall back, food prices return closer to fundamental levels and the effect of VAT increases from the beginning of 2011 disappear, inflation will again fall below 2%", Diron comments.
But significant risks remain with oil prices
There are however significant downside risks to GDP growth and inflation related in particular to further tensions in the Middle East. EEF estimates that if oil prices were to rise and stay at $150/barrel, Eurozone inflation would be raised to around 3% this year and more than 2.5% in 2012. GDP growth would be cut to 1.2% this year and 1.3% next year. With oil prices rising to and staying at $200/barrel, inflation would rise to around 4% this year and remain above 3% in 2012 and GDP growth would remain at 1% for both years. But the negative implications that this would have for growth (in the Eurozone and the world economy) would suggest that non-energy inflation would decline in such scenarios.
Downside risks to growth still dominate
The negative impact of a sustained and deepening Middle East crisis could spread wider as it could trigger a reassessment of risks across financial markets, with share prices falling rapidly and risk premiums rising on a wide range of bonds. For the Eurozone, this could mean very negative developments if it led to renewed escalation of the sovereign bond crisis. While EEF attach a relatively small probability to such a scenario, the latest developments in Portugal are worrying and the consequences would be very serious.
Is the Eurozone still attractive?
Amidst all the gloom, it is easy to forget that the Eurozone can still remain attractive to potential joiners. On 1 January 2011, Estonia became the zone's 17th member and the benefits of joining such a large market a large market and a relatively stable currency are already apparent. "Booming exports will push Estonian GDP growth to over 4% this year and there is no doubt that consumer confidence has been bolstered by Estonia's entry into the Eurozone", Diron explains.