OECD activity is soft and the outlook uncertain

Global activity has slowed – in emerging economies, where it reflects policies to rein-in inflationary pressures, and in OECD economies where it is associated with a sharp fall in confidence. The economic outlook is now more uncertain than usual, with a number of possible events related to the euro area debt crisis and fiscal policy in the United States likely to dominate economic developments in the coming two years. With the nature and timing of such events impossible to predict, a muddling-through projection is presented here, in which disorderly sovereign defaults, systemic bank failures and excessive fiscal tightening are assumed to be avoided. The risks around this projection emerge largely from OECD economies and are tilted to the downside.

The muddling-through OECD projection is very weak in the near term followed by a muted recovery

The muddling-through projection shows very weak OECD growth in the near term, and a mild recession in the euro area, followed by a soft and gradual recovery (). On this basis, unemployment would remain very high while inflation would drift down, though deflation would be avoided provided inflation expectations do not become unanchored. In emerging market economies, inflation is projected to ease as pressures on resources dissipate, with growth staying soft in the near term. The outlook would be much darker if negative events were to occur, notably those that could lead to an intensification of concerns about the robustness of the banking system and contagion in euro-area sovereign debt markets, or an excessively tight fiscal policy in the United States due to political gridlock. On the other hand, prospects for the global and OECD economy could become significantly brighter if measures were taken to successfully stem pressures in the euro area and a credible medium-term fiscal programme was to be enacted in the United States.

The global recovery has lost momentum

OECD area, unless noted otherwise

Statlink http://dx.doi.org/10.1787/888932541626

This chapter is organised as follows. After briefly reviewing the main forces at work, it sets out the muddling-through projection and policy requirements consistent with such an outlook. It then turns to the consequences of alternative scenarios in the euro area, assessing the strength of the different contagion channels and the resources and policies required to stem contagion. An alternative fiscal scenario in the United States is then presented, based on different assumptions about the future stance of fiscal policy. Finally, the chapter sets out key macroeconomic policy requirements and structural reform measures that would become more urgent should activity turn out to be significantly weaker than projected.

The recovery is close to halting

The recovery in the OECD area has now slowed to a crawl, notwithstanding a short-lived rebound from the restoration of global supply chains disrupted by the Japanese earthquake and its aftermath. Emerging market output growth has also continued to soften, reflecting the impact of past domestic monetary policy tightening, sluggish external demand and high inflation. Against this background, the protracted fiscal-policy discussions in the United States and the deepening euro area crisis have highlighted the role of destabilising events and policies as well as the reduced political and economic scope for macroeconomic policies to cushion economies against further adverse shocks. In turn, this has heightened risk awareness and uncertainty, with a corresponding drop in confidence, both in financial markets and in the non-financial private sector. Lower confidence will weigh on the global economy in the coming quarters. Key forces acting include:

Business and consumer sentiment has plummeted…

• Business and consumer sentiment and order books have dropped sharply since the summer in most OECD and non-OECD economies, with Japan being a notable exception. In most cases though, indicators have not reached the levels observed at the depth of the crisis in 2008‑09 (). The PMI surveys in the major global economies now point to weak or, especially in the euro area, no growth in the near term. Survey measures of hiring intentions have also softened in many cases, particularly in Europe, pointing to a continuation of recent up-ticks in unemployment.

… and global activity and commodity prices have weakened

• Trade-related indicators, such as export order books and container shipping rates, point towards weak global trade growth in the near term. Widespread flooding in Thailand has also begun to generate renewed disruptions in global supply chains, which will further damp trade growth temporarily. The softening in global demand has begun to be reflected in global commodity prices, but only to a relatively limited extent to date, especially in oil markets. This may reflect expectations of continued relatively strong growth in comparatively commodity-intensive emerging market economies. Even so, the easing of commodity prices that has already occurred should provide a modest fillip to the OECD economies (whose growth might otherwise have been even weaker) by up to ¼ percentage point per annum, over the next two years. It will also act to further ease recent pressures on headline inflation.

Heightened risk has spurred considerable financial market turbulence…

• Higher perceived risk has generated considerable turbulence in financial markets. Equity prices have declined markedly (), especially for banks in the euro area but also worldwide;*

  With equity prices low relative to cyclically-averaged earnings, their recent correction may in part reflect a rise in the equity risk premium given heightened uncertainty.

  bank credit default swap rates have increased sharply, in both Europe and the United States, reflecting renewed concerns about banks’ solvency (); and the widening of sovereign yield spreads has become generalised beyond euro area programme countries (). The funding pressures on the banking sector are likely to result in moves towards tighter credit standards, with the first tangible evidence provided by the latest ECB Bank Lending Survey and the US Senior Loan Officer Survey.*

  The ECB survey showed that a balance of respondents are now tightening credit standards in the euro area, and the US survey showed that fewer respondents are now easing credit standards. In both cases, these changes serve to make financial conditions less growth-friendly than would otherwise have been the case.

  The flipside of risk re-evaluation has been a substantial decrease in the yields on safe-haven government bonds and top-rated corporate bonds, in some cases to historic lows. The US dollar, the yen and the Swiss franc effective exchange rates have appreciated significantly since mid-year, on the back of safe-haven effects.*

  In response to upward pressure on the Swiss Franc, the Swiss National Bank capped its value at SFr 1.2 per euro through unlimited intervention.

  Putting these developments together, the OECD financial conditions indices (FCIs) show divergent developments across countries (): a deterioration in the euro area and, more recently, in the United States, implying that GDP growth could be reduced respectively by 1 and ½ percentage point in 2012 and ½ and ¼ percentage point in 2013 compared with the outcome if the FCI had not deteriorated; but some improvement in Japan.

Equity markets have weakened again

Index 2000=100

The MSCI index for Emerging Europe also includes Middle-East and Africa.

Datastream.

Statlink http://dx.doi.org/10.1787/888932540239

It has become more expensive to insure unsecured bank debt against default

Annual rates of five-year credit default swap contracts on very large banks

Banking sector 5-year credit default swap rates.

Datastream.

Statlink http://dx.doi.org/10.1787/888932540258

Investors are now discriminating strongly across euro area sovereign bonds

10-year sovereign bond yield, in per cent

Datastream.

Statlink http://dx.doi.org/10.1787/888932540277

Overall financial conditions have been hit in the euro area

A unit increase (decline) in the index implies an easing (tightening) in financial conditions sufficient to produce an average increase (reduction) in the level of GDP of ½ to 1% after four to six quarters. See details in Guichard et al. (2009).

Estimation done with available information up to 17 November 2011.

Datastream; OECD Economic Outlook 90 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540296

… including in emerging markets…

• Financial conditions in emerging economies are becoming less supportive of growth. Sovereign bond spreads have risen, equity prices have declined and credit growth has slowed, including in China; several economies have also recently experienced sizeable exchange rate depreciations against the US dollar, reversing the tendency prevailing earlier in the year.

…and has raised uncertainty

• In addition, indicators of uncertainty in financial markets, as reflected in the daily volatility of equity markets, have risen sharply, back towards the high levels last seen in 2008-09. Such uncertainty, which is not included directly in the FCIs, is likely to result in the postponement of some planned, but hard-to-reverse, expenditures, especially by companies, and also delay hiring decisions ().

This is placing renewed pressures on household balance sheets

Household balance sheets have begun to weaken once more in some economies, reflecting the adverse effects of lower equity prices and persistent housing market weakness, with real house prices now declining in around two-thirds of the OECD countries for which timely estimates are available.*

The direct impact of lower equity prices in the United States and the euro area could imply an eventual reduction in household consumption of just under 1%. In the United States, equity prices have declined by around 8¼ per cent since the end of the first quarter, reducing the value of household financial assets by around $1.6 trillion, taking into account the impact on the value of equities held directly by households and indirectly through pension funds and mutual funds. Assuming a marginal propensity to consume out of financial wealth of 6 cents per dollar (Carroll et al., 2011), this implies an eventual reduction in household consumption of around 0.9%. The equivalent calculations for the euro area, where equity prices have declined by close to 25% since the end of the first quarter, imply a reduction in household consumption of 0.8%. The wealth calculations for the euro area take account of quoted equities, unquoted equities and mutual funds held directly by households and indirectly through insurance and pension funds. Equity price changes are assumed to apply to 40% of unquoted equity holdings and 30% of mutual fund holdings.

Risk awareness, uncertainty and confidence

Recent economic developments have been accompanied by heightened risk awareness and uncertainty, and sharp falls in confidence, both in financial markets and in the non-financial private sector. Such changes are often taken as an early, and timely, indicator of short-term cyclical swings in activity. This is especially so for hard and costly to reverse decisions, such as fixed investment, new hiring and purchase of durable goods. For such decisions, heightened uncertainty raises the option value of waiting, and hence weakens near-term expenditure (Bernanke, 1983; Pindyck, 1991; Bloom, 2009 and 2011). Equally, movements in survey-based indicators of consumer confidence have also been found to have a direct significant association with current and future private consumption growth (Nahuis and Jansen, 2004), particularly if the movements are large (Dees and Brinca, 2011), even if other factors such as income and wealth are taken into account (Carroll et al., 1994; Ludvigson, 2004; Wilcox, 2007).

Two important issues are whether there is a consistent, statistically significant and economically relevant relationship over time between private expenditure and measures of confidence and uncertainty, and whether there is independent information in measures of uncertainty and confidence relevant for understanding near-term developments in private expenditure. To assess these, the OECD has developed simple quarterly indicator-type models for consumption growth and business investment growth in the United States and the euro area (see Jin et al., 2011). These quarterly equations are augmented by separate monthly models for business and consumer confidence.

The results confirm that uncertainty, proxied by the VIX and VSTOXX indices – measures of the respective daily implied volatility of the US and euro area equity markets – and confidence measures influence private spending after accounting for other financial market developments (as reflected in the OECD financial condition indices):

• Business survey measures of investment intentions and production expectations are found to be strongly associated with quarterly changes in capital spending in the United States and the euro area, respectively.

• Monthly changes in the business survey measures are themselves found to be affected directly by monthly changes in stock market uncertainty. In addition, quarterly changes in stock market uncertainty are found to have a separate direct impact on investment spending in the United States, but not in the euro area.

• The quarterly growth of consumer spending is found to be linked to aggregate consumer confidence indicators in both the United States and the euro area, but it does not seem to be affected directly by measures of stock market uncertainty.

The empirical results have been used to produce a profile for business investment and private consumption growth over the coming two years. In both cases, financial conditions are assumed to remain fixed at their last observed level (see main text for details). The results presented here should be distinguished from the main projection where a broader range of factors are incorporated.

• For the investment path, stock market uncertainty is assumed to remain elevated until the end of the first quarter of next year, before reverting to its mean value by mid-2012. The resulting estimates, set out in the first figure below, indicate that near-term business investment growth in the euro area could be particularly subdued, unless uncertainty was to suddenly subside. In both economies, the projected outcome from these equations is somewhat weaker than in the muddling-through projection. This is particularly so in the euro area, where quarterly declines are projected by the indicator equation until the latter half of 2012; in contrast, the muddling-through projection is for weak, but positive investment growth from the second quarter of 2012.

• For the consumption path, consumer confidence is assumed to decline marginally further in the fourth quarter of 2011, and then remain unchanged until mid-2012 before reverting towards longer-term norms thereafter. On this basis, the resulting estimates set out in the second figure below point to small quarterly declines in consumption in the first half of next year in the euro area and little or no growth in the United States; these are somewhat weaker outcomes than incorporated in the muddling-through projection.

The implications of confidence and uncertainty for expenditure growth

Quarter-on-quarter growth rate in per cent

OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540334

Several factors may cushion the lapse in activity

Set against the negative factors above, the extent of any further weakness in activity may be damped by adjustments that have been ongoing since the onset of the recession in 2008. In particular, balance sheets are already adjusting at a sustained pace, which may limit the need for a further large precautionary upward adjustment in private sector saving rates in response to weaker asset prices. Many companies also have large cash holdings, which could be used as a buffer to help support employment and investment if sluggish growth is expected to be only short lived. Survey indicators also suggest that inventories have not yet risen to the excessive levels attained in 2008-09, reducing the likelihood that weakness in final demand will be reinforced by a large contraction in inventory levels. Similarly, other cyclically-sensitive categories of expenditure, notably housing investment and consumer durables, now account for a much lower share of final expenditure than in 2006-07.

Conditional on particular assumptions, growth is likely to remain weak and recover only slowly…

The projections presented here rest on a tacit assumption that sovereign debt and banking sector problems in the euro area can be somehow contained and the assumption that excessive, pre-programmed fiscal tightening will be avoided in the United States. Against this backdrop, near-term output growth is projected to be subdued in the OECD economies and at below-trend rates in the major emerging market economies. In some economies, especially the euro area, a mild recession is projected in the near term. Ongoing support is provided by accommodative monetary policies throughout the projection period (), but continued fiscal consolidation and weak labour, housing and credit markets will all act to check growth. Further ahead, from the latter half of 2012, the recovery is thus likely to be only modest, reflecting the gradual speed and extent to which confidence is assumed to recover as it becomes clear that other, worst-case, scenarios have been avoided. The key features of the economic outlook for the major economies are as follows:

… in the United States…

• Growth in the United States is expected to remain fairly subdued through 2012 before gradually picking up. Weak confidence, soft employment growth and the renewed pressures on balance sheets from lower asset values are all likely to damp consumers’ expenditure. Heightened uncertainty should also moderate business investment growth in the near term, despite healthy corporate balance sheets. Continued fiscal consolidation, although assumed to be at a more moderate pace than in 2011, will also hold back activity. Provided confidence recovers during 2012, as assumed, accommodative monetary policy and strengthening external demand should help to buoy activity through 2013, allowing the sizable negative output gap to narrow marginally. But, despite a pick-up in employment growth, the unemployment rate is projected to remain elevated, declining only to around 8½ per cent by the end of 2013.

… in the euro area…

• The euro area is seen to have entered a mild recession, which will be followed by an only hesitant pick-up in activity. Deteriorating financial conditions and ongoing fiscal consolidation, with several countries having announced additional consolidation in the light of heightened concerns about sovereign debt sustainability, will act as a drag on the economy in both 2012 and 2013. In the near term, with output expectations continuing to decline and the loss of momentum in the economy, business investment is likely to be very weak. Softening confidence, deteriorating labour market conditions and renewed balance-sheet pressures are also likely to weigh on private consumption. Provided sovereign debt and banking problems can be contained, as assumed, and supportive monetary policy actions are undertaken, confidence should gradually recover from the latter half of next year. However, the large negative output gap is projected to close only marginally in 2013. The unemployment rate is projected to remain elevated, at just over 10% at the end of 2013.

… in Japan…

• After an initial rapid rebound in activity following the earthquake and the Fukushima disaster, the pace of the recovery is now moderating. Financial conditions have improved modestly through 2011, providing a stimulus to activity in 2012, and the planned fiscal package (worth 2% of GDP) is likely to boost growth by next year. Ongoing private and public reconstruction expenditure should help to support demand, though the timing of such expenditure remains uncertain. Soft global growth and the appreciation of the real exchange rate are, however, likely to check the pace of the upturn. As public reconstruction efforts fade, stronger business investment and a gradual improvement in labour market conditions should support the recovery, and allow the negative output gap to diminish gradually through the projection period.

… and in emerging markets…

• The contribution of emerging markets to global growth is substantial at present (), and likely to remain so. Even so, output growth in China is projected to be well below potential in the near term. Domestic demand is likely to be relatively resilient, helped by increasing public spending on social housing, but net trade is likely to be a drag on activity, reflecting both strong import growth and, in the near term, soft external demand. As inflation and monetary conditions ease, GDP is expected to pick up from around the middle of 2012 and to grow at rates close to 10% through 2013. In India, the recent moderation in activity is expected to persist through to mid-2012, given tight monetary conditions, leading to a wider negative output gap. Improving domestic confidence, easier monetary conditions and stronger external demand should help growth to pick up to around 8¼ per cent in 2013. In Brazil, domestic demand is projected to remain solid over the next two years, helped by large infrastructure programmes. However, the ongoing drag exerted by net export declines should keep GDP growth below potential rates, at around 3¼-4 per cent per annum. In Russia, GDP growth is expected to remain close to potential rates, at around 4% per annum, sustained by the still-high level of oil prices.

Global growth is heavily dependent on the non-OECD economies

Contribution to annualised quarterly world real GDP growth

Calculated using moving nominal GDP weights, based on national GDP at purchasing power parities.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540315

… subduing world trade growth

• World trade growth is expected to broadly follow its normal pattern relative to world GDP growth through the projection period, picking up from an annualised rate of 3½ per cent in the fourth quarter of this year, to around 8% by the latter half of 2013. A benchmark dynamic-factor model of trade growth (Guichard and Rusticelli, 2011), using a wide range of trade indicator variables, shows that there is a risk that trade growth could be softer than projected in the near term, and possibly even decline in the fourth quarter.

Inflation is peaking…

Annual rates of headline consumer price inflation in most OECD and emerging market economies have now started to decline. Much of the previous run-up had stemmed from the comparative strength of commodity prices, especially in many emerging market economies. However, core inflation rates, abstracting from the direct effects of food and energy price inflation, have also drifted up this year, in part due to increases in indirect taxes and administered prices in several OECD economies and the effects of domestic capacity constraints in economies such as China, India and Brazil. Long-term inflation expectations in the OECD economies, especially as represented by survey-based measures, appear to remain reasonably well anchored.*

Some signs of weaker inflation expectations have begun to appear in market-based measures derived from yield differences between nominal and indexed bonds, but in part this reflects a mis-measurement generated by the flight to more liquid nominal bonds during renewed financial turmoil.

... and will weaken steadily

Weakened commodity prices will help to quickly bring down headline inflation rates. Moreover, continued, and in some cases widening, negative output gaps in the OECD economies should bear down on inflation through much of the projection period ( and ).*

Empirical evidence suggests that the effects of economic slack on inflation are much weaker now than in the past (Koske and Pain, 2008; Moccero et al., 2011).

The anchoring of inflation expectations and the risk of deflation

With growth prospects weakening in an environment characterised by low core inflation and still ample economic slack, concerns about deflation risk have re-emerged. Stable inflation expectations can serve as a powerful buffer against entering a deflationary spiral, raising a question as to how stable these expectations really are.

One means of evaluating the relationship between inflation expectations and realised inflation is to regress indicators of inflation expectations on current and lagged consumer price inflation, using a rolling window, and study the development of the sum of the estimated coefficients (Trehan 2010). In the regression results depicted below, a 15-year rolling window is used and the number of lags is set to seven quarters. The results from regressing US consumers’ short-run or long-run inflation expectations on headline inflation show that the sum of the estimated coefficients is currently lower than in 2007. Results using professional forecasters’ short-run or long-run inflation expectations are similar. These findings suggest that changes in headline inflation have had a declining impact on inflation expectations. For the euro area, results from regressing professional forecasters’ short-run or long-run inflation expectations on headline inflation show that the sum of the estimated coefficients continues to be low.

Therefore, even after the experience of large swings in headline inflation, inflation expectations appear to be well-anchored. This result might give grounds to hope that projected falls in headline inflation, due to weaker economic developments and falls in commodity prices, will not reduce inflation expectations sufficiently to pose significant deflation risk in the muddling-through projection. For instance, based on the coefficient estimates for the most recent period, the one percentage point fall in headline US CPI inflation in the projection between end-2011 and end-2012 would be associated with one-year-ahead inflation expectations falling by roughly ½ percentage point over the same period. This itself contributes ¼ percentage point to the fall in core inflation in 2013 based on the expectations-based Phillips curve estimated in Moccero et al. (2011). Similarly, in the euro area, the ¾ percentage point decline in headline inflation between end-2011 and end-2012 would reduce one-year-ahead inflation expectations by ¼ percentage point, which in turn would subtract ¼ percentage point from core inflation in 2013.

Sensitivity of various measures of inflation expectations to headline inflation

Estimated response of inflation expectations to a one percentage point change in headline inflation

Dotted lines show 90 per cent confidence interval computed by a bootstrap procedure.

Based on inflation expectations from Reuters/University of Michigan Surveys of Consumers.

Based on inflation expectations from US Survey of Professional Forecasters.

Based on inflation expectations from ECB Survey of Professional Forecasters.

Datastream; ECB; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540391

Underlying inflation is likely to moderate

12-month percentage change

PCE deflator refers to the deflator of personal consumption expenditures, HICP to the harmonised index of consumer prices and CPI to the consumer price index. Unit labour costs are economy-wide measures.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540353

Labour markets are now weakening once more…

Following a brief period of improving outcomes, unemployment is now rising once more in several economies, especially in Europe. The projection builds in an assumption that, as in 2008-09, widespread labour hoarding will help to preserve employment through a prolonged period of sub-par growth. Short-time working arrangements could, in principle, facilitate such labour hoarding, but their use may now be reduced, as average hours worked have still not returned to pre-crisis norms in many companies. If working hours do not adjust as much as in 2008-09, companies will either have to accept weak productivity growth as the counterpart to labour hoarding or lay off workers faster than projected.

... and little improvement is foreseen

In the projection, total OECD employment rises by between ½-¾ per cent in 2012 and 2013 (), with ongoing job growth in the United States offset in part by job losses in some European economies and Japan. The OECD-wide unemployment rate is projected to decline by only a ¼ percentage point over the two years to the fourth quarter of 2013. This would leave a large and persistent degree of labour market slack in most OECD economies (), despite the extent to which factors such as higher long-term unemployment and unemployment benefit extensions may have pushed up the structural rate of unemployment in recent years.

OECD labour market conditions are no longer improving

Statlink http://dx.doi.org/10.1787/888932541645

Considerable labour market slack is set to persist

Percentage of labour force

NAIRU is based on OECD estimates. For the United States, it has not been adjusted for the effect of extended unemployment benefit duration.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540372

Structural measures are essential to help tackle rising unemployment

Labour market policies can help to foster near-term employment growth and minimise the employment costs of the downturn.*

A full range of structural reforms that could help to increase near-term employment growth and minimise the employment cost of the downturn are discussed in detail in OECD (2011a).

Current account imbalances are likely to remain elevated

The narrowing of global imbalances since the advent of the crisis in 2008 has now slowed, and imbalances seem likely to remain broadly stable over the projection period (, ). The sum of all external balances in absolute terms is projected to remain around 3½ per cent of world GDP over the projection period, well below the level immediately prior to the crisis. Global imbalances are being kept elevated, at least in part, by the large increase in the external surpluses of the high-saving oil-producing economies, on the back of the still-high level of oil prices. Whilst re-spending of oil revenues is likely to reduce the external surpluses of oil-producing economies somewhat, much of the additional revenue accrued is likely to be saved, as appropriate for countries in which oil reserves are being depleted gradually.

Global imbalances remain elevated

Current account balance, in per cent of world GDP

The vertical dotted line separates actual data from forecasts.

Include Azerbaijan, Kazakhstan, Turkmenistan, Brunei, Timor-Leste, Bahrain, Iran, Iraq, Kuwait, Libya, Oman, Qatar, Russian Federation, Saudi Arabia, United Arab Emirates, Yemen, Ecuador, Trinidad and Tobago, Venezuela, Algeria, Angola, Chad, Rep. of Congo, Equatorial Guinea, Gabon, Nigeria and Sudan.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540410

In the major economies, a deterioration of the oil trade balance has been an important factor behind recent changes in external imbalances. In the nine months to September, this deterioration more than accounted for the nominal decline in the aggregate external trade surplus of China, compared with the same period a year ago; in the United States it accounted for around two-thirds of the rise in the external trade deficit compared with the same period a year ago.*

The changes in the balance of oil trade reflect both the impact of higher oil prices and changes in the volume of net oil imports. In China, where activity growth has been relatively strong, the volume of oil imports (proxied by import tonnage) in the first eight months to August was 7% higher than in the same period a year earlier. The volume of US oil imports declined in the same period.

World trade is slowing and imbalances remain

Statlink http://dx.doi.org/10.1787/888932541664

Structural reforms would help narrow imbalances

Further durable reductions in global imbalances will likely require greater exchange rate flexibility, as well as structural reforms and fiscal adjustments, with consolidation needs generally greater in external deficit OECD countries than in external surplus economies. In addition to having a direct benefit on prospects for national growth and welfare, many structural reforms are likely to help address the underlying determinants of global external imbalances over the medium term, via their impact on national saving and investment rates (OECD, 2011b). In particular, measures that stimulate investment in external surplus economies by reducing product market regulations in sheltered sectors, in conjunction with measures to improve social welfare systems and liberalise financial markets (while ensuring adequate prudential regulation) in non-OECD economies with an external surplus, could help to narrow global imbalances in the years ahead. In external deficit economies, rebalancing could be assisted by giving priority to: measures that enhance job creation, thereby reducing incentives for firms to substitute capital for labour; reforms that improve the efficiency of the tax system, and enhance the incentive to save; and measures that enhance non-price competitiveness. As discussed below, structural reforms are also needed to durably reduce imbalances within the euro area.

Risks are mainly event-driven and to the downside…

The main risks around the projection, on both the upside and the downside, relate to possible events arising from the evolution of the euro area debt crisis and fiscal policy in the United States that are discussed in detail below. In addition there are a number of other specific downside risks and fragilities that could weaken growth if they materialised:

… but also stem from possible developments in Japan…

• In Japan, an important downside risk to activity arises from ongoing uncertainty about the extent to which electric power shortages as a result of nuclear plant suspensions and closures may continue, and the extent to which this may check the recovery.

… China…

• In China, an important near-term risk is that activity could slow more than projected against the backdrop of the tightening of monetary conditions over the past year, and declines in property and financial asset values. Indeed, recent survey indicators have underlined concerns about such a risk. Further ahead, uncertainties relate to the extent to which stable, high growth rates can be sustained in the context of the need to lower the share of fixed investment in aggregate demand.

… oil markets…

• Crude oil supply has tightened recently on account of supply disruptions in Libya and temporary but wide-spread disruptions outside OPEC. An easing of supply disruptions could, in principle, allow oil prices to fall below current levels. But the upside risk to prices remains a greater concern, with oil consumption by emerging markets continuing to trend upwards and current levels of oil stocks being fairly low.

… and a further weakening of potential output

• There is a risk that the loss of momentum in the recovery and heightened risk aversion in financial markets may further weaken potential output, by raising the prospects of an increasing part of the rise in unemployment since the onset of the crisis becoming long-lasting, and by raising the cost of capital for many companies. An implication would be that fiscal imbalances are structural to an even larger extent than currently thought.

Accommodative monetary policy is warranted…

The weak economic outlook with low inflation and predominantly downside risks in the OECD area calls for strongly accommodative monetary policy. In addition, central banks should provide ample liquidity to calm tensions in financial markets. In some OECD economies where monetary tightening had already started, policy interest rates should be reduced. Near zero-interest-rate policies are not costless as they can prompt excessive risk taking and capital misallocation. Nevertheless, in the current weak economic environment with significant downward risks, such considerations are outweighed by the need to provide monetary accommodation. Indeed, given the outlook, interest rates need to be close to zero in most OECD countries over the projection period, with further support coming from non-conventional measures:

… in the United States…

• In the United States, in response to the weakened economic prospects, the Federal Reserve stated in August that economic conditions were likely to warrant exceptionally low levels of the policy rate at least until mid-2013. In addition, the Federal Reserve decided in September to extend the average maturity of its holdings of securities by the end of June 2012 (Operation Twist). These measures are expected to stimulate the economy by lowering medium and long-term interest rates and the yield curve indeed flattened in the wake of their announcement, especially following the former policy decision. On the basis of the projections, it would be appropriate to keep the target Federal Funds rate at the current level until end-2013. However, government bond yields are assumed to rise as safe haven considerations dissipate gradually and government debt rises.

… the euro area…

• In the euro area, the European Central Bank raised the main refinancing rate in April and July from 1 to 1½ per cent, despite a large output gap and relatively low core inflation rates – especially once corrected for indirect tax increases.*

  Indirect tax increases are estimated to have contributed about ½ percentage point to core inflation in the euro area in 2011.

  In face of renewed turmoil since early August, it has started to again make sizeable government bond purchases under the Securities Market Programme, further expanded liquidity provision, including two operations of around 1 year and a new covered bond purchase programme, and reduced the main refinancing rate to 1¼ per cent in early November. The weak prospects for the euro area economy and fading inflation strongly argue for further prompt reductions in interest rates. In the projections, the overnight interbank rate is assumed to fall to its post-Lehman low of 0.35% before the end of this year, and to stay at this level, which can be achieved through a combination of cuts in the main refinancing and deposit rates and ample liquidity provision.

… Japan…

• In Japan, the current zero-interest-rate policy needs to be continued until inflation is firmly positive. In the absence of a clear trend toward achieving the implicit 1% inflation target, the Bank of Japan should undertake further measures, including the expansion of the scale of the asset purchase programme. The policy rate is assumed to be kept at the current level over the projection period.

… and the United Kingdom…

• In the United Kingdom, against the background of a significant weakening of the economic outlook, the Bank of England announced an expansion of its bond purchasing programme by £75 billion. If inflation comes down rapidly, further asset purchases will be appropriate, an action which is incorporated in the projections (for an additional amount of £125 billion, see ).

… and more would be needed in the event of the downturn intensifying

Furthermore, in view of downside risks, monetary authorities in most countries and areas should prepare contingency plans that could be implemented swiftly if the weakness looks set to be more pronounced than in the projection. Such contingency plans could contain measures ranging from recently tested unconventional instruments to yet untested options.

In the large non-OECD economies, monetary policy is at a crossroads

In the large emerging market economies outside the OECD, falls in commodity prices and the slower growth of the global economy have started, or will soon start, to mitigate inflationary pressures. However, in deciding whether, when and how rapidly to ease, central banks need to take into account that inflation in some cases starts from a level well above implicit or explicit targets. In China, monetary policy has continued to be tightened gradually this year through increases in official interest rates and required reserve ratios while individual lending quotas have been applied for each bank. By contrast, the effective appreciation of the exchange rate since the beginning of the year has been very small. Going forward, and as the easing of overall monetary conditions becomes warranted, more significant appreciation of the effective exchange rate would increase the scope for a domestic policy response. A useful first step would be for the Chinese authorities to manage the exchange rate with reference to a clearly-defined basket of currencies. Without such currency policy, domestic monetary policy instruments – which are harder to calibrate – have to be kept at comparatively more restrictive levels to keep inflation on track. Such a strategy involves a risk of an excessive economic slowdown, especially if it were to trigger a downward spiral between property prices and bank capitalisation due to a potential problem of poor-quality lending in the property sector. In India, where continued high inflation has put the anchoring of inflation expectations at risk, some easing will be possible once inflation starts to decline noticeably, which is projected to occur in the second half of 2012. In Brazil, the central bank has ample room to reduce the policy rate further in response to weaker prospects for the economy.

Fiscal deficits are falling while debt ratios continue drifting up in most countries

In the projection, the OECD area-wide fiscal deficit is expected to fall by ¾ per cent of GDP in both 2012 and 2013, with the improvement more than accounted for by planned consolidation measures, partly offset by rising interest payments. For most countries, present consolidation plans envisage some mix of spending restraint and revenue-raising measures, with more weight being put on the former (). Gross debt in terms of GDP continues drifting upwards, with 2013 debt ratios projected to exceed 2011 levels in the United States, the euro area and Japan by 11, 2½ and 15 percentage points, respectively ().

The composition of fiscal consolidation plans

Change in the underlying primary balance 2011-13, in per cent of potential GDP

Total consolidation is the projected difference in the underlying primary balance; revenue side is the projected increase in the underlying receipts excluding interest earned on financial assets; and spending side is the projected decline in the underlying primary spending excluding interest payments on debt.

OECD Economic Outlook 90 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540448

Fiscal positions will improve only slowly

Per cent of GDP / Potential GDP

Statlink http://dx.doi.org/10.1787/888932541683

The key fiscal policy assumptions are…

The fiscal policy assumptions employed in the projections are based on government programmes in most cases, though normative assumptions have been made where there is particular uncertainty about the likely evolution of budget policy in 2012 and 2013:

... in the United States, less near-term consolidation than currently embedded in legislation…

• In the United States, given the uncertainty surrounding fiscal policy in the coming two years, a normative assumption has been adopted that the underlying primary balance will improve by ½ and 1 percentage point of GDP in 2012 and 2013, respectively. This compares with a fiscal tightening embodied in current legislation of about 2 and 3 per cent of GDP in 2012 and 2013 respectively, which would be excessive given the relatively weak economic outlook. This programmed tightening would be substantially reduced if the Administration’s proposed stimulus, worth some 3% of GDP in the coming two years, were to be approved by Congress, but this remains uncertain. The recent failure of a Congressional committee to conclude a bi-partisan agreement on a medium and long-term consolidation programme may weaken confidence in the long-term anchoring of fiscal policy and, thus, limit the fiscal space that the authorities have to respond more flexibly to a much weaker-than-expected economy, if that were to occur.

... in Japan, stimulus reflecting government reconstruction plans…

• In Japan, based on government policy, the underlying budget deficit is assumed to widen by ½ of a percentage point of GDP by 2013. This incorporates cumulative post-earthquake reconstruction spending of around 2% of GDP in 2012 and 2013 that is assumed to be financed only partially by higher revenues, and limits on central government primary spending, excluding reconstruction spending, to the nominal level in the initial budget for FY 2011. The revised three-year medium-term fiscal framework announced in August 2011 maintained the aims of halving the primary budget deficit (relative to GDP) of central and local governments by FY 2015, achieving a primary surplus by FY 2020 and steadily reducing the public debt ratio thereafter. However, it is yet to be decided how to attain the targets. Given the very high sovereign debt level, the top priority must be to establish a detailed and credible fiscal consolidation programme, including tax increases, spending limits and privatisation revenues.

... in the euro area, planned consolidation programmes…

• In the euro area as a whole, the fiscal projections are based on announced policies, implying a reduction in underlying deficits of 1½ and 1% of GDP in 2012 and 2013, respectively. Reductions in underlying deficits are particularly steep in the IMF/EU programme countries, Italy and Spain: close to 2¾ and 1¼ per cent of GDP in 2012 and 2013 respectively, for the group on average. Planned consolidation must be implemented to help regain confidence. In France, fiscal tightening is set to amount to around 1¾ per cent of GDP in both 2012 and 2013. On the other hand, relatively modest annual consolidation of around ½ per cent of GDP or less is appropriately planned in some of the countries with comparatively sound public finances (e.g. Germany).

... and in the United Kingdom, the government’s deficit reduction strategy

• In the United Kingdom, the projection embodies consolidation amounting to 1¼ per cent of GDP in both 2012 and 2013, in line with the government’s medium-term consolidation strategy, which targets reaching cyclically-adjusted current balance by the end of a rolling five-year period. This programme is appropriate to regain fiscal sustainability.

Public finances are generally relatively healthy in emerging markets

In emerging market economies, fiscal positions vary considerably, although in most cases they are better than in the majority of OECD countries, not least because high growth rates tend to ease debt dynamics. In China, fiscal policy looks set to be expansionary, especially in 2013, as off-budget financing of social housing is stepped up. In Brazil and India, consolidation is underway and should remain a priority.

Financial market policy has a key role to play in restoring confidence…

The recent turmoil in the euro area has seen investors losing confidence again in the reliability of banks’ financial statements and official stress tests, and hence in banks’ solvency. The immediate concern is that accounting rules allow sovereign debt held in banking books to be valued at acquisition cost and not at market prices when banks declare that they intend to hold these securities to maturity. With sharp cuts in the market price of sovereign bonds issued by many countries in the euro area, this has opened up a gap between market and accounting measures of these assets. In addition, there is a lack of clarity in the treatment of sovereign bonds held in the banking book that are available for sale: under international financial reporting standards they are expected to be marked to market, but some countries are reported to have applied prudential filters allowing banks to value them at amortised cost for the purpose of calculating compliance with regulatory capital requirements. Another source of uncertainty about banks’ financial statements relates to the treatment of their credit default swap (CDS) exposures as it appeared in October that a significant euro area bank had previously classified them as guarantees (which can receive a special accounting treatment), meaning that it did not have to recognise mark-to-market losses. There are also concerns that some banks outside the euro area could have large exposures to vulnerable euro area countries and banks, especially through credit default swaps (see below).

... by insisting on more solid capital bases of banks

To strengthen confidence in banking systems, EU governments have announced a plan to strengthen the core capital ratios of the major European banks (see ). Capital has to be raised swiftly, to anticipate any sovereign credit events. To avoid a process of credit curtailment and generalised bank deleveraging which could prove extremely disruptive, regulators should ensure that banks increase their capital levels rather than shrinking assets. To the extent that public capital injection is needed, it should come in the form of ordinary shares so as to give tax payers a share not only in potential losses but also potential upsides. The European co-ordination process could be used to avoid stigma effects by making recapitalisation occur in a harmonised way across countries. This effort should extend to banks located outside the euro area that have large exposures, through loans, guarantees or derivatives, to the vulnerable countries of the euro area.

There are both downside and upside risks for the euro area

The euro area crisis represents the key risk to the world economy at present, with concerns about sovereign debt sustainability having become increasingly widespread. Financial markets have priced in a restructuring of sovereign debt in Greece with large losses for creditors and also significant contagion to other fiscally vulnerable members of the euro area. This is particularly so for Italy and Spain, with government bond yield spreads surging towards levels that are ultimately hard to sustain, but also Belgium and, to a lesser extent, France and Austria. Indeed, contagion has entered a new phase and spread beyond euro area countries normally seen as fiscally vulnerable, suggesting that fiscal concerns are no longer the only driving force behind contagion. The policy measures announced at the Euro Summit and the EU Council meeting on 26 October (), like previous policy packages, provided only a temporary respite to market pressures.

A number of downside scenarios can be envisaged

A number of downside scenarios can be envisaged depending on the combination of particular events, transmission channels and interactions at work. An orderly debt write-down, without invoking CDS trigger clauses, might have only muted cross-border impact; a disorderly default, with comparatively large losses for investors and the triggering of CDS credit clauses, could give rise to uncontrollable contagion to other vulnerable countries. Accentuated concerns about the future integrity of the euro area could, even in the absence of sovereign defaults, lead to disorderly financial market developments with substantial economic fall-out. The trigger of a downside scenario could even be a separate event, for example the threatened collapse of one or more large financial institutions.

This section sketches particular scenarios on the downside…

This section sketches the possible implications of a disorderly sovereign default in various downside scenarios, depending on the contagion channels at work and their virulence, ranging from relatively benign to catastrophic outcomes. The particular scenarios described below should be seen as illustrative examples of how contagion channels could transmit shocks if a specific set of events were to occur in a particular sequence. In practice, each event can give rise to different outcomes, giving a large number of possible scenarios.

... and on the upside

This section also presents an upside scenario in which decisive policy measures, including those announced at the October Euro Summit and the EU Council meeting, are taken swiftly to break the link between sovereign debt and banking distress, to deal with Greece and to end the present contagion to sovereign debt markets in other European countries. The numerical estimates below give an illustrative example of the possible orders of magnitude in the different scenarios. In general, in the absence of a clear and credible policy commitment to halt contagion, backed by resources that are seen to be adequate, some form of downside scenario would become ever more probable; alternatively, if such a commitment is made, and succeeds in restoring confidence, an upside scenario will become more likely.

A disorderly default would have a cross-border impact…

Cross-border financial spill-over effects from a disorderly sovereign default in the euro area can take different forms:

... via losses for banks…

• Foreign creditor banks would suffer losses on: their holdings of government bonds in the country concerned (unless they have insured their holdings with credit default swaps, in which case the counter-party bears the loss); their exposures from loans to banks in that country (most of which would become insolvent if the write-down is large and there is no countervailing measure); and their claims on the non-bank private sector. These losses could have ripple effects throughout closely inter-connected banking systems if the write-downs cast doubt about the capacity of the affected banks to honour their obligations to counter-parties.

… and other creditors…

• Foreign non-bank creditors holding impaired sovereign debt or exposed to it via CDS contracts would also be affected. Some official creditors, such as the IMF, the EFSF and national governments, may enjoy priority status, but there is uncertainty as to the treatment that would apply to others.*

  ECB holdings of sovereign bonds from the country concerned, purchased under the Securities Market Programme, may also be affected (though the bonds are most likely to have been acquired at a significant discount to face value). Impaired government bonds used by banks as collateral for their borrowing from the ECB would not give rise to losses for the ECB as long as the debtor banks remained solvent.

  Little is known about foreign non-bank private creditors, but they are likely to include insurance companies and pension funds. The lack of information about the exposure of institutional investors to sovereign debt could in itself be a source of uncertainty, triggering excessive precautionary withdrawals by policy holders and forcing pension funds to liquidate assets.

... higher government bond yields…

• Perceived default probabilities may rise on sovereign debt in other fiscally weak countries for several reasons. First, investors would realise that default can occur. Secondly, default in one country would create a precedent, which could result in other fiscally challenged countries considering it as one possible way of adjusting. Thirdly, the fiscal positions of other euro area countries could be weakened by losses on official bilateral loans, calls on EFSF guarantees or the need to recapitalise or resolve domestic banks with large exposures to the defaulting country. Such contagion would show up in higher government bond yields, further undermining public finances. Furthermore, were a default to strengthen expectations of euro-area exit, other weak countries might also see their bond yields increased by fears of a domino effect.

... lower equity prices…

• Diminished expectations of economic growth in the countries concerned would be swiftly incorporated into the equity prices of foreign corporations that derive significant earnings from exporting to, or operations in, these countries. Share prices would also reflect lower growth outside the countries concerned by default, brought about by other contagion channels.

… legal uncertainty…

• In the absence of EU bankruptcy rules for individual sovereigns, legal uncertainty could arise about the resolution of sovereign debt, further adding to the risk premium demanded by creditors on debt issued by fiscally weak member countries.

... and increased risk aversion

• A generalised increase in risk aversion could put downward pressure on all assets seen to be relatively risky and reduce the willingness to be exposed to all but the most-safe counterparties.

The direct contagion effects of a default via the banking system will depend on the country concerned

The extent to which the contagion effects from a disorderly default are manageable will depend in part on the size of the economy in which the default occurs and the size of the exposures that foreign banks have to that economy. Provided it does not trigger off panic reactions, related for example to uncertainty about the allocation of exposures to the country, the direct consequences of a default in a comparatively small euro area economy would seem to be manageable. A default by a larger economy or contagion to a large group of economies would prove much more disruptive.

In a small country, such as Greece, the direct contagion effects should be manageable

In the specific case of Greece, the agreement reached at the October 26 Euro Summit and EU Council meeting has increased the likelihood of voluntary private-sector write-down. If a credit event occured, whether voluntary or otherwise, creditor banks would have to write down the value of their claims on the Greek government, amounting to e34 billion as of end-2010 for EU banks outside Greece ().*

Even in the absence of a default, some of this outstanding amount is likely to be written down provided private sector investors participate in the voluntary bond exchange programme announced at the Euro Summit in October.

Bank exposure to Greek sovereign and total debt

Statlink http://dx.doi.org/10.1787/888932541702

Official loans to the governments of Greece, Ireland and Portugal

Billions of euros

Countries' exposures cover bilateral loans under the Greek Loan Facility and loans by the European Financial Stability Facility (EFSF) to Ireland and Portugal, disbursed until March, September and October 2011 for Greece, Ireland and Portugal, respectively. In addition, loans have been dispersed by the European Financial Stabilisation Mechanism (EFSM) and the IMF. Moreover, bilateral loans to Ireland from Denmark, Sweden and the United Kingdom amount to 0.5 billion euros combined until September 2011 (not included in the chart).

European Commission; European Financial Stability Facility (EFSF); and IMF.

Statlink http://dx.doi.org/10.1787/888932540467

Sovereign debt in other programme countries should also be manageable

If a sovereign debt restructuring in Greece raised perceived default probabilities in one or both of the other programme countries, government bond yields would rise in Portugal from already high levels and the recent sharp drop in spreads in Ireland could be reversed. However, much of the funding needs of these two countries in the coming two years is covered by the IMF/EU programmes (), the increase in yields in secondary markets would have minimal near-term effects on actual borrowing costs. Higher yields might, however, require some capital injection into domestic banks to offset losses on their holdings of domestic sovereign bonds. Foreign creditor banks would also incur losses on their holdings of Portuguese and Irish sovereign debt, but the amounts involved would be small relative to total core Tier 1 capital in the banking system of the creditor countries.

EU / IMF Programme countries : Funding needs and sources

Billion euros

Statlink http://dx.doi.org/10.1787/888932541721

A wider contagion to vulnerable countries would have dire consequences for…

The intensified concerns that have appeared about sovereign debt sustainability in other larger countries with high or rapidly rising debt, and the recent extension of contagion to countries normally seen as having relatively solid public finances, have the potential to massively escalate the economic disruption. This is particularly so for Italy, where long-term government bond yields have risen rapidly by more than 100 basis points in the month to mid-November, but also Spain and Belgium, notwithstanding differences in their initial government debt levels, budget deficits, bond-yield spreads and potential growth prospects. Major negative turns in market sentiment, of the sort that in the past have been reflected in increases of 350 basis points in long-term government bond yields in affected countries,*

For instance, as uncertainty grew about the effective lending capacity of the EFSF, Irish and Portuguese yields rose by almost 3½ per cent from mid-June to mid-July 2011.

... public finances…

• Public finances would be impaired by higher debt servicing costs. Given the maturity structure of public debt, this effect would occur gradually but would require additional consolidation of 2% to 3% of GDP by 2020 to offset the impact on net lending in the countries concerned (). The risk is that little progress in reducing debt ratios, or even continued increases in debt ratios, would further weaken confidence in public finances and result in an adverse feedback loop with additional interest rate increases forcing additional consolidation measures to be undertaken to meet headline budget objectives, which would further sap growth and confidence.

Belgium, Italy and Spain: the impact of higher interest rates on consolidation needs

In per cent of GDP

The bars show by how much the underlying primary balance as a share of GDP would need to increase to stabilise the debt ratio over the period 2014-20 at its 2013 level, if government bond yields were 3.5 percentage points higher than assumed in the baseline. This implies stabilising the debt-to-GDP ratio at high levels, in particular in Italy (at 127%) and Belgium (at 101%). The baseline is based on the OECD Economic Outlook 90 projections until 2013 and thereafter on the long-term scenario presented in OECD Economic Outlook 89.

OECD Economic Outlook 90 database; OECD Economic Outlook 89 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540543

... and banking systems…

• Banks’ balance sheets would be weakened as would their capacity to raise liquidity. The increase in yields would imply a reduction of around a quarter in the market value of sovereign bonds issued by the three countries. This would have the biggest effects on the domestic banks in these countries, given their vast holdings of domestic sovereign debt. However, outside these three countries, pressures on banks could also become stronger, as has already been seen in France. Weaker balance sheets could possibly prompt deleveraging that would sharply curtail credit extension and raise fears that government funds would be required to safeguard the banking system. In turn, any perceived need for government-funded bank recapitalisation would exacerbate sovereign debt stress, pushing yields higher. The significant widening of French government bond spreads in the wake of French bank funding stress since mid-2011 illustrates the potential strength of this crisis amplification channel.

... with potentially extreme effects for the euro area as a whole

The interaction between public finance and banking woes could result in a self-reinforcing feed-back loop: banking problems requiring costly public interventions, which in turn would raise long-term interest rates with additional adverse effects on economic growth, banks, etc. If unchecked, such a development could lead to fears of possible sovereign and banking defaults. This would have dramatic effects on the stability of the banking system in the euro area as a whole, and on government bond yields in previously unaffected countries, given the very large exposures of banks throughout the area to sovereign and private debt in the vulnerable countries ().

Stress-tested banks’ exposures to Belgian, Italian and Spanish debt

Statlink http://dx.doi.org/10.1787/888932541740

An intense euro area crisis would have strong global effects both directly…

An intense euro area crisis would have significant adverse effects outside the euro area through many channels. For example, banks in the United States and Japan would take a hit on their holdings of sovereign, bank and non-bank debt of the euro area countries in question, though the total direct exposure to Greece, Ireland, Portugal, Spain, Italy and Belgium is small relative to Tier-1 capital in the US and Japanese banking system (). US banks have large gross exposures to Europe through guarantees, including gross CDS exposure; however, their net exposures are likely to be substantially smaller due to accompanying hedging operations, as long as the counterparties are solid.*

In mid-2011, the stock of credit default swaps sold by the top 25 US commercial banks and trust companies in derivatives was almost equal to total credit default swaps bought by the same institutions, see Comptroller of the Currency (2011).

US and Japanese banks: Exposure to programme and vulnerable euro countries

% of Tier 1 capital

Statlink http://dx.doi.org/10.1787/888932541759

… and indirectly

Intense sovereign debt problems in the euro area could also highlight the extent to which rapid public debt accumulation has yet to be arrested in the United States and Japan, though yields in the deep government bond markets in these two countries are likely to be determined primarily by factors other than contagion. However, equity markets in the two countries would be hit as profits of US and Japanese exporters to Europe would fall, as would earnings of subsidiaries of US and Japanese companies in Europe. This effect would likely be reinforced by a general reduction in risk appetite. Heightened general risk aversion would also be an important channel by which emerging market economies would be affected by an intense crisis in the euro area, with large-scale capital outflows depressing economic growth in addition to the effect of much weaker export markets.

The global consequences of a contagious sovereign debt event on activity would also be large

Some illustrative estimates of the possible outcomes in one particular stylised scenario are set out in , pointing to: sharp falls in the level of output in the OECD economies relative to the muddling-through projection, especially in the euro area; a decline in the level of world trade relative to the muddling-through scenario possibly amounting to between 9-10% by the latter part of 2013; and likely deflation in many OECD economies by 2013. These estimates are highly stylised and only illustrative. They consider only a restricted sample of countries despite the recent generalisation of contagion, and they do not discriminate among the three countries concerned in spite of their present differences in fiscal situations and government bond yields. That said, the estimates highlight the scale of the policy challenge involved if such a scenario did occur, and the urgency of taking action to put in place mechanisms that can prevent it from occurring.

Calibrating a stylised downside scenario in the euro area

The scenario set out below provides some illustrative indications of the possible economic effects resulting from one particular stylised downside scenario in the euro area. It assumes that contagion from a disorderly sovereign debt restructuring, for instance in Greece, is widespread in the euro area and, as a very stylised assumption, equally reflected in sovereign debt markets in Italy, Spain and Belgium, notwithstanding present differences in their fiscal positions and government bond yields. The scenario does not allow for the possibility of exit from the euro area, or for stronger expectations thereof, or for possible major discontinuities that might arise if any major financial institutions ceased to operate. The effects shown should be seen relative to the muddling-through projection, which incorporates the impact of the deterioration in financial conditions that has already occurred since the summer.

Given the likely global nature of the downturn and the key role of financial market contagion, as in the 2008-09 crisis, the downside scenario is calibrated on developments observed in that crisis. In particular, the deterioration in credit conditions, corporate bond spreads and equity prices between the latter half of 2007 (the half-year prior to the onset of a generalised collapse in confidence) and the height of the crisis in the first quarter of 2009 has been used to calibrate a benchmark for the declines that could occur in major OECD economies in this downside scenario. These benchmark declines are applied to the average value of credit conditions, bond spreads and equity prices in the six month period to July this year (the corresponding six months before the collapse in confidence began in August). The resulting calibrated levels of credit conditions, bond spreads and equity prices are assumed to be reached by the second quarter of 2012, and to remain at this level until end-2012. Thereafter, the reversion in these variables towards more normal, pre-crisis levels is assumed to be protracted compared with 2008-09, reflecting the more limited scope for sizable support from macroeconomic policies at the current conjuncture. In addition, as discussed in the main text, long-term government bond yields in this stylised scenario are also assumed to rise by 350 basis points in Italy, Spain and Belgium, in line with past experience following major turns in financial market sentiment. In practice, if such a scenario materialised, the situation in each country could differ, reflecting their different starting positions.

The broader economic impact of such developments can be quantified in a number of different ways:

• Aggregate financial conditions would quickly deteriorate in the euro area and other economies (see the first figure below). The decline in the FCIs implies, all else being equal, that the level of output in the major OECD economies (and the output gap) could be around 5% lower by the first half of 2013 than might otherwise be the case. A change of this magnitude from the muddling-through baseline would be associated with a deep recession in the euro area, and also push the United States and Japan into recession. It would also give rise to strong disinflationary, or even deflationary, forces. Financial conditions in the emerging market economies might also be strongly adversely affected in such circumstances, not least because of the likely rise in financial outflows from these countries as OECD financial institutions repatriate capital.

• In this situation, the decline in financial conditions would likely be accompagnied by a further increase in uncertainty and a continued weakening of consumer confidence (see the second figure below). As above, the changes between the latter half of 2007 and the height of the crisis in 2008-09 have been used to calibrate the changes in uncertainty and confidence, using the average value over February-July 2011 as a starting point.

• Using the analysis referred to in , the recalibrated FCIs and the associated alternative paths for uncertainty and consumer confidence point to a sustained and deep contraction in business investment relative to the muddling-through projection (see the third figure below). Such changes would likely have an adverse impact on near-term potential growth, by lowering the capital stock. The investment impact in the United States could even be larger than in the euro area, reflecting a greater estimated sensitivity of investment to changes in both the FCI and uncertainty in the United States. Private consumption would also weaken considerably; all else equal, the growth of private consumption would be lowered by around 2 percentage points in 2012 in the euro area and the United States, and by close to 3 percentage points in 2013 relative to the muddling-through projection.

Financial conditions in a stylised euro area downside scenario

OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540486

Uncertainty and consumer confidence in a stylised euro area downside scenario

OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540505

Private sector demand in a stylised euro area downside scenario

Annual growth rate in percent, change from the muddling-through scenario

Calculated from separate equations for investment and consumption, using financial conditions, uncertainty and confidence. See  for further details.

OECD calculations.

Statlink http://dx.doi.org/10.1787/888932540524

A broader picture of the possible near-term outcomes and effects in this downside scenario can be obtained from simulations on NiGEM, the global macroeconomic model of the National Institute of Economic and Social Research. This allows a full account to be taken of the spillovers between countries arising from changes in trade and international financial linkages via asset prices and net foreign asset accumulation.

In a simulation of the downside scenario, equity risk premia, corporate bond spreads, household sector interest rate spreads, equity prices and euro area bond yields are changed as set out above for the changes applied to recalibrate the FCIs. In addition, the simulation incorporates a 40% decline in equity prices worldwide (again reflecting the pattern of changes between the latter half of 2007 and the first quarter of 2009) and a stylised rise of 350 basis points in long-term government bond rates in Italy, Spain and Belgium. All shocks are assumed, for simplicity, to persist fully for two years. Policy interest rates are assumed to remain at their baseline settings (close to the zero bound). Budget solvency rules are turned off, so that the full effect of the downturn is reflected in the automatic stabilisers, apart from in the six euro area countries assumed to be at the heart of the crisis in this scenario (the programme countries, Italy, Spain and Belgium) and Japan, which as discussed in the main text on the OECD Strategic Response to a potential new relapse in economic activity, would have to at least partly offset the automatic stabilisers to avoid losses in market confidence about sovereign debt sustainability.

Broadly in line with the results above, the simulation results (see the Table below) point to a likely prolonged and deep recession in the euro area in the absence of any discretionary policy responses, given the already weak area-wide activity in the muddling-through baseline. The OECD as a whole would move into recession, with marked declines in activity in both the United States and Japan. The emerging market economies would not be immune from this shock, with global trade volumes around 9½ per cent lower than baseline after two years, and the value of their international asset holdings being hit by weaker equity prices. Differences across countries in the response to the shock reflect differences in the sensitivity of expenditure to changes in financial conditions and asset values in the macroeconomic model, as well as differences in real and nominal rigidities. In part, these help to account for the relatively slow first year response of euro area activity to the shocks. The response in Japan is relatively large, in part because the automatic fiscal stabilisers (which are small to begin with) are being offset by other fiscal measures so that the headline budget balance remains unchanged, and in part because of the relative sensitivity of net exports to changes in demand and the real exchange rate.

Disinflationary forces would intensify, with deflation likely occurring in many OECD economies by 2013, given the already low level of inflation in the main projection and the gradual extent to which stronger disinflation begins to push down inflation expectations. Unemployment would also rise sharply, by close to 2 percentage points in the OECD economies by 2013, and possibly even by more if past labour hoarding now led firms to reduce employment levels more actively. If other governments made efforts to stick to their announced fiscal objectives for the headline budget balance, the necessary further ex-ante fiscal tightening in the remaining euro area economies would exceed 1% of GDP in 2012 and over 2½ per cent of GDP in 2013; if implemented such changes would further intensify the adverse near-term effects on growth.

A stylised euro area downside scenario: macroeconomic model simulation results

Difference from baseline

Statlink http://dx.doi.org/10.1787/888932541816

Euro area exit would be devastating in the very short run…

In a worst-case situation, albeit one with only a small probability of occurring, the downside scenario above could be strongly accelerated and amplified if it was accompanied by one or several countries leaving the euro area and re-establishing their own national currencies – or even just by expectations thereof. For instance, this could be prompted by the need to restore external competitiveness after a large erosion since entry into the currency union. Although this would most likely prove to be extremely costly for the country in question in the short run, and possibly even in the long run,*

Empirical estimates made after a decade of monetary union in Europe suggested that the combined direct and indirect benefits on area-wide productivity from the move to a single currency could be as high as 5% in the long run (EC, 2008). The break-up of the euro area would put such gains at risk.

… and would entail huge costs for all euro area countries

If everything came to a head, with governments and banking systems under extreme pressure in some or all of the vulnerable countries, the political fall-out would be dramatic and pressures for euro area exit could be intense. The establishment and likely large exchange rate changes of the new national currencies could imply large losses for debt and asset holders, including banks that could become insolvent. Such turbulence in Europe, with the massive wealth destruction, bankruptcies and a collapse in confidence in European integration and cooperation, would most likely result in a deep depression in both the exiting and remaining euro area countries as well as in the world economy.

Ring-fencing can take various forms that differ in terms of cost and effectiveness…

A credible commitment by euro area governments that contagion will be blocked, backed by resources that were seen to be adequate, could serve as a trigger for an upside scenario. The measures announced at the October Euro Summit and EU Council meeting go some way towards this objective, but have not proved sufficient to damp market tensions. Fully-credible commitments to halt contagion to otherwise solvent sovereigns should result in a significant reduction in long-term rates in the countries concerned, with improved confidence and lower uncertainty prompting households and businesses to increase spending. Various ring-fencing mechanisms have different intermediate aims and would require significantly different resource commitments, and include the following:

• Taking full control of government bond yields in Italy, Spain and Belgium would require the euro-area authorities to be ready to buy all debt that investors were not ready to hold at a given price. This would go beyond the measures announced at the recent Euro Summit. To be credible, such a policy would need to be backed by an ample level of resources – even if credibility would imply that few resources would have to be actually disbursed. This might imply a sizeable share of the combined size of the bond markets in the three countries, which amounts to around e3 trillion (around 30% of GDP in the euro area) (, Panel A). A full guarantee of public debt of these countries would imply similarly large outlays in case of default and would therefore have to be backed by a similar level of resources to be credible, though outlays would be delayed compared with direct interventions to control the bond markets. Partial guarantees would require fewer resources, but would also likely be less effective in reducing yields.*

  The impact of partial guarantees, e.g. guaranteeing losses up to a certain per cent, would depend on the scope of such programmes. Guaranteeing a certain percentage of all existing and new debt should lead to a reduction in yields, although the impact is uncertain and depends on which combination of loss-given-default and probability of default is reflected in current spreads and on how the probability of default would be reassessed after the introduction of a guarantee. As an illustrative example, Italian government bond spreads over swaps as of 18 November 2011 can be interpreted as reflecting an implied probability of default of 6.1% a year over the next ten years using the value-weighted average loss-given-default rate of 69%, i.e. the average of the episodes of default surveyed in Moody’s (2011). Under this assumption, a 20% guarantee would reduce yields by less than 140 basis points. If, alternatively, loss-given-default is assumed to be equal to the un-weighted average of 47% in the study, the associated implied probability of default is 10.9% a year and the yield reduction for a 20% guarantee would reach almost 200 basis points.

  In the longer term, jointly issued or jointly guaranteed euro-bonds could achieve the same effects but would likely take time to introduce and would raise similar types of moral hazard concerns.

• Decoupling public finance developments from the government bond markets could be achieved if euro-area authorities were to satisfy the funding needs (i.e. roll-over of debt plus government deficits) of governments exposed to strong contagion in the same way as for the IMF/EU programme countries at present. In the cases of Italy, Spain and Belgium for 2012 and 2013, this would require resources equivalent to around e1 trillion (10% of GDP in the euro area) (, Panel B). However, such interventions would not necessarily imply low yields in secondary markets for government bonds, as demonstrated by the currently high yields in the programme countries, and knock-on effects on domestic banking systems could increase public funding requirements considerably. In addition, high yields would have adverse effects on creditor banks in other euro area countries.

• Guaranteeing the value of sovereign bonds in banks’ portfolios throughout the euro area would not address the feedback loop between higher yields and public finances, but would switch off the interaction between weakening banking systems and flagging confidence in government finances. Again using Italy, Spain and Belgium as an example, the resources required for this, if the guarantee became effective, would be equal to EU bank holdings of sovereign debt of the 3 countries, amounting to around e0.7 trillion (7% of GDP in the euro area) (, Panel C).

Whether the second or third option would be sufficient to completely arrest contagion to and from the vulnerable countries is questionable, especially given recent signs of contagion becoming more generalised and also affecting fiscally healthy countries.

Belgium, Italy, Spain and euro area programme countries: bond-market size, government funding needs and banks' holding of sovereign bonds

Based on the ESA95/SNA (as opposed to Maastricht) definition. For Greece, Portugal and Ireland see in the main text.

OECD Economic Outlook 90 database; Bloomberg; and European Banking Authority bank reports, August 2011, stress test.

Statlink http://dx.doi.org/10.1787/888932540562

... and resources can come from different institutions…

The vast resources involved could come from increasing or leveraging existing EFSF funds, as currently proposed, an increased use of the ECB balance sheet, directly from national authorities, or from the rest of the world through loans that could be channelled through the IMF. Indeed, the different actors could be assigned different tasks in ring-fencing strategies with many different permutations possible.*

For example, the EFSF could be tasked to deal with current programme countries and bank recapitalisation in vulnerable countries, national authorities with capital injections into banks in the stronger countries, and the ECB with ensuring that bond yields in vulnerable countries do not turn too high; the ECB could ensure low sovereign bond yields in both programme and vulnerable countries, thereby minimising losses for the European banking system, with the EFSF’s role being limited to inject the capital into banks that might still be needed in vulnerable countries, etc.

... but the ECB would most likely have to play a key role

Relying extensively on EFSF funds would arguably be more appropriate in the ring-fencing process as it would make the potential fiscal costs more transparent and would assign it to the fiscal authorities. However, it might prove difficult in practice to raise the capacity of the EFSF sufficiently, especially if funds were needed to support a large number of countries and private banks. Because of practical, legal and political economy barriers, the ECB would most likely have to play a key role in providing the required resources – possibly via the EFSF which would help ensure a more appropriate allocation of credit risk. The ECB can sterilise any expansion of its balance sheet and, more to the point, can use its deposit rate to steer market interest rates independently of outstanding liquidity should this become necessary. However, such a strategy could come at the cost of the ECB becoming heavily engaged in quasi-fiscal operations, and moral hazard could be created that could render inflation control difficult in the future. Set against this, a credible and decisive programme may not increase ECB exposure compared with the end result of the current drip-wise intervention under the Securities Market Programme. Irrespective of the institutional mechanisms employed, access to resources should only be made with strict conditionality, so that strong corrective action is taken by the receiving country.

Future fiscal governance in the euro area needs to be decided

At the same time as mobilising adequate resources, it is important to continue to progress on steps to strengthen future fiscal governance in the euro area. In particular, it is necessary to establish mechanisms to counter the potential moral hazard from intervening to block contagion. There are various options available to attain that end: stronger adherence to central rules and automatic penalties for non-compliance, e.g. monetary fines or the federation taking control of national VAT rates to attain targets; blue/red bonds that would provide countries with incentives to prevent their debt exceeding a certain limit where they could no longer benefit from low interest rates backed by a federal guarantee; increased use of market mechanisms to discipline fiscal behaviour, which would require establishing a framework for orderly sovereign default; etc. These options differ in terms of the extent of administrative and market control, and the ultimate arrangement will depend on members’ preferences in these matters, but the multiplicity of possible solutions should not delay the adoption of adequate arrangements. At its October 2011 meeting, the EU Council agreed to expand administrative controls to limit the risk of excessive deficits of individual member countries in the future (see ) and further measures are under discussion.

Successful action would offer near-term benefits

A successful blocking of contagion and the establishment of strengthened incentives to pursue sound medium-term fiscal policies, could offer significant near-term benefits for the economic outlook. In particular, there would likely be a marked reduction in long-term government bond spreads in many euro area countries, as well as a more general improvement in financial conditions and restoration of confidence. An illustrative scenario is set out in , incorporating a reduction in euro area government bond yield spreads and the rapid reversal of the decline in financial conditions since August. The results suggest that OECD output growth could be 1¼-1½ percentage points higher in 2013 than in the muddling-through projection, and considerably higher than would be the case if a downside scenario had materialised.

Calibrating a stylised upside scenario in the euro area

The scenario set out below provides an illustrative NiGEM simulation of the possible short-term economic effects of a stylised upside scenario in the euro area, with governments having made a fully credible commitment which ensures that any potential contagion to otherwise solvent governments is blocked. The effects shown should be seen relative to the muddling-through projection, which incorporates the impact of the deterioration in financial conditions and the rise in long-term government bond yields that has occurred since the summer. They do not incorporate any potential near-term effects from structural reforms announced as part of a package to help restore market confidence.

It is assumed that the long-term government bond yields of Italy, Spain, Belgium, France and Austria decline from their level in the muddling-through projection to 50 basis points above that of Germany, and that there is a 5 percentage point reduction in the level of 10-year government bond rates in Ireland, Portugal and Greece. In all economies, allowance is also made for an assumed rise of 20% in equity prices and small reductions in risk premia and private sector interest rate spreads. The latter reductions correspond to approximately one-quarter of the increases included in the downside scenario (), broadly taking these financial variables back to their level in the six months to July this year before risk aversion was heightened in August. Thus, there is an easing in financial conditions outside the euro area as well as inside. In the macroeconomic model simulation of this scenario, all shocks are assumed, for simplicity, to persist fully for two years. Policy interest rates are assumed to remain at their baseline settings. Budget solvency rules are turned off other than In the three euro area programme countries plus Italy, Spain and Belgium, who are assumed to continue to meet their target headline budget balances, implying a modest fiscal easing in these countries relative to the muddling-through projection.

Model simulations suggest that such changes might raise OECD output growth by between ¾‑1 percentage point in 2012 and between 1¼-1½ percentage points in 2013 (see the Table below). Global trade volumes would be around 5% higher after two years; this and the heightened asset values in the OECD economies should boost activity in the emerging  market economies  as  well.  The  largest  benefits  are  felt  in

the euro area, though these take some time to emerge, in part reflecting the relative openness of the euro area economy, with stronger euro area domestic demand offset by a large increase in the volume of imports. Thus, in the first year, the euro area GDP increase is only marginally faster than in the rest of the OECD. Overall, when combined with the muddling-through baseline, the upside scenario would imply the euro area growing at more than twice its estimated potential growth rate in 2013.

The boost to output could help to lower the unemployment rate, by around 1-1¼ percentage points in the euro area after two years and by some ¾-1 percentage point in the OECD overall. Inflationary pressures would be somewhat stronger, but not strong in an absolute sense given the disinflationary pressures in the muddling-through projection. There would also be improved fiscal outcomes in the euro area, with the budget balance improving by over 1% of GDP by 2013. Such an outcome would also likely be accompanied by improvements in private sector confidence and reductions in uncertainty, which would also be expected to boost expenditure relative to the muddling-through projection.

A stylised euro area upside scenario: macroeconomic model simulation results

Difference from baseline

Statlink http://dx.doi.org/10.1787/888932541835

Structural reforms are urgent in the euro area…

The present crisis has its origins in the economic imbalances that have built up gradually among the euro area economies. Symptoms amongst the weaker economies have included: weak competitiveness, loss of market shares and external deficits; low growth that has exacerbated fiscal imbalances through adverse debt dynamics; and over-reliance on domestic demand to drive growth. Amongst the stronger economies, growth has been excessively reliant on exports, and domestic saving has been used only partially to finance domestic investment (which has fallen relative to GDP), with surplus saving flowing to finance consumption and investments, with sometimes very weak or even negative returns, in weaker economies. Going forward, there is a need to not only establish sound fiscal policies, but also to: ensure that private saving and investment decisions are based on sound incentives; ensure that cumulated competitiveness positions converge quickly towards levels that are sustainable in the long term; and ensure that growth is not held back by policy barriers. The more rapidly such adjustments occur, the shorter the period in which weaker economies have to live with high unemployment and depressed activity. Structural reforms are crucial for achieving rebalancing and for speeding up the process of adjustment. In addition, structural reforms will also help economies to cope with, and adjust more flexibly to, future economic shocks.

... to improve growth prospects…

In addition to contributing to higher living standards, stronger growth in the euro area would help to improve debt dynamics. The potential growth rate is estimated to be around 1¼ per cent in the euro area as a whole, with markedly lower rates in some of the countries facing intense market pressure. Although implementing growth-enhancing structural reforms is important in all euro area countries, it is particularly urgent to introduce reforms in the countries faced with serious credibility problems. In addition, at the EU level; reforms to strengthen and deepen the Single Market; the effective implementation of the new procedure for the surveillance and correction of macroeconomic imbalances, and financial sector reforms all have an important role to play. In the financial sector, a truly unified banking system, where all regulatory and supervisory responsibilities are transferred to the euro area level, is especially necessary to eliminate the return of adverse feedback loops between national banking systems and sovereign debt.

… and to tackle imbalances…

Structural reforms are also much needed in all euro area countries to help with the restoration of appropriate levels of competitiveness and to establish sustainable levels of saving, investment and current account positions (OECD, 2010).

… both in external deficit economies…

• In the euro area external deficit countries, reversing the large deterioration in cost competitiveness that has taken place since the start of the monetary union () would help to reduce current account deficits and stimulate foreign demand at a time when fiscal consolidation is depressing domestic demand. However, against the backdrop of extremely weak area-wide inflation, progress in rebalancing competitiveness may be modest in some countries, reflecting downward rigidities in wages and prices. Structural reforms that boosted productivity growth would clearly help. The actual and planned implementation of structural reforms to enhance product and labour market flexibility would also support the necessary adjustment of the real exchange rate required to regain external competitiveness. Amongst the programme countries, adjustment is continuing to proceed relatively rapidly in Ireland, in part reflecting the relatively low level of rigidities in Irish labour and product markets. Declines in unit labour costs are also projected in Greece and Portugal in both 2012 and 2013. Other external-deficit countries in the euro area (including Italy and Spain) also have significant scope to reform labour and product markets to strengthen competitiveness and growth prospects, starting with reductions in labour-market dualism and regulatory barriers to competition.

The evolution of intra-euro area unit labour costs

Domestic unit labour costs relative to German unit labour costs, index 1999=1

Economy-wide unit labour costs. 2011 incorporates the muddling-through projection.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540429

… and in external surplus economies

• At the same time, chronic external-surplus countries (including Germany and the Netherlands) can contribute to reducing external imbalances, as well as increasing their GDP per capita, by removing obstacles to investment, notably in the services sectors, by reducing barriers to entry and operational regulations.

US fiscal policy could be considerably tighter than assumed in the projection…

As discussed above, a second key downside risk around the projection stems from uncertainty about the likely path of fiscal policy in the United States. Existing legislation, including the Budget Control Act of August, implies that in the absence of offsetting action there could be a fiscal tightening of, respectively, up to 2 and 3 per cent of GDP in 2012 and 2013 (when the extensions of the 2001-03 tax cuts are set to expire, and automatic expenditure reductions worth around ¾ percentage point of GDP would be enacted). In contrast, the normative assumptions in the projection build in a fiscal consolidation worth only ½ per cent of GDP in 2012 and 1% of GDP in 2013.

… with additional consolidation worth 1½ per cent of GDP in 2012 and just under 2% of GDP in 2013

A simulation on the global macroeconomic model NiGEM provides one means of assessing the possible short-term effects of tighter fiscal policy in the United States. In the simulation, shocks have been applied that reflect the difference between the moderate fiscal tightening in the muddling-through projection and currently programmed consolidation.*

Government final consumption is reduced relative to the baseline by 1½ per cent of GDP in 2012 and ¼ per cent of GDP in 2013, and personal income tax revenue is raised (ex-ante) by 1½ per cent of GDP in 2013, hitting household incomes.

The US economy would come close to recession…

The simulations suggest that if the full amount of additional consolidation was undertaken in the circumstances of the already-subdued growth in the muddling-through projection, the likely outcome would be that the US economy would move close to recession in 2012 and experience only weak growth in 2013 (). The pattern of the activity effects in the simulation reflects the contrasting natures of the shocks applied in 2012 and 2013; the near-term effect on activity from a direct cut in government consumption (which weighs heavily in 2012) is much larger than the near-term multiplier effect from a rise in household income taxes (which weighs heavily in 2013), particularly in circumstances in which much of the revenue is likely to come from middle-to-high income earners with a lower propensity to consume.*

This abstracts from possible longer-term differences in the effects on economic growth of changes in government consumption expenditure and taxes on income. The size of the simulation responses might also vary if forward-looking behaviour was allowed for in the simulations.

The impact of stronger US fiscal consolidation

Difference from baseline

Statlink http://dx.doi.org/10.1787/888932541778

… with especially severe consequences if coinciding with the euro area downside scenario

In the event that additional fiscal consolidation in the United States occurred at a time in which the euro area downside scenario was materialising, there would be a prolonged and severe recession in the OECD economies and a large downturn in world trade. The results of a combined simulation on NiGEM of the euro area downside scenario () and the tighter US fiscal policy described above are shown in . In the OECD as a whole, GDP would be lower by around 6% after two years, and the level of world trade would be reduced by around 10½ per cent. Unemployment would rise sharply, by more than 2½ percentage points in the United States and by over 2 percentage points in Europe. With the induced reduction in inflation coming on top of the already low rate of price increases in the muddling-through projection, deflation would likely be widespread. In such a situation, a broad strategic policy response across countries would be called for to arrest the decline in output. The available macroeconomic and structural policy options at the national level to respond to much greater weakness than embodied in the muddling-through scenario are set out below.

The combined impact of stronger US fiscal consolidation and a stylised euro area downside scenario

Difference from baseline

Statlink http://dx.doi.org/10.1787/888932541797

The OECD has prepared country-specific strategic responses in case a new crisis were to take place…

As part of its Strategic Response to a potential relapse in economic activity, the OECD has identified key macroeconomic policies as well as structural reforms which, while desirable in any case, would become more urgent should the economy turn out to be much weaker than projected. The country-specific policy recommendations are presented in . In general, the structural policy recommendations build on analyses reported in Going for Growth on the most effective measures to adopt in a crisis. While these reforms would be beneficial in other, more clement, states of the world, they would have added urgency if activity relapsed. They should be accompanied by multilateral confidence-building measures, such as the conclusion of the Doha trade round and the further strengthening of the global financial system as planned by the G20. The country-specific macroeconomic and structural policy recommendations are briefly summarised below.

... fiscal stimulus when possible…

In most countries, public finances are sufficiently sound and credibility sufficiently strong to allow government budgets to support the economy in the event of a serious downturn in activity.

• Around half of all OECD countries would be in a position to give a temporary discretionary stimulus to aggregate demand, implying either declines in underlying net lending (including Germany, Canada, Australia and Korea) or tempering planned reductions in underlying deficits (e.g. the United Kingdom and the United States) whilst maintaining medium-term targets. Within this group, the need for accommodative fiscal action along these lines would be greater in countries where automatic stabilisers are relatively low, such as Korea, the United States and Canada ().

• In most other OECD countries, weak government finances would not permit fiscal support to go beyond allowing the automatic stabilisers to work around a trajectory of structural improvements in budget balances, and then, in some cases (including France and Austria), only partially. In view of its high indebtedness, Japan would have to at least partly offset the automatic stabilisers and they are, in any case, relatively small.

• A small group of countries, consisting of Italy, Spain, Greece, Ireland and Portugal, would not have any scope to buffer the impact of a crisis on the economy, with adherence to planned consolidation targets (in nominal terms or relative to GDP) likely to be necessary to avoid further losses in confidence.

• Outside the OECD, given their comparatively low debt ratios and strong budget positions, Brazil, China, India and Indonesia have the capacity to provide a demand stimulus to their economy. In contrast, the fiscal situation only warrants allowing the operation of the automatic stabilisers in the Russian Federation and South Africa.

• In all countries, a priority for fiscal policy would have to be to ensure the integrity of the financial system. Likewise, ensuring adequate social protection would be crucial. Depending on countries’ fiscal room for manœuvre, such priority spending would either have to be offset or could be allowed to affect the overall budget balance.

The size of the automatic fiscal stabilisers

Change of the budget balance in per cent of GDP in response to a one percentage point change in the output gap

Girouard and Andre (2005).

Statlink http://dx.doi.org/10.1787/888932540581

... backed by greater transparency of future public finances and independent fiscal councils

To strengthen confidence in the soundness of public finances in the medium term, and thereby create more scope to support the economy temporarily in a crisis, governments should strive to increase transparency and shift to multi-year annual budgeting. Increased transparency would be facilitated by independent fiscal councils that would prepare economic projections to be used as a basis for the budget and the monitoring of fiscal outcomes relative to plans. Multi-year budgeting could prove to be a useful tool to link short-term budgetary developments to medium-term targets.

Monetary policy has still scope to provide support in most areas

In the event of a crisis, monetary policy could provide further support to demand in many countries. The muddling-through projection already assumes that policy interest rates are taken down to, or maintained at, close-to-zero levels in most OECD areas. However, there would still be scope in a number of countries to reduce official interest rates, including in Canada, Australia, Korea, Mexico, Norway, Sweden and Turkey. In addition, many countries and areas (including the United States, Japan, the euro area and the United Kingdom) could make further use of unconventional monetary measures, such as increasing purchases of domestic government debt. Such strategies would risk being subject to diminishing returns, possibly requiring the use of additional unconventional instruments, such as commitment and communication policies, or even purchases to be concentrated in more risky private securities. As an ultimate recourse, fiscal instruments could be used to generate negative real after-tax interest rates. Outside the OECD area, there is significant scope in most countries to relax monetary policy to offset a renewed unexpected weakness.

Structural policies have a key role in cushioning a possible downturn, including…

Some structural policy reforms could boost near-term confidence and even have a direct positive impact on short-term aggregate demand developments, in addition to increasing potential output in the long term. Moreover, the effect on potential output may increase the scope for near-term fiscal policy. Key structural reforms that would become particularly urgent in the event of a flagging economy include:

... product market reforms…

• Product market reforms targeted at increasing competition in general, or in network industries (e.g. France, Mexico and Turkey), professional services (Germany, France, Italy) and retail services (e.g. France) in particular, would spur growth and encourage innovation activity. Increased privatisation would also be an appropriate reaction to a crisis in some countries (including Italy and Poland). In the European Union, further integration of national markets, notably services, could provide a boost to demand and confidence. Outside the OECD area, product market reforms would be called for in China and South Africa.

... stronger public sector efficiency…

• Increasing the drive for public sector efficiency, including in the United Kingdom (notably in the National Health Service that has been protected from consolidation so far) and New Zealand, could help to generate increased space for fiscal manoeuvre in the near term.

... increased openness…

• Increased international openness would be appropriate inter alia in Japan and Korea, as well as in the Russian Federation and India. Higher inward foreign direct investment could boost investment levels and increased trade openness in countries with robust activity should raise real incomes and support exports from countries with weaker activity.

... labour market reforms…

• Labour market reforms can raise long-term sustainable employment levels and provide fiscal room for manoeuvre while also easing adjustment processes; therefore they become more urgent in a crisis. Such reforms are warranted in around half of all OECD countries (including Italy, United Kingdom, Canada, Belgium, Estonia, Ireland, Portugal, Slovenia, Spain, Sweden and Turkey) and outside the OECD area, in Indonesia and South Africa.

... pension reforms...

• Pension, early-retirement and disability/sickness reforms would be called for in several countries (including Belgium, Denmark, Finland, Norway, the Slovak Republic and Slovenia) to reduce the future public costs of population ageing and hence increase confidence in the future strength of the public finances.

... tax reforms…

• Revenue-neutral tax reform aimed at reducing taxes on labour and corporate incomes and increasing indirect taxes and other taxes could give an important long-run stimulus to growth in several OECD countries, including Japan, Germany, France and Canada. Outside the OECD area, tax reform would be particularly urgent in Brazil.

... and financial market reform

• Rapid implementation of already decided financial reforms would become more urgent in the United States. Increasing the capacity of large banks in Switzerland to absorb losses would also become critical. In the United States, enhancing the possibility of refinancing mortgage loans at a low rate could be a particularly effective counter-cyclical device.

Growth will remain subdued as household budgets continue to be under pressure

The underlying pace of activity remains weak and consumption growth sluggish, notwithstanding some rebound from the very poor first-half growth. There have been some indications that credit supply conditions are improving, though at a slower pace than earlier in the year, and survey data indicate that banks are more willing to extend new loans. Significant progress has been made in private-sector deleveraging, with household financial obligations well below their peak and businesses accumulating large cash balances. But with equity markets having moved down again and consumer sentiment near its all-time low, consumption growth is projected to remain modest for several quarters. Once balance-sheet pressures and fears about the outlook lessen in intensity, growth should pick up gradually.

GDP growth and confidence indicators

United States

OECD Economic Outlook 90 database; Datastream.

Statlink http://dx.doi.org/10.1787/888932540600

Investment growth is set to moderate

Residential investment increased modestly in the middle of this year but turned down again in the third quarter. A sustained recovery in the sector remains some time off, as the overhang of unsold homes, including a large shadow inventory of houses not yet on the market, remains high. Elevated foreclosure rates also suggest further inflows of distressed properties are ahead. Mortgage rates have fallen to historical lows, but many households are not in a position to take advantage of the favourable financing, or they are reluctant to buy in an uncertain pricing environment. Outside of the housing sector, business investment has been expanding at a healthy pace, probably reflecting the release of some pent-up demand as businesses replace their ageing capital. But with capacity utilisation at low levels, and the indicators of business sentiment having deteriorated, the pace of non-residential investment growth is likely to step down in the coming quarters.

Employment, income and inflation

United States

Statlink http://dx.doi.org/10.1787/888932541854

The labour market is moving sideways

Employment gains have been modest in the private sector, and the improvement has not been large enough to make a dent in the unemployment rate, which has remained relatively flat so far this year at around 9%, well above its structural rate. Job creation is projected to be tepid for some time to come, and although it should pick up with stronger output growth, it will be a number of years before the unemployment rate is anywhere near its pre-recession levels. And the share of long-term unemployment is likely to remain stubbornly high, highlighting the continued risk of rising structural unemployment.

Unemployment rates and general government deficit

United States

Share of labour force unemployed 27 weeks or more.

OECD Economic Outlook 90 database; Bureau of Labor Statistics.

Statlink http://dx.doi.org/10.1787/888932540619

Financial indicators

United States

Statlink http://dx.doi.org/10.1787/888932541873

Demand and output

United States

Statlink http://dx.doi.org/10.1787/888932541892

External indicators

United States

Statlink http://dx.doi.org/10.1787/888932541911

Fiscal consolidation should proceed gradually

Fiscal policy has moved from supporting growth to restraining it, as declines in government spending subtracted nearly a percentage point from GDP growth in the first half of 2011. Deficit reduction needs to be calibrated to maintain credibility in medium-term consolidation goals while not forestalling the fragile recovery. To this end, the projection assumes that the pace of fiscal consolidation over the next two years is limited to a reduction in the underlying primary deficit of 1½ percentage points of GDP, considerably less than would occur if there were no change in current law.

Monetary policy should remain accommodative

Commodity price pressures are abating, and given the substantial slack in resource utilisation, both headline and core inflation are projected to decelerate. With inflation expectations safely anchored, monetary policy should remain accommodative for the foreseeable future.

The level of uncertainty is high, and risks are weighted to the downside

The future path of fiscal policy remains highly uncertain, as are its attendant effects on the broader economy as fiscal stimulus is withdrawn. Moreover, negative spillovers from the turmoil in European markets could be greater than expected and have the potential to derail the recovery in activity and renew fears among financially fragile households and businesses.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Fiscal support should be implemented in the event of a weaker economy. The strengthening of automatic stabilisers already assumed in the baseline projection – prolongation of extended unemployment benefits – should be taken further by increasing access to earned-income tax credits and food stamps. Effective activation measures will be vital to minimise a heightened risk of rising structural unemployment.

• Easing the pace of fiscal tightening in the short term will raise the importance of establishing a clear medium-term budget consolidation roadmap. While the agreed caps on discretionary spending and the new process to achieve additional savings over the next 10 years are welcome developments, more needs to be done to secure fiscal sustainability. A credible commitment to fiscal sustainability would aid the recovery by increasing confidence, reducing uncertainty and lowering the risk of disruptive logjams over the federal debt ceiling and possible resulting government shutdowns.

• The Federal Reserve still has options to support the economy. The FOMC decision to keep short-term interest rates at an exceptionally low level through at least mid-2013 was a welcome signal. Further actions to adjust the Fed’s portfolio toward holding longer-dated securities could help ensure that the yield curve does not steepen.

• In the wake of the large past house price declines, many financially stressed but otherwise creditworthy households are still unable to refinance their debt at low mortgage rates because they have little or no remaining equity in their homes or because they face other institutional hurdles. Measures that would allow these households to reduce their payment burdens by refinancing would reinforce a critical channel for low interest rates to stimulate the economy.

• The financial sector reforms laid out in the Dodd-Frank legislation need to be implemented without delay, as financial institutions would come under even greater stress if downside risks materialise. Action to introduce a macroprudential framework would provide confidence that financial stability will be maintained.

The recovery is continuing, though at a slower pace…

The economy is recovering from the March 2011 Great East Japan Earthquake, Japan’s worst post-war disaster. Despite electricity shortages and supply chain disruptions, industrial production has risen to within 8% of its pre-earthquake peak. However, the pace of recovery is now moderating after an initial spurt. Moreover, the initial rebound in some confidence indicators has been reversed, reflecting concerns about the strength of the world economy and the appreciation of the yen, which has risen 7% in effective terms since May.

… led by public and private reconstruction spending

The government plans to spend a total of around 19 trillion yen (about 4% of GDP) over five years for reconstruction following the disaster, which caused damage officially estimated at around 3½ per cent of GDP. In addition to the two packages already passed by the Diet, amounting to a total of 6 trillion yen, the Cabinet has approved a third package of around 9 trillion yen (including 2 trillion yen to respond to the impact of the yen appreciation). Public spending, which is focused on infrastructure, is being supplemented by business and residential investment to rebuild private firms’ fixed capital and housing.

Exports, production and business confidence

Japan

Data are three-month moving averages of seasonally-adjusted industrial production and exports.

Diffusion index of ’’favourable’’ minus ’’unfavourable’’ conditions.

A survey of workers, such as taxi drivers and shop clerks, whose jobs are sensitive to economic conditions.

Large enterprises are capitalised at a billion yen or more and small enterprises at between 20 million yen and a hundred million yen.

Except for the economy watchers index where there are no projections, numbers from October to December are companies’ projections made in September 2011.

Ministry of Economy, Trade and Industry; Bank of Japan; Cabinet Office.

Statlink http://dx.doi.org/10.1787/888932540638

Employment, income and inflation

Japan

Statlink http://dx.doi.org/10.1787/888932541930

The government budget deficit is projected to remain around 9½ per cent of GDP

The third reconstruction package will be initially financed by reconstruction bonds, which will be redeemed by temporary tax hikes, with most beginning in 2013 and perhaps lasting up to 25 years. Surcharges on personal and corporate tax income will be the main sources of additional revenue. Other government spending in 2012-13 will be constrained in line with the three-year medium-term fiscal framework announced in August 2011. This aims to cut the central and local governments’ primary budget deficit by half by financial year (FY) 2015 and achieve a primary surplus and stabilise the public debt ratio by FY 2020, a target that is essential to foster fiscal sustainability. To meet these objectives, central government spending (excluding debt repayment and interest) and the issuance of conventional government bonds are to be limited to their initial FY 2011 levels. Even if these targets are met, the budget deficit will remain around 9½ per cent of GDP (excluding one-off factors) through 2013. Consequently, gross government debt is projected to approach 230% of GDP in 2013, pushing Japan’s public finances further into uncharted territory.

Exchange rates and underlying inflation

Japan

Trade-weighted, vis-à-vis 41 trading partners.

Deflated based on consumer price indices.

Corresponds to the OECD measure of core inflation, which excludes food and energy.

OECD, Economic Outlook 90 database

Statlink http://dx.doi.org/10.1787/888932540657

Financial indicators

Japan

Statlink http://dx.doi.org/10.1787/888932541949

Japan has taken other steps to support the recovery

The Bank of Japan has kept the policy interest rate at close to zero, while expanding quantitative measures in the wake of the March disaster and the appreciation of the yen since mid-2011. It expanded the funds-supplying operation, i.e. lending to financial institutions at the policy rate, by another 5 trillion yen to 35 trillion yen (7% of GDP). In addition, its asset purchase programme has been gradually increased from 5 trillion yen when it was introduced in October 2010 to 20 trillion yen (4% of GDP) by October 2011. Nevertheless, the core consumer price index (excluding food and energy) fell by 0.4% in the third quarter of 2011 (year-on-year). The authorities also intervened unilaterally in the foreign exchange market in August and October.

Demand and output

Japan

Statlink http://dx.doi.org/10.1787/888932541968

External indicators

Japan

Statlink http://dx.doi.org/10.1787/888932541987

The expansion is projected to continue through 2013…

Output is projected to rise by 2% in 2012, supported by public and private reconstruction spending. As public investment’s contribution to growth fades, the pace of the expansion is likely to moderate. Nevertheless, business and residential investment are expected to help sustain the recovery through 2013. Moreover, the pick-up in world trade in 2012-13 will boost Japanese exports. Deflationary pressures, though, may remain headwinds for growth through 2013.

… although there are many risks, both domestic and external

In the wake of the Fukushima accident, most of Japan’s nuclear power plants, which supplied almost one-third of the country’s electricity, have been closed for safety checks. Delays in re-opening these plants – or in securing alternative energy sources – could constrain output growth. In addition, the delay in fiscal consolidation and the continuing rise in the public debt ratio compound the risk of a run-up in long-term interest rates. Finally, the risk of a sharp deterioration in the world economy creates great uncertainty about the projection.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Reconstruction spending, amounting to about 4% of GDP over five years, is further exacerbating Japan’s fiscal situation in the short run. With a budget deficit of 9½ per cent of GDP (excluding one-off factors) in 2012-13 and gross public debt set to rise to almost 230% of GDP, Japan does not have scope for additional fiscal measures to cope with any renewed weakness in economic activity and in that event would have to at least partly offset the automatic stabilisers, which in any case are relatively small.

• A detailed and credible fiscal consolidation plan to meet the government’s target of achieving a primary budget surplus and stabilising the public debt ratio by FY 2020 is a top priority. Given the large deterioration in the fiscal situation and long period of consolidation ahead, improving the fiscal policy framework would help to bolster confidence in such a plan. Key reforms should include creating an objective fiscal assessment body at arm’s-length from the policy-making process and a stronger legal foundation for medium and long-term fiscal targets.

• In addition to maintaining a virtually zero-interest-rate policy, the Bank of Japan should further expand its funds-supplying operation and its asset purchase programme. These quantitative measures should be further expanded to cope with any economic weakness, thereby helping to bring a definitive end to more than a decade of deflation.

• Promoting Japan’s integration in the global economy would boost growth. Removing obstacles to inflows of imports, capital and labour, in line with the New Growth Strategy, is thus a top priority. Such reforms, along with a reduction in the high level of agricultural support, would facilitate Japan’s participation in the Trans-Pacific Partnership, as well as in free trade agreements with major trading partners.

• In addition to providing revenue for fiscal consolidation, tax reform is a priority to promote economic growth. Reform should broaden direct tax bases while lowering tax rates on corporate income. The consumption tax, which has a less negative impact on growth than other types of taxes, should be the main source of additional revenue. Environmental taxes also have a role to play, including in helping to promote green growth.

Financial conditions have deteriorated

The sovereign debt crisis has intensified and broadened reflecting the absence of strong policy action at the EU level, continued balance sheets weaknesses in banks and insufficient consolidation plans in some countries with high debts. The functioning of the interbank market has become impaired with some institutions suffering reduced access to market financing and a withdrawal of funding by US mutual funds. The ECB October Bank Lending Survey points to a renewed tightening of loan standards for businesses and households. At the same time, euro area equity markets have plunged. The crisis led to a modest depreciation in the effective euro exchange rate. Business and consumer confidence is deteriorating.

GDP growth components and sectoral borrowing

Euro Area

Contribution to the quarterly percentage change of the euro area GDP.

Net lending/borrowing by sector, four-quarter moving average, per cent of GDP.

European Central Bank and OECD, OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540866

Employment, income and inflation

Euro area

Statlink http://dx.doi.org/10.1787/888932542329

Activity will slow

GDP is projected to contract modestly in the final quarter of 2011 and the first quarter of 2012. Consumption growth will slow as households undertake precautionary saving, investment will be weak as projects are put on hold and financing becomes scarcer, and global weakness will hurt export growth. Recovery is anticipated to take hold from mid-2012 as confidence gradually improves among households, businesses and in the financial sector. Monetary easing will contribute to more favourable financing conditions. The recovery will be muted, however, as a result of weakened labour market conditions, the continued need to resolve underlying economic imbalances in some countries and remaining fragilities in financial conditions. On-going and necessary fiscal consolidation will be a drag on demand.

Confidence indicators and loans

Euro Area

The series are normalised and averaged 0 over the period January 1999 to the latest observation.

Net percentage of banks anticipating tightening standards applied to the approval of loans.

Eurostat and ECB (2011), Bank Lending Survey, October.

Statlink http://dx.doi.org/10.1787/888932540885

Financial indicators

Euro area

Statlink http://dx.doi.org/10.1787/888932542348

Unemployment will rise

The unemployment rate will edge up, perhaps more than projected given the limited adjustment observed in recent years during the financial crisis. This underlines the importance of reforms to labour market institutions, particularly to ensure that unemployment benefit systems provide good work incentives and that regulation does not impede job creation.

Demand and output

Euro area

Statlink http://dx.doi.org/10.1787/888932542367

External indicators

Euro area

Statlink http://dx.doi.org/10.1787/888932542386

Underlying price pressures remain weak

Headline inflation rose to 3% in September, but inflation is expected to moderate over the coming quarters as energy prices fall. Unusually large increases in indirect taxes have contributed strongly to inflation over the past year, which may continue as further fiscal consolidation is undertaken. Inflation is expected to moderate as output falls further below capacity and labour market weakness contains wage pressures.

The ECB should further lower policy rates

The ECB’s main refinancing rate was lowered to 1.25% in November. Since the sovereign debt crisis intensified in August, the ECB has again extended non-standard measures. Given the slowdown in activity at a time of existing spare capacity and weak underlying inflationary pressures, policy rates should be lowered and non-standard measures continued as planned with the aim of reducing the overnight interbank rate to a very low level. A rigorous and credible assessment of all risks to the banking sector is required and measures taken to ensure that all banks are well capitalised as currently planned.

Fiscal consolidation should continue as planned

Euro countries should pursue the consolidation plans set out in Stability Programmes. For countries with severe fiscal problems and where fiscal credibility is weak, authorities should ensure that headline targets are met. More detailed and credible plans for fiscal consolidation should be set out as soon as possible in all countries to enhance the credibility of current plans.

Policy orientation should downside risks materialise

Overall risks are mainly on the downside. If such risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Countries with severe consolidation needs and weak credibility should ensure that headline targets are met, while countries with fiscal space should allow the automatic stabilisers to work and in some cases could undertake stimulus measures if there is a severe downturn.

• The expanded scope of the EFSF should be used as necessary to maintain stability in the euro area, both to address sovereign and banking problems. The resources available for intervention have to be at a level where market confidence would be regained. Where solvency problems are identified, a voluntary private sector debt restructuring should take place as anticipated in the ESM and new financing arrangements should be put in place by official creditors.

• The balance sheet and funding positions of euro area banks should be rigorously assessed taking into account all the relevant risks and the appropriate policy measures should be taken, including a large-scale recapitalisation. EFSF funds should be made available where necessary.

• More radical, non-standard measures would be required if monetary policy transmission in the euro area as a whole were to become more seriously impaired.

• The new EU fiscal and economic governance framework should be effectively and courageously applied to ensure that no country loses fiscal credibility and jeopardises the functioning of the monetary union. National fiscal frameworks should be rapidly upgraded in line with the new requirements.

• Financial market regulation and supervision should continue to be strengthened. The newly-created European supervisory bodies and European Systemic Risk Board should play a key role in identifying and resolving financial weaknesses.

• A well designed package of reforms to labour and product markets in countries with a need to rebalance their economies, whether with current account surpluses or deficits, would facilitate adjustment and make growth more sustainable.

Economic activity is slowing sharply…

Real GDP returned to its pre-crisis level in the second quarter, but the economy appears to have entered a mild recession in the fourth quarter. It has been hit by a marked deterioration of world trade and by a rapid loss in confidence related to the sovereign debt crisis in some euro area countries. As a result, the contribution to growth from exports is likely to fall given Germany’s significant exposure to foreign trade, notably to international demand for investment goods. In addition, domestic firms are likely to be more hesitant to invest over the coming quarters as signalled by decreasing business confidence indicators. Weaker confidence and substantial losses in equity markets may also lead households to raise their savings rate, which may weigh on consumption and partly offset an increase in disposable income.

…while the labour market remains robust

The labour market usually lags the cycle and has so far been unaffected by the weakening in economic activity; the unemployment rate has fallen further, reaching its lowest level in more than two decades. To some extent this reflects the beneficial effect of past labour market reforms which lowered structural unemployment. With slower growth envisaged for 2012, the decline in unemployment is projected to reverse somewhat. However, the increased flexibility of working hours at the company level – which was demonstrated forcefully in the past recession – will damp the adverse effects if companies believe that the slowdown is short lived and respond accordingly with renewed labour hoarding.

Business confidence and orders

Germany

Deutsche Bundesbank; Ifo Institut für Wirtschaftsforschung.

Statlink http://dx.doi.org/10.1787/888932540676

Employment, income and inflation

Germany

Statlink http://dx.doi.org/10.1787/888932542006

The budget deficit has fallen

The fiscal situation has much improved and the budget deficit is projected to fall significantly this year. This is due to both the favourable cyclical situation up to now and improvements in the structural balance. Over the projection horizon the government is expected to continue implementing its planned consolidation measures, which amount to around 0.3% of GDP per year, in accordance with the fiscal rule that requires a structural deficit at the federal level of at most 0.35% of GDP by 2016. The forecast is for an almost unchanged budget deficit in 2012 as the cyclical deterioration offsets most of the improvements underlying consolidation. With an improved growth outlook in 2013 the deficit is set to continue declining.

Government debt and unemployment rates

Germany

Note: Gross debt (Maastricht definition) refers to general government debt.

OECD, Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540695

Financial indicators

Germany

Statlink http://dx.doi.org/10.1787/888932542025

Growth is set to recover gradually during 2012

Following the slowdown of economic activity during the winter months, growth is set to pick up during 2012. This reflects a projected improvement of world trade and hence strengthening exports. Confidence is also expected to gradually rise, thus leading to a pick-up in investment spending. Financial conditions remain very easy and there are pent-up investment opportunities. Consumer spending will also benefit as the rise in the household saving rate may be reversed and disposable income improves on the back of wage increases. The recovery from the period of weak growth is envisaged to continue through 2013 and is likely to be stronger than in other euro area countries because in Germany there is no need for deleveraging in either the household or corporate sectors. However, despite this recovery the output gap is expected to remain negative, thereby damping inflationary pressures and leading to a fall in annual headline inflation to around 1½ per cent by 2013.

Risks relate to world trade and the banking sector

The main risks around this forecast are a more marked slowing in world trade and a substantial deterioration in domestic bank balance sheets in the context of further stress in euro area sovereign debt markets. The latter could lead to sustained problems in credit availability which would adversely affect the outlook, in particular for domestic spending. On the upside, successful crisis resolution in combination with better regulated financial markets could unleash again a longer and stronger upswing. Overall, risks are predominantly on the downside.

Demand and output

Germany

Statlink http://dx.doi.org/10.1787/888932542044

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Automatic stabilisers should be allowed to work fully, as is explicitly allowed by the constitutional fiscal rule. The fiscal rule is the main element of Germany’s credible framework and adherence to it remains essential. If the economy were to be significantly weaker than projected, it would be appropriate to provide temporary measures to stimulate demand in a way that does not harm the credibility of the fiscal rule domestically and internationally. Such measures would usefully include support for short-time work arrangements.

• Strengthening domestic demand through structural reforms should remain high on the policy agenda. Such reforms would foster the replacement of missing external growth by a new domestic dynamism. Such a reform would also contribute to lowering the current account surplus and ease international imbalances. They should reduce entry barriers and increase the scope for investment, innovation and employment creation. For example, the strict regulation of professional services needs to be reduced, including rethinking compulsory chamber membership.

• To support growth, the structure of taxation should be reviewed, and the burden shifted to immobile bases, including environmentally harmful activities, and away from mobile ones, notably labour, which is particularly highly taxed.

Growth has gone off track

The French economy is likely to have stalled in the last quarter of 2011 following the sharp deterioration in confidence all across the board. Unless the sovereign debt crisis is decisively resolved, confidence is likely to be restored only gradually. This renewed weakness is occurring while the labour market still carries the scars of the Great Recession: long-term unemployment and the share of older workers among the unemployed have kept increasing rapidly. As a result, the risk that structural unemployment will rise is significant.

Financing conditions have been deteriorating

Credit growth has slowed recently, especially for household loans. There are some early signs that the housing market has turned downwards, and factors that helped to limit the house-price adjustment in 2008-09, such as declining mortgage rates, public support and low indebtedness, are now playing a much smaller role. In addition, the large exposure of the French banking system to countries at the core of market tensions has become a source of increasing uncertainty, contributing to the sharp rise in the government bond yield spread vis-à-vis Germany. With contagion having spread to France, higher borrowing costs will affect the whole economy.

GDP growth and unemployment rates

France

Harmonised.

Workers registered at Pole emploi for more than 1 year (categories A, B and C).

Workers aged 50 or more registered in Pole emploi’s A category (multiplied by 2 for illustrative purposes).

Dares; OECD, Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540714

Employment, income and inflation

France

Statlink http://dx.doi.org/10.1787/888932542063

The fiscal framework should be strengthened

Given the steady deterioration of public finances over the past few decades and current market stresses, there is no room for discretionary measures to offset the current economic weakness without endangering the nation’s sovereign credit rating. As a result, the government is commited to reducing the general government deficit from 5.7% of GDP in 2011 to 4.5% in 2012 and 3% in 2013. The projection herein assumes that these objectives will be met. Given slow economic growth and the increased cost of debt, reaching the 2012 target will require additional consolidation measures, of the order of 0.4% of GDP. To preserve credibility, the fiscal framework needs to be strengthened.

Government debt and risk premium

France

Maastricht definition.

5-year French sovereign bond; 2011Q4 is extrapolated based on daily data available up to November 16th.

2006Q1 = 100; 2011Q4 is extrapolated based on daily data available up to November 16th.

OECD, Economic Outlook 90 database; Datastream.

Statlink http://dx.doi.org/10.1787/888932540733

Financial indicators

France

Statlink http://dx.doi.org/10.1787/888932542082

Detailed medium-term measures are lacking

While the detailed measures that would allow the 2013 target to be met should be announced quickly, the 2012 elections are no doubt delaying that process. Beyond 2013, part of the deficit should disappear as the output gap is reduced, but a further structural tightening of at least 0.5% of GDP will be necessary to lower the deficit to a level that will bring debt down at an appropriate pace.

Demand and output

France

Statlink http://dx.doi.org/10.1787/888932542101

Public spending should be curbed

Most of the consolidation effort in France should come from restraining spending, especially as the recent deterioration of the fiscal balance came almost entirely from the spending side. Extending the General Public Policy Review to all levels of public administration and shrinking programmes that are not cost effective will be key. Consolidation of small municipalities and elimination of departments could generate substantial economies of scale. Considerable savings could also be made without impairing the quality of the health-care system by reducing the frequency and length of hospital stays, lowering administrative costs, eliminating reimbursement of the least effective drugs, expanding the use of generics and implementing capitation-based physician compensation.

Growth will be weak

Real GDP is projected to increase by only 0.3% in 2012 and by about 1.5% in 2013. Private investment is likely to be affected by the deterioration in companies’ self-financing ratio, while poor employments prospects will weigh on private consumption. Fiscal consolidation will prevent a narrowing of the output gap, but its impact will be limited by the design of the measures announced so far and partly offset by an accommodative euro-area-wide monetary policy, and a decline in the household saving rate from the current abnormally high level. The unemployment rate is likely to resume its upward trend and peak at about 10.4%, and headline inflation decline to near 1%.

Larger risks remain on the downside

Considerable uncertainty surrounds this projection. Healthy household balance sheets might trigger a faster recovery if confidence improves more rapidly. In contrast, failing to strengthen fiscal credibility could heighten the perceived risks of holding French government debt, further raising interest rates and requiring necessary but damaging additional fiscal measures. A deepening of the European downturn carries by far the largest vulnerability.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Renewed sluggishness complicates fiscal policymaking. While there is no room for offsetting an adverse shock through discretionary fiscal expansion, the automatic stabilisers should be allowed to work in part in order to cushion activity.

• To limit adverse impacts on financing conditions and enhance fiscal discipline, this strategy depends crucially on the implementation of a strengthened fiscal framework. This should be based on a structural fiscal balance rule, a detailed multi-annual budget law enshrined in the constitution and an independent fiscal council whose main roles should be to judge the multi-year programme’s consistency with the fiscal rule and detect slippages during execution.

• Fiscal consolidation should be accompanied by structural reforms to boost potential output. The labour tax wedge should be lowered, possibly via temporary tax relief for new hires. Tax expenditures should be scaled back, and environmental and property taxes increased.

• The political economy context might be favourable for implementing long overdue product-market reforms at lower fiscal costs. Priority should be given to reducing professional services regulations, removing regulatory entry barriers in potentially competitive segments of network industries, and easing restrictions on retail price competition and setting up new stores.

Activity appears to have stalled

Industrial production, confidence and exports have all been very weak. Credit conditions have been tightening, more due to banks’ difficulties in accessing external finance than to heightened perception of lending risk, though this has risen too. The trade deficit remains quite high given the depressed level of demand in Italy, a sign of poor cost competitiveness. Unemployment has been falling slightly even though the number of people benefitting from the short-time working income-support scheme has fallen to 0.8% of total employment. Despite weak demand growth underlying inflation has been rising.

Wavering policy commitment added to financial market worries

The deterioration in confidence in Italy is partly self-inflicted as the last government appeared hesitant about following through with its plans to balance the budget by 2014, although this was first foreseen in 2010 and confirmed in the EU Stability Programme. Its commitment to structural reform, despite publication of a National Reform Plan in the spring of 2010, also seemed in doubt. The consequent steep rise in interest rates on government debt then forced the government to adopt an even tighter fiscal stance, aiming to eliminate the deficit by 2013.

Public debt, GDP growth and unemployment rate

Italy

In 2011, data on government deficit and debt are OECD estimates. From 2012, OECD projections.

General government gross financial liabilities, Maastricht definition.

In percentage points. Difference between Italy and Germany, 10-year government bonds. Last observation Q3 average.

Quarter-on-quarter, annualised rate.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540752

Employment, income and inflation

Italy

Statlink http://dx.doi.org/10.1787/888932542120

The yield curve has steepened considerably

The financial market tension took the spread between Italian and German 10-year government bonds to as high as 500 basis points in November. Significantly, yields on short-term debt have also risen substantially as well, 1-year bills yielding as much as 6% in November.

Current account deficit and labour cost competitiveness

Italy

Competitiveness-weighted relative unit labour costs in the manufacturing sector in dollar terms.

OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540771

Financial indicators

Italy

Statlink http://dx.doi.org/10.1787/888932542139

Growth is set to remain weak

Growth was probably negative in late 2011 and is projected to remain weak in 2012. This is partly because Italy is exposed to the same forces as other European economies, deteriorating confidence, weak export market growth and difficult financial conditions. As this outlook is well below that assumed in the 2012 budget, further measures will be required (and are included in these projections) to keep the fiscal adjustment programme on track. Export growth should recover somewhat in 2013 with a revival in world trade, and if confidence returns investment may pick up too. But government expenditure will continue to decline and low disposable income growth will mean low private consumption.

Demand and output

Italy

Statlink http://dx.doi.org/10.1787/888932542158

There are significant downside risks

Growth could be somewhat higher if decisive action by the new government brings interest rate spreads down quickly and boosts confidence. But the planned fiscal tightening is very severe, will require strong determination on the part of the new government, and may have stronger contractionary effects than projected here.

Policy measures should downside risks materialise

If the downside risks materialise, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Faced with bond-market anxiety, Italy has no room for discretionary fiscal action or for allowing the automatic stabilisers to play. Fiscal actions need to be introduced as needed to eliminate the deficit by 2013 and put the debt ratio on a declining trajectory. In the event of still greater weakness in activity, there will be little choice but to introduce further tightening measures to keep fiscal policy on track. Spending restraint rather than taxation should form the backbone of longer-term consolidation and further tax amnesties would be counterproductive.

• Creating a credible and independent fiscal council to monitor progress of fiscal consolidation and reform would help in communicating the effectiveness of reforms – such as the progress already made in multi-year budgeting – to the markets. The council should publish an assessment of macroeconomic outlook and implementation of fiscal targets at regular intervals.

• While room for fiscal action is lacking, there is broad scope for structural reform to enhance economic growth. The previous government’s letter of intent to the European Union outlined a number of structural reforms and the new government should embark on such a programme as early as possible.

• Reformed employment protection in the most rigid parts of the labour market would increase flexibility and reduce labour market segmentation. Wage moderation is imperative to reverse the long increase in relative unit labour costs. A stronger lead from the public sector, with cuts in nominal wages and regional differentiation, would be a good signal.

• Italy’s product markets need to be exposed to greater competitive pressure by easing regulation and lowering barriers to entry, especially in the liberal professions and business services. Privatisation of local public services, and establishing an independent regulator, would increase efficiency. National level privatisation could also improve competition and provide some debt-reducing revenue. A level playing field for foreign investors, including in financial institutions, should be ensured.

The economy is weakening sharply

Retrenchment by the household and public sectors continues to be a drag on the economy. Further headwinds come from a weakening global economy, lower asset prices and rising uncertainty related to the euro area debt crisis. With household consumption falling, government spending shrinking and export growth slowing, the economy is weakening. Continued fiscal retrenchment will remain a drag over the coming years, but slowing inflation and gradually recovering export demand from 2012 will shore up consumption and exports and support an initially weak recovery. As consumer confidence improves and real incomes start to rise, consumption growth will gain strength over 2012. In 2013, rising business confidence and increasing capacity utilisation will support business investment, quickening the recovery.

The labour market is worsening

Employment is falling and unemployment is already higher than during the 2008-09 recession. Government employment will continue to fall, while the business sector will further decrease hiring in response to flagging demand. The weakening of the economy is likely to have a proportionally bigger impact on employment than in the recent recession, as real wages and shorter working hours may adjust less this time. Unemployment is set to pick up through 2012 before stabilising around 9% in 2013. To mitigate the consequences of rising unemployment, especially among youth, resources for labour market training are warranted.

GDP growth, business confidence and labour market

United Kingdom

Quarter-on-quarter.

Refers to domestic orders.

Changes compared to 2008Q1.

OECD, OECD Economic Outlook 90 database and the British Chambers of Commerce.

Statlink http://dx.doi.org/10.1787/888932540790

Employment, income and inflation

United Kingdom

Statlink http://dx.doi.org/10.1787/888932542177

Inflation is starting to come down

Inflation is peaking, but is likely to remain above the 2% target through 2012. However, inflation expectations remain well-anchored. As effects from the 2011 VAT hike recede and import price growth slows, a large negative output gap and slow-growing unit labour costs should pull inflation below the target in 2013.

Inflation and public debt and net lending

United Kingdom

Implied by yield differentials between 10-year government benchmark bonds and inflation-indexed bonds.

Maastricht definition.

OECD, OECD Economic Outlook 90 database, Bank of England and Office for National Statistics.

Statlink http://dx.doi.org/10.1787/888932540809

Financial indicators

United Kingdom

Statlink http://dx.doi.org/10.1787/888932542196

More monetary support is needed

With the Bank rate at 0.5% and quantitative easing (QE) recently expanded to 18% of GDP (£275 billion), monetary policy is highly expansionary. Even so, more support is needed urgently as headwinds are strong. The projection assumes that the Bank of England increases QE further to a total of £400 billion by early 2012, leaving the Bank with almost 40% of the total stock of outstanding government bonds. Given ongoing weakness in lending to small firms, targeted measures, as currently discussed by the government, could be useful.

Demand and output

United Kingdom

Statlink http://dx.doi.org/10.1787/888932542215

External indicators

United Kingdom

Statlink http://dx.doi.org/10.1787/888932542234

Fiscal consolidation should continue

Despite ambitious consolidation plans, government debt will continue to rise through the projection period. The fiscal deficit is estimated to fall to 9% of GDP in 2011, still twice the EU average and higher than other G7 countries, apart from the United States and Japan. In 2013 gross government debt is expected to be close to 100% of GDP. Hence, planned fiscal consolidation tightening needs to continue despite the significantly weakening economic outlook, and this is assumed in the projection. The underlying primary balance will improve by about 1.3% of GDP per year between 2010 and 2013. In line with the fiscal plans and targets, the automatic stabilisers are assumed to be left to work fully.

Fiscal risks are significant

Fiscal risks remain in terms of existing exposure and potential need for further support to the banking sector. Weak short and medium-term growth prospects could also weigh more on public finances than projected. Further structural reforms to promote fiscal sustainability and growth, for example further increasing the state pension age, should therefore be pursued.

Risks remain on the downside

The downturn may turn out to be deeper than projected. Investment may contract more than forecast due to high uncertainty, weak corporate cash flows and tightening financial conditions. The materialisation of international risks, and their potential repercussions on the banking sector and overall confidence, would weaken both domestic demand and exports. Household consumption may fall more than expected as uncertainty, weaker balance sheets and rising unemployment trigger higher precautionary savings. At the same time, more persistent inflation could further squeeze incomes. On the positive side, a robust resolution of the euro area crisis could boost confidence and support a stronger recovery.

Policy orientation should downside risks materialise

If downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• More stringent regulations and potentially surging losses could force further recapitalisation of banks, preferably through private capital. However, the government should be prepared to step in if private capital fails to materialise.

• Short-term fiscal support would be warranted, for example by easing up on the planned cuts in public investment, temporarily slowing consolidation in relation to government plans. However, credibility will demand that the medium-term fiscal targets be retained and achieved, implying greater tightening later on. The measures to implement this future compensating tightening should be announced upfront. Possibilities include ending exemptions and abolishing lowered VAT rates in 2013, or increasing the state pension age. Such a package would improve both short and long-term growth prospects.

• Quantitative easing should be expanded further still if the economy weakens more than expected.

• Tight spending plans will reduce the availability of public services unless productivity is improved. While health care spending has been ring-fenced in consolidation plans, structural reforms in terms of containing compensation for some categories of National Health Service (NHS) personnel and reinforcing competition among providers could increase efficiency and provide savings.

• The weak economy is worsening social conditions. To mitigate the social and long-term economic impact of the recession, targeted support for the weakest is needed. Upgrading the quality of vocational training and providing stronger financial incentives for young people from poorer backgrounds to remain in education and training would cushion the long-term labour market impact of the crisis. Effective measures to combat fast-rising homelessness should be implemented.

Activity has lost steam

Economic activity has slowed considerably as a result of weakening external demand and moderating household spending. Real GDP declined slightly in the second quarter of 2011, undermined by a significant drag from external trade. The weakness was compounded by transitory factors hampering oil and gas extraction, as well as manufacturing supply-chain disruptions caused by the Fukushima disaster, which have reversed in the third quarter. Meanwhile, domestic demand has held relatively firm, led by private non-residential investment, as business credit has expanded robustly. Residential investment also posted solid gains in the first half of 2011, and more recent indicators point to continued buoyancy in housing markets over the near term. However, the unemployment rate has hovered at around 7.3% in the second half of the year, with some recent trimming of private-sector jobs.

Domestic demand will moderate…

Public-sector cutbacks and softening private employment growth are likely to moderate household spending. Consumer confidence has deteriorated since the beginning of the year, and equity prices have trended down for the past six months, generating a dip in household wealth. Although food and energy price moderation should provide some relief to real household incomes, debt levels remain at a record 150% of disposable income. Consumers have therefore pared back borrowing to its slowest pace since the early 1990s. House prices remain at historically high levels relative to incomes and rents, and some cooling of housing demand is expected, given the tightening of mortgage insurance regulations that took effect in March and April 2011. The sound financial position of the corporate sector and a low cost of capital should continue to sustain strong growth in business investment.

Business investment and consumer spending

Canada

Spending on machinery and equipment over the next 12 months.

Bank of Canada, Business Outlook Survey; Thomson Datastream; OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540828

Employment, income and inflation

Canada

Statlink http://dx.doi.org/10.1787/888932542253

… while exports will lag

The tradables sector will continue to face significant headwinds from a sluggish recovery in the United States and persistent strength in the exchange rate. By the first half of 2011, exports to the United States had recovered only about 60% of their losses since the 2007 peak, whereas those to the rest of the world now exceed pre-crisis levels. Despite some depreciation in recent months, the strong exchange rate should continue to depress the competitiveness of Canadian export-oriented manufacturers.

Household indebtedness and export performance

Canada

Ratio of export volume to export market (defined as the trade-weighted average of trading partners’ imports).

Statistics Canada; Thomson datastream.

Statlink http://dx.doi.org/10.1787/888932540847

Financial indicators

Canada

Statlink http://dx.doi.org/10.1787/888932542272

Monetary policy should remain accommodative

Annual headline inflation has fluctuated close to 3% since March, mainly reflecting rising food and energy prices. Core inflation has crept higher, however. Recent declines in commodity prices and the persistence of considerable economy-wide excess capacity should weaken inflationary pressures. In light of heightened economic risks, interest-rate increases should be delayed until 2013.

Demand and output

Canada

Statlink http://dx.doi.org/10.1787/888932542291

External indicators

Canada

Statlink http://dx.doi.org/10.1787/888932542310

Fiscal consolidation should continue with flexibility

In its fall budget update, the federal government delayed its target to balance the budget by one year, to 2015-16, reflecting in large part the weaker economic outlook, but also a lower increase in Employment Insurance premiums and an extension of the Work Sharing Program by one year. The projection assumes that expenditure cuts are implemented as budgeted, with the total government deficit narrowing to 3% of GDP in 2013.

Output is projected to grow slowly

Output is projected to expand at a slow pace as exports are restrained by sluggish external demand. Domestic spending should sustain growth but at a moderate rate, as high debt and waning sentiment curb consumption growth. The output gap is projected to narrow gradually but remain substantial enough to lower annual headline and underlying inflation to around 1½ per cent.

Risks are skewed to the downside

Persistence or worsening of global growth prospects and financial-market turbulence may lead to a sharper slowdown in exports, while damaging business confidence and investment. A sharp correction in house prices could further damp consumption. On the upside, robust growth in emerging-market economies could reignite commodity prices, boosting incomes in primary sectors and inflationary pressures.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• A sound financial system and the strong credibility enjoyed by the government lend it some fiscal space to respond to possible negative shocks. Federal and provincial governments should allow the automatic stabilisers to function, and implement plans for fiscal consolidation as a baseline, with some flexibility to delay or relax the pace of tightening should external demand or labour-market conditions deteriorate further.

• To reinforce fiscal credibility, it will become more urgent for the federal government to move towards a rules-based system for determining transfers to provincial governments. Credibility at the provincial level, which accounts for a significant proportion of the general government fiscal deficit, should be bolstered by following the federal example and implementing one or more fiscal councils to provide independent analysis of provincial budgets.

• The Bank of Canada should ease monetary policy via further interest rate cuts, which in a downside scenario would be consistent with the inflation target.

• Structural reforms will need to take more of the burden of promoting growth, allowing some under-financing in the short term. Further shifts towards a growth-friendly tax mix would be warranted, with a greater role for environmental and value-added taxes, while eliminating inefficient and poorly targeted tax expenditures. Employment could be boosted by implementing stronger measures to integrate immigrants into the labour market and facilitate inter-provincial labour mobility, including by removing remaining barriers to inter-provincial trade in professional services

The mining boom is sustaining growth

Despite the drop in growth to 1% year-on-year in the first half of 2011 because of natural disasters and fragile confidence over the international environment, the mining boom has sustained export, investment and consumption. However, the rising exchange rate has subdued growth in the non-mining trade-exposed sectors. The unemployment rate remains close to its structural level. Underlying inflation, which has been decreasing since 2008, fell below 2½ per cent in the third quarter of 2011.

The current monetary stance seems adequate

With the easing of inflation pressures, the Reserve Bank of Australia (RBA) lowered its cash rate by 25 basis points to 4.5% in November 2011. This more neutral monetary stance will help offset the depressing effect of the persistent downside risks surrounding the global economy on the equity market. Despite the decline in long-term interest rates since the third quarter of 2011, financial conditions have remained relatively tight because of the strength of the Australian dollar, which has averaged 7% higher in 2011 than in 2010 in real effective terms.

Fiscal policy remains restrictive

Withdrawal of the fiscal stimulus adopted in 2009 cut the federal deficit to 3½ per cent of GDP in FY 2010/11. Stringent spending control, consistent with the government’s plans, is still necessary to offset the revenue declines induced by the financial crisis and natural disasters. The authorities have reaffirmed their objective of returning to surplus by FY 2012-13, to restore room for manoeuvre. This strategy should not be affected by the introduction of a fiscally neutral carbon tax in July 2012.

Terms of trade, domestic demand and exports

Australia

Contribution to growth.

Quarter-on-quarter percentage change, annual rate.

OECD, OECD Economic Outlook 90 database and Australian Bureau of Statistics.

Statlink http://dx.doi.org/10.1787/888932540904

Demand, output and prices

Australia

Statlink http://dx.doi.org/10.1787/888932542405

Growth is projected to strengthen

Initially driven by a rebound in exports, growth should reach 4% in 2012 before settling to about 3¼ per cent in 2013. The mining boom’s effects on investment and income are likely to offset the negative impact of the strong exchange rate and fiscal consolidation. The unemployment rate could hover around 5¼ per cent. With the gradual reduction of the output gap, inflation should stabilise at around 2½ per cent, if one excludes the temporary increase – estimated at approximately 0.7 percentage point – due to the introduction of the carbon tax as from mid-2012.

Downside risks prevail

Domestic risks are balanced in this projection. They mainly concern household savings, which is expected to stabilise at a high level, but could increase (fall) if confidence deteriorates (improves). However, confidence will depend on global economic developments, which are subject to important downside risks, with potential additional negative implications for the terms of trade in Australia.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• Monetary policy should be eased significantly to sustain demand in the context of moderating inflation.

• There is also room to provide fiscal support, given low public debt and contingent liabilities, although doing so would postpone the return to budget surplus. In advance of the reform proposals under discussion with regard to the tax treatment of business losses, a targeted tax cut in this area might be considered. Reforms of housing-related local taxes should also be envisaged.

• To improve the effectiveness of fiscal policy, the process of identification of infrastructure requirements and how they are met should be strengthened. Reforms to enhance co-ordination and planning of infrastructure projects at the national level and to reduce the regulatory obstacles impeding capital investment in this area would become urgent.

• New structural reforms would bolster productivity, which has dipped significantly since the late 1990s, and thus growth. More transparent, harmonised and less restrictive zoning and planning regulations across states, and the removal of tax distortions that hamper the supply of housing and property transactions, would enhance resource allocation and labour mobility.

The export-investment driven recovery has come to a halt

The strong growth in the first half of the year was driven by exports, investment and re-stocking. The general slowdown in global growth and, in particular, the intensification of the European debt crisis since mid-year has reduced external demand from Austria’s most important trading partners. Heightened uncertainty and loss of confidence associated with the debt crisis has in addition weighed on domestic investment growth as firms delay investment decisions. This has led to a significant slowdown of output growth in the second half of 2011 and will continue to do so into the first half of 2012. As uncertainty is reduced and confidence returns, activity is projected to pick up in the second half of 2012 and into 2013 as the growth of both exports and investment resumes.

The labour market will weaken somewhat and inflation will abate

The labour market has performed exceptionally well since the financial crisis with unemployment being the lowest in the European Union. With many crisis measures, such as the short-term working scheme, still in place, the weakening activity is projected to have only a limited effect on unemployment. Inflation increased sharply and is expected to be above 3% this year on the back of increased global food and energy prices as well as excise tax hikes. Higher inflation has reduced household real income and consumption growth. With commodity and food price increases abating and rising spare capacity, inflation is projected to slow. This, in conjunction with a robust labour market, will support continued moderate consumption growth going forward.

Government bonds and labour market

Austria

As of 17th November 2011.

First half for 2011.

Datasream; OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540923

Consolidation should continue

Austrian sovereign bond spreads have increased markedly in recent months, to above the levels of the 2008 crisis. Planned efforts to reduce the structural deficit should therefore be continued and any slippage avoided to assure market confidence. The government recently announced plans to introduce a debt brake which envisages a structural deficit of 0.35% of GDP for the central government and a balanced budget for sub-central government levels from 2017 onwards. Swift implementation of this reform should foster confidence in the medium-term sustainability of public finances.

Demand, output and prices

Austria

Statlink http://dx.doi.org/10.1787/888932542424

Risks are biased towards the downside and particular risks exist also outside the euro area

Downside risks are mainly related to a further deterioration of the euro area sovereign debt crisis and especially the situation in Italy, to which Austria maintains important trade and financial linkages. A particular risk for the outlook also concerns the exposure of Austrian banks to countries outside the euro area in central-eastern and south-east Europe. If the economic outlook for these countries weakens significantly, this might cause additional stress for the Austrian banking system with repercussions on the real economy through the credit channel. The government should thus consider how the necessary additional capital requirements for the Austrian banks, in line with the new regulation concerning lending put in place by the financial regulator, can be obtained without undercutting their lending capacity.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• To foster confidence in the medium-term sustainability of public finances, the proposed debt brake should be implemented quickly. In this case, the automatic stabilisers can be allowed to work in part to cushion the downturn.

• Cuts in social security contributions or reductions in effective marginal tax rates should be considered for the low-skilled, who are particularly vulnerable in a downturn.

• To boost growth, further product market reforms should be implemented quickly to facilitate entry and competition in network industries and professional services.

Growth is slowing due to external developments

After relatively strong growth in the first half of 2011, the economy is slowing as exports weaken and falling confidence holds back domestic demand. Employment growth, which had been relatively strong earlier in the year, has also slowed sharply. Inflation has come down somewhat since peaking at 3.8% (y-o-y) at mid-year, reflecting the waning effects of earlier energy price increases, but underlying inflation has remained around 1¾ per cent (y-o-y). Despite the agreed low real wage increases in 2011 and 2012, the automatic wage indexation will translate past price increases into higher nominal wages, eroding external cost competitiveness.

Fiscal consolidation is required to secure sustainability

Sustained fiscal consolidation is needed to calm financial markets’ concerns over high Belgian sovereign debt, which have resulted in spreads vis-à-vis Germany long rates reaching more than 200 basis points on a number of occasions. The 2011 budget stipulates fiscal tightening of about ½ per cent of GDP, through a number of small measures. As revenues and spending are slowing together, the government’s objective of a budget deficit of 3.6% of GDP should be achieved. At the time of writing, the 2012 Budget proposal had not been presented. In line with the Stability Programme, an improvement of the structural fiscal balance per year of 1% of GDP is assumed over the projection period, technically implemented with equal weights on the spending and revenue side. Based on these assumptions, the deficit will fall by close to ½ per cent of GDP in 2012 and about 1% of GDP in 2013.

Confidence indicators and government bond yields

Belgium

Ten-year government bond yields.

OECD, Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888932540942

Growth should resume slowly by mid-2012

Stronger growth is only likely to take hold from mid-2012 onwards as world trade growth accelerates and the domestic economy benefits from supportive monetary policy. However, fiscal consolidation will be a restraining factor throughout the projection period. Unemployment is expected to increase throughout most of the projection period and only stabilise, at a relatively high level, in the second half of 2013.

Demand, output and prices

Belgium

Statlink http://dx.doi.org/10.1787/888932542443

Risks are downwards biased

The main downside risk is that fiscal consolidation does not suffice to calm financial markets, with negative effects on spreads and confidence. On the upside, the stabilisation of the political situation may entail a firmer commitment to raise long-term growth, boosting consumer and business confidence.

Policy orientation should downside risks materialise

If downside risks materialise, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms, which, while desirable in any case, would become essential to raise growth:

• To avoid negative financial market reactions, the planned fiscal consolidation needs to be maintained while the automatic stabilisers should be allowed to work. To bolster fiscal policy credibility, this needs to be coupled with a stronger fiscal framework via multi-annual budgets combined with greater external scrutiny of budget assumptions.

• To ensure sufficient wage flexibility to respond to a sharp slowdown, a more flexible and forward-looking wage formation process is needed to align wage increases with domestic productivity developments.

• To increase labour supply, priority should be given to closing down various exit routes into early retirement.

Growth is moderating

After a robust recovery of output and strong employment growth fuelled by favourable financial conditions and post-earthquake reconstruction, the Chilean economy is losing some momentum. Although the terms of trade remain favourable, the current account has moved into deficit, as imports are growing fast and the growth of both mining and industrial exports has slowed down considerably, reflecting global conditions. The peso appreciated strongly during the first half of 2011, but has depreciated since mid-September amid worsening international developments and declining copper prices. Confidence measures and advanced indicators both point to a slowdown.

There is room for monetary easing if necessary

Concerns about overheating have decreased with headline inflation and activity slowing, in part related to lower commodity prices and a rapid succession of monetary policy rate hikes during the first half of 2011, which have contained core inflation. The central bank has left the policy rate at 5.25% since July, close to its estimated neutral level. Monetary policy is expected to ease somewhat in early 2012, because of the signs of slowdown and the external uncertainty. With a slowing economy and inflation well within the target range, there is room for monetary loosening if a worsening of the global economy makes it necessary.

Activity and confidence indicators and inflation

Chile

Indicador Mensual de Actividad Económica (IMACEC), monthly indicator of economic activity.

Indice de Percepción de la Economía (IPEC), 50 represents the equilibrium between positive and negative sentiment.

Eleven month ahead, Monthly Survey of Economic Expectations.

Central Bank of Chile.

Statlink http://dx.doi.org/10.1787/888932540961

The fiscal position is strong

The government expects a headline budget surplus of 1.2% of GDP in 2011 thanks to strong economic growth and high copper prices coupled with some spending restraint and tax increases. It aims to keep public spending growth below GDP growth in 2012 and reach a structural deficit of 1% of GDP by 2014. Once reconstruction winds down and the external environment improves, the government should eliminate the structural deficit and rebuild buffers in the copper fund, which has proved useful in weathering past shocks.

Demand, output and prices

Chile

Statlink http://dx.doi.org/10.1787/888932542462

Growth will shift towards a more sustainable path

After reaching 6½ per cent in 2011, growth is expected to slow towards 4% in 2012 as the global economy weakens. It is projected to pick up towards 5% through 2013, which would be in line with potential growth, as confidence improves and the global economy normalises. Inflation is projected to remain well within the target range of 3% (+/–1) until the end of the projection period.

A global recession is the main risk

Chile’s economic performance could be stronger than projected here, which would argue for an earlier return to structural fiscal balance and normalisation of monetary policy rates. By contrast, a deterioration of the external economic situation with greater risk aversion, lower global growth and commodity prices may weaken growth more than projected.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• The automatic stabilisers should be allowed to operate, as allowed under Chile’s fiscal rule. The government should introduce temporary fiscal support as needed, using the scope afforded by a strong fiscal position.

• The fiscal rule has served the country well, limiting volatility related to copper price swings. To make the fiscal rule even more effective, and thereby strengthen credibility, the government should establish an independent fiscal council that would monitor fiscal policy and the correct application of the fiscal rule.

• With well-anchored inflationary expectations and inflation slowing, the monetary stance should become supportive.

• Growth will be dependent on structural measures. The government is making progress in lowering red tape by reducing the time and costs to create a company. Such efforts should be accelerated. The conditions for entrepreneurship and innovation should be improved. Stronger competition will also be needed via a reinforced competition law that enforces anti-trust rules and hinders collusive behaviour.

Growth will slow down in 2012 and accelerate again in 2013

Real GDP growth slowed in the second quarter and stagnated in the third quarter. Economic activity has been supported primarily by foreign trade and investment, while consumption, both private and in the public sector, has constituted a drag. Nonetheless, the labour market situation has improved, but the unemployment rate continues to fall only very gradually. Recent monthly indicators point to continued weak growth. Also, confidence among business and consumers has been declining. Economic growth will be subdued next year as exports are likely to weaken and fiscal consolidation will weigh further on domestic demand. With external conditions improving through 2012, the economy will again gather momentum.

The central bank should be ready to act on changing economic prospects

Inflation is close to the central bank’s target of 2% and inflationary pressures remain low. The exchange rate remains strong, helping to restrain price increases. Headline inflation will increase temporarily next year, as a result of a scheduled hike in the preferential VAT rate, but should decline again in 2013, a pattern consistent with market inflation expectations. The main refinancing rate should stay at its historical low until the last quarter of 2012 when the economy picks up more strongly. However, given the increasingly uncertain outlook, the authorities are rightly prepared to move the rate in either direction.

Interest rates, production and exports

Czech Republic

The spread is the ten-year government bond yield minus that for Germany, quarterly to 2011Q3. The PMI is an indicator of manufacturing performance where a value greater than 50 indicates overall improvement. For other indicators annual growth is shown.

European Central Bank; Eurostat; Markit Economics.

Statlink http://dx.doi.org/10.1787/888932540980

Fiscal policy aims to bring down the deficit and to finance structural reforms

Fiscal consolidation continues. The draft budget for 2012 includes a number of revenue measures, in particular the increase in the preferential VAT rate from 10% to 14%, a first step in unification of the rates in 2013. Part of the extra revenues should be used to cover the expected shortfall in pension contributions resulting from the introduction of a voluntary carve-out of the public defined-benefit tier. Furthermore, efficiency savings in public procurement and across ministries are planned. However, some reforms may complicate meeting deficit targets in 2013 and the authorities are considering a possibility of postponing them.

Demand, output and prices

Czech Republic

Statlink http://dx.doi.org/10.1787/888932542481

Significant risks stem from the external side

As the economy has no significant internal imbalances, major risks to the projection come from further unfavourable developments in the external environment and are strongly tilted to the downside.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• With a relatively favourable fiscal position, the authorities should allow automatic stabilisers to work.

• At the same time, to maintain solid market confidence, its commitment to prudent medium-term fiscal targets should be reinforced by strengthening the fiscal framework. This should include an explicit debt target, a stability pact with lower levels of government and an independent fiscal council to monitor fiscal performance.

• The central bank has kept its main interest rate at a historically low level of 0.75%. If downside risks for the economic outlook materialise, monetary policy should be eased further.

• The government should consider temporary subsidisation of short time working schemes, linking them to training measures.

• Long-term sustainability of public finances will be enhanced by current reforms in the healthcare and pension systems. Implementation of the government’s Anti-corruption Strategy, that includes improved public procurement practices and transparency, should lead to efficiency savings and a better business environment. Also, quick implementation of the range of reforms planned in the Competitiveness Strategy would further boost confidence and activity.

• Projects co-financed by the EU’s structural and cohesion funds, such as infrastructure investment, training schemes and credit facilities for SMEs, should be streamlined and frontloaded, as they can have an immediate impact on domestic economic activity.

The muted recovery is expected to come to a halt

The recovery has been subdued, partly due to the reverberations of the collapse of the housing bubble and high leverage of households and firms. Private demand has been weak and growth in 2011 has been led by government investment. In response to worsening global conditions, both consumer and business confidence have declined. Corporate hiring expectations foreshadow no significant decline in unemployment. With low wage growth and falling consumption, inflation has been subdued.

Financial conditions add to the uncertain environment

The housing market remains under pressure, with a large number of homes for sale, long times on the market and prices falling anew. With declining global liquidity, Danish banks face funding challenges despite the expansion of the credit facilities at the Central Bank. This holds back bank lending to households and firms. Monetary conditions are, however, expected to become more supportive in 2012-13.

Fiscal policy will be supportive in 2012

Public consumption growth is set to be kept in check. However, the new fiscal stimulus, in the form of public investment and the pay-out of contributions from the early retirement scheme as part of its reform, will lead to fiscal easing in 2012. The projection assumes that some tightening will take place in 2013 to put the fiscal position on a path consistent with EU targets.

Relative unit labour costs and government balances and debt

Denmark

OECD, Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932540999

Demand, output and prices

Denmark

Statlink http://dx.doi.org/10.1787/888932542500

Both domestic and external demand will be weak

The deterioration in global conditions will lead to further weakening of export growth as the recently observed gains in competitiveness are not expected to be permanent, with the crisis-induced decline in unit labour costs and the rebound in productivity partly reversing. The pay-out of early retirement contributions to households will support consumption in 2012 and public investment will also contribute to growth. With low growth, labour market recovery will be slow, pointing to continued wage moderation. Employment, private demand and GDP growth are projected to pick up only gradually in 2013.

Downside risks dominate

A sharper-than-projected slowdown in Denmark’s partner economies would depress exports. On the domestic side, one risk is that consumption could be weaker as a result of worse-than-expected labour market performance and a further housing market deterioration. In response, highly indebted Danish households, whose net wealth depends mostly on home equity and pension wealth, could step up saving. More expensive loans to the corporate sector by banks facing funding pressures and further deterioriation in global conditions would curtail investment.

Policy orientation should downside risks materialise

If downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• With a new stimulus of 0.5% of GDP already decided and a one-off pay-out of early retirement pension, there will be some fiscal support in 2012. In the event of a significantly sharper downturn, Denmark would have some fiscal space for further temporary support to the economy beyond the functioning of automatic stabilisers. However, this would require a postponement of the tightening needed to meet EU targets in 2013.

• To strengthen confidence, fiscal stimulus needs to be accompanied by a stronger fiscal framework that, in particular, ensures better control of public spending. Multi-annual spending rules for general government and a system of credible sanctions at the local level would help better control public expenditure growth.

• With slack in the economy and lack of inflationary pressures, there is scope for interest rate reductions in line with developments in the euro area.

• To raise employment and enhance fiscal sustainability, sickness and disability benefits should be reformed by increasing incentives to return to ordinary employment for those with some ability to work and lowering subsidies to the disabled employment.

• Measures to restore competitiveness, which has deteriorated significantly over the past decade, are needed. Strengthening the competition framework and improving competition in the services sector would boost productivity growth.

Export and investment-driven growth will slow

The economy expanded by 9% in the first half of 2011 compared with the corresponding period a year before, fuelled primarily by an export-led recovery in manufacturing. Investments and inventories also increased strongly and consumption continued to recover. However, quarterly growth is slowing due to the deterioration in external conditions. The economy should continue to grow throughout the projection period, benefiting from unit labour cost reductions in the crisis and recent investments in export-oriented manufacturing. Real GDP growth is projected to be less than 4% in 2011 but to pick up again as external conditions improve in the second half of 2012.

Employment is increasing but long-term unemployment is high

Growth has been underpinned by strong employment gains, leading to the rapid reduction of the overall unemployment rate, and by increasing participation rates, particularly among the youth. However, long-term unemployment remains very high, pointing to the risk of a permanent increase in structural unemployment. Emerging labour market bottlenecks linked to qualification and regional mis-matches also imply an increasing role for labour market policies, including training and work-apprentiship schemes.

Growth, exports, investment and unemployment

Estonia

Short-term is less than 12 months, long-term is 12 months or more.

OECD, National Accounts database; Statistics Estonia, Labour Force Survey.

Statlink http://dx.doi.org/10.1787/888932541550

Demand, output and prices

Estonia

Statlink http://dx.doi.org/10.1787/888932543051

High inflation is persistent

The low policy rates in the euro area that translate into negative real rates in Estonia provide strong support to the economy. Headline inflation remains high despite a softening of global food and commodity prices, pointing to a low level of competition at the wholesale and retail level. Despite inflationary persistence, externally driven price pressures are likely to subside. Wages continue to fall in real terms, but high nominal wage growth might lead to the emergence of domestic sources of inflation. Electricity price increases will have a temporary impact in inflation in 2013.

Government investment will provide fiscal stimulus

Fiscal policy remains prudent. Total public debt will remain below 7% of GDP in 2011, and government net assets are positive. The underlying fiscal position will remain close to balance during the projection period, notwithstanding a temporary deterioration of the headline fiscal balance in 2012 due to the phasing out of one-off measures and large government investment obligations linked to the previous sales of Kyoto emission permits. The investment will provide a substantial stimulus to the economy as other sources of growth fade. As growth slows the automatic stabilisers should also be allowed to work.

The downward risk to the projections is substantial

The main risk to the projections is linked to to the strength of external demand and, in particular, to the larger-than-expected slowdown among major regional trading partners. There is also a risk that persistently high structural unemployment and the early emergence of labour shortages suffocate growth and increase wage pressures, contributing to high inflation. High dependence on funding from foreign parent banks implies indirect exposure to risks affecting Europe’s core banking sector.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• The longstanding policy of low public debt has earned Estonia strong fiscal credibility and left scope to provide fiscal support in the event of a significantly weaker economy. At the same time, to cement its hard-won credibility Estonia should introduce a fiscal rule coupled with multi-year expenditure ceilings. The fiscal framework could be complemented by assigning a fiscal monitoring role to the Bank of Estonia.

• To increase space for further employment gains, active labour market policies should focus on improving incentives and qualifications among persons with long-term unemployment spells and Estonians currently working abroad.

• Strengthening competition in domestic markets will be important for raising productivity and growth.

• To counter pressure on the Estonian financial system, close cross-border banking supervision cooperation, including in the Nordic-Baltic Cross-Border Stability Group, would be particularly important.

The economy is losing momentum

The recovery in exports stalled in the first half of 2011. Weak exports and uncertainties linked to developments in the world economy, not least in the euro area, will hold back business investment. Consumer confidence has deteriorated sharply, as household purchasing power has eroded due to slowing wage growth and persistent inflation generated by increases in indirect taxes and higher food and commodity prices. Household consumption and residential investment are therefore set to weaken. As uncertainty fades and real income growth resumes, consumption growth should pick up again in 2013.

The labour market will worsen temporarily

Unemployment will rise somewhat in the short term. From mid-2012, the unemployment rate should resume its downward trend as the recovery starts to take hold. Wage growth is likely to be subdued, which, along with a fading impact of tax hikes and food and commodity price increases, will bring inflation back below 2% in 2013.

Output growth, employment and exports

Finland

Export market for goods and services, volume, USD, 2005 prices. Figures are calculated as weighted share of imports from partners to Finland.

OECD, OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932541018

Demand, output and prices

Finland

Statlink http://dx.doi.org/10.1787/888932542519

Monetary and financial conditions are supportive; fiscal policy is tightening

Low ECB interest rates will provide support to the economy. However, access to financing for households and firms might become more difficult if the turmoil in world financial markets intensifies, despite the solidity of the Finnish banking system, which holds large amounts of high-quality capital and very low exposure to risky foreign assets. The 2012 budget implies a mild fiscal contraction in 2012 and 2013. Given the medium-term need for consolidation and the fact that automatic stabilisers are allowed to work outside the expenditure ceiling, this stance looks appropriate.

Risks are mainly on the downside

The Finnish economy has proved relatively resilient to recent global economic and financial shocks. Should the international economic environment brighten, Finland would likely return to steady growth and falling unemployment. Nevertheless, as a very open economy, it is vulnerable to a further fall in world demand. The Finnish financial system is solid enough to withstand additional turbulence in the global financial environment. However, no system is totally immune to risks in extreme conditions.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• With a projected deficit of less than 2% of GDP in 2011 and a debt-to-GDP ratio of around 50%, Finnish public finances are relatively healthy. Automatic stabilisers should therefore be allowed to work if the economy weakens and further support would be warranted in the form of temporary and targeted fiscal stimulus. Nevertheless, as a rapidly ageing population is pushing spending up, medium-term fiscal consolidation would have to be re-established.

• The fiscal framework should be strengthened by adopting a medium-term fiscal target for the general government balance (while allowing automatic stabilisers to work) that is consistent with a debt target, and expanding the expenditure ceiling to cover general government spending. The creation of an independent fiscal authority, which could provide assessments of the budget situation and evaluate the ability of policies to meet fiscal targets, would further improve policy formation.

• Greater labour force participation, which would support long-term growth and fiscal sustainability should be promoted by raising the retirement age, improving incentives to work for older individuals and further tightening early-retirement schemes. Announcing concrete reforms upfront would provide more room for short-term fiscal loosening.

The economy remains mired in a serious recession

Output contracted sharply in 2011 driven by a collapse in domestic demand, falling incomes, worsening labour market conditions, and limited access to credit. However, exports rebounded on the back of strong tourism and gradually improving competitiveness. The unemployment rate has risen rapidly to the highest in the OECD, after Spain. Inflationary pressures have eased as domestic demand weakened further, with headline inflation corrected for tax changes remaining significantly below the euro area average.

Putting debt on a declining path is a key priority

After the considerable progress made in 2010, the consolidation process lost steam in 2011. The government’s deficit target will be missed owing to the deeper than expected recession and slow implementation of some critical structural fiscal reforms. The 2012 draft Budget aims at a revised deficit target of 9% of GDP in 2011 and 5.4% of GDP for 2012 taking into account the October 26, 2011 package agreed at the European level, including the 50% write-down of privately-held public debt. The draft budget, which incorporates commitments agreed with the IMF and the EU, foresees a primary surplus for first time after many years. The OECD projection is for a deficit of 9% of GDP in 2011 and 7% of GDP in 2012, declining to 5¼ per cent of GDP in 2013. This implies that the debt-GDP ratio will continue to rise. However, this projection is based on a weaker growth assumption and excludes debt write-down measures in the October package for lack of specific information on the details. Implementation of the October agreement, continued fiscal adjustment and reforms to make the economy more competitive are therefore needed for more favourable debt dynamics. OECD preliminary estimates suggest that the implementation of the private sector involvement (50% haircut and bank recapitalisation) entailed in the October agreement could reduce the debt-to-GDP ratio by around 35%, allowing the debt to fall close to 120% of GDP by 2020 if the adjustment programme remains on track.

Inflation and fiscal imbalances

Greece

Year-on-year percentage change.

General government deficit and debt (Maastricht definition).

OECD Economic Outlook 90 database and Eurostat.

Statlink http://dx.doi.org/10.1787/888932541037

The economy should gradually exit from recession

The economy is projected to continue contracting in 2012, mostly under the weight of fiscal retrenchment. It would then return to growth in 2013 boosted by a rebound in investment and exports as competitiveness-enhancing structural reforms take hold, external demand strengthens and the absorption of European Union structural funds rises. Inflation is set to fall to zero in the projection period in view of the substantial degree of economic slack and high unemployment. The current account deficit is projected to narrow to around 5½ per cent of GDP in 2013.

Demand, output and prices

Greece

Statlink http://dx.doi.org/10.1787/888932542538

Projections are subject to important downside risks

Any weakening of the authorities’ resolve to fully implement the adjustment programme would increase the risk of debt default. The government’s ability to implement reforms is being tested by heightened social unrest. The banking sector’s limited capacity to support growth poses additional risks to the outlook. Growth could be further undermined by a marked weakening in export markets.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• The sizeable consolidation required to arrest and reverse increases in the high debt-to-GDP ratio leaves no scope for fiscal easing in Greece, or even the operation of the automatic stabilisers. In maintaining fiscal targets under weaker conditions, reducing wasteful spending would be less harmful for growth than further tax increases.

• A better fiscal framework is essential to achieving sustainable public finances and restoring confidence. Budget monitoring needs to be improved and fiscal measures need to be systematically assessed on a medium-term basis. It is also important to ensure that the recently established Parliamentary Budget Office is provided with sufficient independence and resources to conduct its tasks, which focus largely on the evaluation of government budgetary projections and the monitoring of fiscal outcomes.

• Fiscal adjustment hinges on meaningful progress in tax collection efficiency. Tax evasion should be tackled decisively to restore confidence and increase public acceptance of the ongoing fiscal consolidation effort. Effective prosecution of tax evaders and the enforcement of deterrent penalties along with a wider use of tax compliance certificates to access certain services could play a crucial role.

• The swift implementation of the liberalisation of the closed professions would raise growth relatively quickly by opening up new market opportunities and boosting competition. In addition, by reducing rents of well-off interest groups, such a reform facilitates a fair sharing of the growth gains among all groups.

• In the event that the current crisis turns out to be deeper than expected, vulnerable groups should be protected through well targeted interventions and more effective active labour market policies.

• Channelling liquidity to the economy is crucial for the recovery, especially if the worst case downside risks materialise. Beyond the potential support for the recapitalisation of the Greek banks at the EU level through the European Financial Stability Facility (EFSF), the managers and shareholders should explore the option of partnerships or mergers with foreign banks, while the authorities should refrain from imposing protectionist measures.

Growth has been subdued

The recovery in economic activity has been weak, driven by headwinds from the euro area debt crisis, private sector deleveraging and the distributional effects of domestic policies. The labour market is ailing. The new public works programme is partially compensating for insufficient unskilled labour demand in the private sector, but risks locking in workers to relatively unproductive subsidised jobs.

The room for monetary easing is small

Price pressures are likely to intensify temporarily in the wake of recent currency depreciation and increases in indirect taxes and the minimum wage before receding in 2013. But despite a large degree of slack in the economy, tensions in financial markets constrain the monetary authorities’ scope to reduce interest rates. A unilateral decision to allow borrowers to repay foreign currency loans at an off-market exchange rate has further undermined confidence and should be scrapped as it may precipitate a credit crunch. This projection assumes an interest rate cut of only 50 basis points to 5.5% by end-2012 and an unchanged rate in 2013.

Fiscal consolidation should start

The underlying fiscal balance has deteriorated in 2011, driven notably by cuts in personal and corporate income taxes that have been offset by one-off measures, mainly the assumption of pension assets by the public sector. As a result, despite an expected fiscal surplus in 2011, the government balance is projected to return to a deficit in 2012 and 2013. Fiscal consolidation, preferably supported by an agreement with multilateral organisations, is urgently needed to establish credibility with the markets. Without such agreement there is little choice but to meet announced fiscal targets. The fiscal consolidation plan, which aims to achieve a headline deficit target of 2.5% of GDP in 2012, is mainly based on increases in healthcare contributions, various excise taxes and the VAT rate from 25% to 27%. Spending measures have been less well defined, calling into question the actual implementation of the planned adjustment in 2012 and 2013.

Interest rates and confidence indicators

Hungary

Ten-year government bond spreads relative to the German rate.

OECD Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888932541056

The economy is facing a mild recession

The economy is projected to remain in recession in the first half of 2012, due to weak investor confidence, tight financial conditions, an ongoing adjustment of private sector balance sheets and a significant fiscal consolidation. A recovery should start in the latter half of 2012 as the effect of these factors diminishes. The unemployment rate is projected to increase notably with advances in labour force participation spurred by cuts in the generosity of social benefits, and employment losses partly reflecting a programmed large hike in the minimum wage in 2012. A recent elimination of the job-search benefit could reduce labour mobility and increase mismatches in the labour market.

Demand, output and prices

Hungary

Statlink http://dx.doi.org/10.1787/888932542557

Risks are mainly on the downside

Beyond the risk of a sharp global deterioration, growing uncertainty over domestic policies is the main threat to investors’ confidence. Recent steps to impose a new financial burden on banks could lead to a further tightening of credit conditions.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• Reaching an agreement with multilateral organisations is critical to avoid a further loss of investors’ confidence. If no agreement can be reached, the government needs to bolster financial market confidence by meeting its 2012 deficit target of 2.5% of GDP, taking further measures as needed to offset the effects of weaker economic growth.

• To reinforce credibility, the fiscal framework should be strengthened by equipping the new fiscal council with its own analytical staff and enlarging its mandate to assess fiscal policy on an ongoing basis. Targets for structural deficits would also improve the multi-year budgeting framework.

• The stance of monetary policy should be eased as much as possible, but the scope for doing so is quite tightly constrained by currency weakness and higher risk premium, while adopted and planned substantial increases in the minimum wage and indirect taxes should further push up headline inflation. A credible fiscal retrenchment would create conditions for monetary policy accommodation.

• The average tax wedge has been cut significantly. Yet, the tax wedge has increased for low-income earners and incentives to work will be further undermined if the employment tax credit is removed as planned. Labour demand should be strengthened through marginal employment subsidies targeted to disadvantaged groups, which will be hardest hit by a more severe downturn.

• Facilitating the deleveraging of households is key to restore growth, but this should not be done by undermining the stability of the banking sector. A viable restructuring programme will be needed that focuses on low-income borrowers facing real repayment difficulties.

Economic recovery has begun

Following severe adjustment to the financial crisis, the Icelandic economy began to grow again in 2011 despite the weakening of the global economy. The recovery has been led by strengthening private consumption and investment expenditure. Residential construction has soared as work on incomplete housing projects has been resumed. The unemployment rate has fallen from the peak late last year, but remained high at 6.6% (seasonally adjusted) in the third quarter. Large collective wage increases and rising commodity prices have pushed up inflation, although it remains well below the increase in disposable income.

Fiscal consolidation is set to continue

The general government budget deficit is estimated to have fallen to 5½ per cent of GDP in 2011. Further budget consolidation amounting to around 1½ to 2 percentage points of GDP per year is planned in 2012-13, yielding rising primary surpluses from 2012 onwards. On the basis of these plans, general government gross debt (including civil service pension liabilities of 20% of GDP) should peak at 128% of GDP in 2012, and net debt at 51% of GDP. The authorities aim to reduce gross debt to 60% of GDP in the long term, including through asset sales.

Labour market and publc and private sector wage rates

Iceland

Year-on-year percentage change.

Deflated by the consumer price index, year-on-year percentage change.

OECD Economic Outlook 90 database; Statistics Iceland.

Statlink http://dx.doi.org/10.1787/888932541075

Financial stress is receding and monetary accommodation is gradually being withdrawn

Considerable progress is now being made in restructuring non-performing loans to households and small businesses, improving their financial situation and increasing banks’ capacity to lend to viable clients. The main banks appear to be well capitalised. The government completed a US dollar bond issue over the summer at 320 basis points over inter-bank rates, demonstrating its ability to borrow in international capital markets and thereby fulfilling one of the conditions for lifting capital controls. The government is also advancing on other elements of the strategy to lift capital controls, although this is unlikely to occur by 2013. To contain inflation, policy interest rates were increased by 0.25 percentage point in both August and November to 4.5% currently. Further withdrawal of monetary accommodation is in prospect.

Demand, output and prices

Iceland

Statlink http://dx.doi.org/10.1787/888932542576

The economic recovery should level off in the projection period

Growth is projected to strengthen over coming months, led by buoyant private consumption and investment expenditures but to weaken somewhat thereafter, initially owing to deterioration in net exports and subsequently to lower growth in investment expenditures as large projects are completed. Economic growth should settle at around 2½ per cent over 2012-13, cutting unemployment to 5% by the end of 2013. Inflation is projected to fall towards the authorities’ target (2½ per cent) as the temporary factors that recently boosted it pass and economic slack continues to weigh on price setters.

Risks to the outlook are mostly on the downside

The main risks to the economic outlook are that the global economy could deteriorate by more than assumed and that private-sector balance sheet deleveraging could be more aggressive than expected. In addition, inflation may prove more persistent than projected, necessitating further monetary policy tightening.

Policy orientation should downside risks materialise

If such downside risks materialised the OECD has identified as part of its Strategic Response key macroeconomic policies as well as structural reforms, which while desirable in any case, would become essential to raise growth.

• Automatic stabilisers should be allowed to function. However, the government cannot afford to further weaken its medium-term fiscal consolidation plans. Thanks to lower-than-expected direct costs of the financial crisis, these plans have already been scaled back as much as possible to boost the recovery. Maintaining fiscal consolidation plans will help to rebuild fiscal policy credibility, which will support medium-term economic growth by reducing borrowing costs for both the government and the private sector.

• The government should adopt a rule that ties down a budget-balance path that is compatible with its debt reduction objectives. Such a rule would complement the expenditure targets and top-down budgeting already implemented and thus increase fiscal credibility. To strengthen enforcement of the rule, the government should create an independent fiscal council to report to parliament on whether or not fiscal policy is consistent with short and medium-term objectives.

• Barriers to FDI, which are amongst the highest in the OECD, should be reduced to stimulate growth. To this end, FDI law should be revised to clarify the authorities’ scope for action, reducing uncertainty, and to introduce a silence-is-consent (after 60-80 days) rule.

• Barriers to product-market competition should be lowered by reducing red tape, using plain language in regulations, and reducing entry barriers in the electricity, telecommunications and transport sectors. These reforms would support economic growth by increasing purchasing power and making it easier to develop new businesses.

The recovery is slowing from its initially rapid pace

Moderating growth is projected in 2012 as export demand weakens and the decline in domestic spending resumes as temporary factors reverse. Deteriorating external conditions and tighter financial conditions will also hem in consumer demand and business investment. As a consequence, unemployment will remain high and core inflation low. Export-led growth will help to underpin a further increase in the current account surplus. A lessening drag from domestic demand and better world trading conditions will see a pick-up in growth in 2013.

The banking system has been recapitalised

The process of healing in the banking sector is underway. Encouragingly, private equity was raised by one financial institution and the banks have begun to sell-off foreign assets, which will help them to repay their large debt to the Eurosystem. The stabilisation of the banking system, the decision to reduce interest rates on EU official finance to Ireland, and resolute implementation of the fiscal consolidation programme have all improved financial-market confidence. However, regaining access to the sovereign bond market still remains a challenge, especially in the current international environment.

Export growth, loans and current account balance

Ireland

In volume, year-on-year percentage change.

4-quarter moving average.

OECD Economic Outlook 90 database; Central Statistics Office Ireland and Central Bank of Ireland.

Statlink http://dx.doi.org/10.1787/888932541094

Demand, output and prices

Ireland

Statlink http://dx.doi.org/10.1787/888932542595

The fiscal consolidation is on track

Fiscal revenue and expenditure have remained in line with the 2011 budget targets and limits, respectively, and the government deficit is expected to fall to 10.3% of GDP in 2011. For 2012 and 2013 it is assumed the government fully implements the consolidation measures announced in the recently published Medium-Term Fiscal Statement. Interest payment reductions of around 0.5% of GDP in 2012 and 0.7% of GDP in 2013 due to interest rate cuts on finance provided by the EU are assumed to be used to narrow the fiscal deficit. This will help the government to reduce the deficit to 8.7% of GDP in 2012, despite only moderate nominal GDP growth, and to 7.6% of GDP in 2013.

Vulnerability to foreign shocks remains high

Ireland has steadfastly tackled difficult challenges and Ireland’s export-led growth is supported by a wide range of structural strengths that may help to propel a stronger recovery than expected. However, risks to this projection are skewed to the downside. Rebalancing of the economy is underway but deleveraging continues and Ireland remains highly reliant on, and vulnerable to changes in, foreign demand. Debt reduction may exert a stronger drag on domestic demand than incorporated in this projection, especially if employment growth does not resume as anticipated. In addition, the banks must carry out a fine balancing act of selling assets and reducing in size while still maintaining new lending to support the recovery in a very difficult international financial environment.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified as part of its Strategic Response key macroeconomic policies as well as structural reforms, which while desirable in any case, would become essential to raise growth.

• The government should continue to adhere to the EU-IMF fiscal programme fiscal targets, adopting additional measures if necessary to offset the effects of unanticipated economic weakness. It will become increasingly important to share the burden of any such additional measures fairly across society.

• The government recently established an independent Fiscal Advisory Council and it should implement the planned fiscal framework as soon as feasible. The framework should focus on multi-year budgets and on a debt-to-GDP target to be achieved by a specified date. A ceiling for nominal expenditure broadly defined should be used to help achieve the debt target.

• Structural reforms should be accelerated to enhance economic growth. In the product market, competition should be increased, including in the legal professions and health care provision. In addition, electricity costs should be lowered by opening the market further to competition, as the state-owned electricity company still dominates most market segments.

• To reduce the heightened risk that long-term unemployment becomes persistent, Ireland should implement better activation policies and welfare reforms to improve the matching of supply and demand of labour and increase work incentives.

Monetary policy has shifted to an easing stance

Growth is now slowing following a period of robust expansion, which had significantly narrowed the output gap and resulted in historically low rates of unemployment. Exports shrank sharply in the third quarter of 2011, inflation is easing, and the housing market has cooled off somewhat. Also, bond-market indicators show a fall in inflation expectations towards the centre of the target band (1 to 3% increase in consumer prices) for the year ahead. The policy interest rate was reduced to 3% in October. This has contributed to significant depreciation of the shekel against the dollar; the Bank of Israel has not made any foreign-currency interventions since July.

Measures in response to the social protests are being developed

The committee appointed in response to social protests has, recommended, inter alia, higher direct taxes (notably, cancellation of scheduled cuts in corporate tax and top rates of income tax) to fund reductions in indirect taxation. Significant expansion in early childhood education, offset by lower defence outlays, was also recommended. The authorities appear appropriately committed to ensuring that, overall, the response is revenue neutral and does not break the budgetary spending ceiling.

GDP growth and inflation

Israel

Year-on-year change.

Based on comparison of yields on CPI-indexed and non-indexed government bonds.

Bank of Israel; CBS; OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932541113

Growth will slow markedly in 2012

Output growth is expected to drop from 4¾ per cent in 2011 to around 3% in 2012, conditional on further monetary loosening. The projection assumes two further cuts in the policy rate, which should help to bring about some renewed pick-up in activity next spring. During 2013 a resumption of interest-rate normalisation would be appropriate, as real output growth is projected to expand by nearly 4% for the year as a whole. A modest rise in the unemployment rate is projected for the coming quarters, and consumer-price inflation may fall back to the middle of the target band. The budget deficit is projected to be close to target in 2011 (with a reduction of 1.0 percentage point of GDP) but may well overshoot in 2012 (with only a 0.2 percentage-point reduction).

Demand, output and prices

Israel

Statlink http://dx.doi.org/10.1787/888932542614

Heightened geopolitical tensions pose additional risks to the economy

The main risk is for further weakening of external demand due to a sharp global deterioration. Geopolitical tensions remain high and disruptions to natural gas supplies from Egypt continue. There is also a risk that the recent cooling of the housing market could develop into a substantial downturn.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• The automatic stabilisers should be allowed to operate on the revenue side, while government spending should increase according to the spending rule. The government should provide some temporary discretionary fiscal support, but this should not be allowed to derail medium-term fiscal policy.

• The fiscal framework is basically sound. The authorities have a good track record in achieving their fiscal targets. However, reaching them may require interim budgets if spending set under the current two-year budget cycle becomes incompatible with economic developments.

• There is ample room for further cuts in the monetary policy rate. However, additional loosening may have to be combined with targeted macro-prudential measures to ensure a soft landing in the housing market.

• Red tape facing business remains significant, particularly the time and effort required to complete procedures in setting up a business and with regard to the construction of premises. Additional efforts to streamline the procedures would boost business confidence and performance at no fiscal expense.

• Proposed measures to strengthen market competition in light of the tent protests should be implemented quickly, particularly in supply chains for energy and other retail products. This would help bolster consumer confidence and may have measurable near-term effects on prices.

Output growth is slowing as exports level off

The economy experienced slowing output growth and rising inflation during 2011. The deceleration of exports has been accompanied by weaker domestic demand, including fixed investment. In addition, private consumption has been subdued as wage gains have failed to keep up with inflation, which exceeded the central bank’s target range during the first three quarters of 2011. Meanwhile, core inflation has risen to nearly 4%, boosting expected inflation. The unemployment rate has fallen to 3¼ per cent, despite rising labour force participation.

Monetary conditions remain supportive of growth

The normalisation of the policy interest rate, which had remained at a record low of 2% until mid-2010, has paused since June 2011. At 3¼ per cent, the rate remains negative in real terms. Monetary conditions have been further eased by a moderate depreciation of the won, which has declined by 3% since May 2011 in effective terms. Although Korea has a current account surplus, estimated at almost 2% of GDP in 2011, the won remains relatively volatile, particularly during periods of global financial turbulence. Once the economy has overcome the current soft patch and high uncertainty, further policy interest rate hikes will be needed to contain inflation.

Production, exports and inflation

Korea

Seasonally-adjusted for production and a three-month moving average for non-seasonally-adjusted exports.

Korea National Statistical Office, OECD Economic Outlook 90 database and Bank of Korea.

Statlink http://dx.doi.org/10.1787/888932541132

Demand, output and prices

Korea

Statlink http://dx.doi.org/10.1787/888932542633

Fiscal policy is focused on limiting public debt

Korea continues to limit government spending growth in line with the National Fiscal Management Plan’s objective of balancing the consolidated central government budget (excluding the social security surplus) by 2013. The fiscal stance is appropriate given that Korea faces strong pressure to boost public social spending from its current low level, not least to cope with rapid population ageing. In addition, there is considerable uncertainty about the eventual cost of greater economic integration with North Korea.

A gradual pick-up in growth is projected during 2012-13…

After a few quarters of sub-par output growth, the economy is projected to pick up as world trade rebounds in 2012. Korean exports will be sustained by strong demand from China, its largest trading partner, and by the relatively low level of the won. Stronger exports should prompt a recovery in fixed investment and a pick-up in private consumption, boosting output growth to more than 4% in 2013.

… depending in part on developments in the world economy

The economy faces both domestic and external risks. Household debt has continued to increase, reaching 132% of household income in 2010. Rising interest rates could thus have a larger than expected damping effect on private consumption. On the external side, with exports accounting for more than half of GDP, Korea is particularly vulnerable to a sharp deterioration in the world economy.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• Given its strong fiscal position, with gross government debt around 35% of GDP, fiscal stimulus would be warranted.

• Making spending targets more binding, while maintaining flexibility to cope with shocks, would further strengthen confidence in public finances and thereby allow continued flexibility to deal with shocks.

• There is scope to cut the policy interest rate if output growth were to falter.

• Enhancing labour productivity would spur growth, particularly in network industries and services, where productivity is only around 60% of that in the manufacturing sector. Regulatory reform, including reducing entry barriers, is essential to enhance productivity.

• Another priority to boost productivity growth is to deepen Korea’s integration in the world economy by increasing inward foreign direct investment, which is currently the second lowest in the OECD area as a share of GDP. Encouraging greater inflows requires reducing explicit barriers, which are among the highest in the OECD area, and improving the business climate.

The banking and sovereign debt crisis are depressing activity

Deteriorating financial conditions and uncertainty about the sovereign debt and banking crisis in the euro area are depressing activity. Exports of financial services are projected to decline sharply, driven by a fall in the value of equities worldwide. Investment will slow, reflecting deteriorating business confidence and more difficult financing conditions and consumption will be restrained by low real wage growth.

Growth is projected to pick up again in mid-2012

Export growth will resume as external demand recovers during the course of 2012. Private consumption and investment should gain momentum from improved confidence. Monetary easing will contribute to more favourable financing conditions and stimulate domestic demand. Fiscal consolidation should modestly damp demand.

Unemployment will rise modestly

The unemployment rate, which had barely declined in the recovery from the 2008-09 crisis, will rise somewhat as growth slows, and unemployment among residents is expected to remain high due to rigidities in the labour market.

Growth contributions and inflows to mutual funds

Luxembourg

Year-on-year percentage change.

Three-month moving average. Inflows are defined as net of markets’ variations.

OECD, OECD Economic Outlook 90 database and Commission de Surveillance du Secteur Financier.

Statlink http://dx.doi.org/10.1787/888932541151

Demand, output and prices

Luxembourg

Statlink http://dx.doi.org/10.1787/888932542652

Underlying price pressures are weak

Annual headline inflation peaked at fairly high levels in the first part of 2011, but with fuel and commodity prices easing and the economy slowing, it is expected to decline. Inflation will only pick up from mid-2012 as the recovery takes hold.

Fiscal consolidation should go on as planned

The fiscal consolidation measures set out in the Stability Programme should be followed, but automatic stabilisers should be allowed to function. More detailed and credible plans for medium-term fiscal consolidation should be set out soon to enhance the credibility of current plans. Far-reaching and comprehensive pension reforms need to be implemented to achieve long-run sustainability.

Risks are mainly on the downside

The main risk to the outlook is a worsening of the sovereign debt crisis in the euro area, which could have a lasting impact on the large financial sector. On the other hand, in the past years the economy has proved to be resilient to recent global financial and economic shocks.

Policy orientation should downside risks materialise

If downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• The fiscal consolidation measures set out in the Stability Programme should be followed, but the automatic stabilisers should be allowed to function.

• The budgetary framework should be strengthened in line with new EU requirements and to ensure that there is an effective system for managing long-term fiscal sustainability and ensuring value for money in the provision of public services.

• Continue to participate in European initiatives to ensure that the banking system is well-capitalised and adequately funded.

• Reforms to strengthen incentives to work are needed to ensure that higher unemployment does not add to structural unemployment. This would require reducing unemployment benefits, stronger activation requirements and tightening unemployment insurance eligibility for young people without work histories.

• Increase competition in the domestically focused services sector to boost activity and employment. Easing of restrictive product market regulations in the domestically-oriented sectors, especially for professional services, would help to achieve this.

Exports and activity are slowing

After a strong recovery of output and domestic demand, manufacturing export growth is now losing momentum and confidence indicators point to a slowdown, mainly related to weaker growth in the United States. However, with low public debt, large foreign reserves and a Flexible Credit Line agreement with the IMF, Mexico has sound macroeconomic fundamentals and should be able to avert a sharp downturn. Formal employment has recovered strongly, although not enough to significantly bring down unemployment. With world trade and industrial activity in the United States projected to recover after mid-2012, Mexican exports and activity should regain strength towards 2013.

Inflation has declined

Core inflation has declined continuously for more than a year and both headline and core inflation are now well within the central bank’s inflation target range (3% +/–1 percentage point variability interval), as are long-run inflationary expectations. With still considerable free capacity and moderate real wage increases, the impact of the recent peso depreciation on inflation is expected to be moderate and transitory.

Inflation and labour markets

Mexico

For a horizon of one to four years.

Workers affiliated with Instituto Mexicano del Seguro Social.

OECD Economic Outlook 90 database; Bank of Mexico; INEGI.

Statlink http://dx.doi.org/10.1787/888932541170

Demand, output and prices

Mexico

Statlink http://dx.doi.org/10.1787/888932542671

Monetary policy is supportive

The central bank has left the policy rate at 4.5% since July 2009, well below its neutral level. It can keep interest rates low for some time, as inflation expectations are firmly anchored.

The government has delayed fiscal tightening, but revenues need to increase in the long run

Mexico has maintained a sound fiscal position, thanks to an early move towards consolidation in 2010 and a stabilisation of oil revenues for now. Given considerable uncertainties regarding the health of the world economy the government has decided to delay the return to a balanced budget by one year. The public sector net borrowing requirement is expected now to fall from 4% of GDP in 2009 to 2% in 2013. This translates into a balanced budget, based on the government’s definition of the deficit that excludes the national oil company’s investment, but includes a number of pure financing operations. However, in the long run Mexico will need further tax reform to reduce dependence on oil-related revenues and a further cut in energy subsidies to meet important spending needs for education and social policies. The government should also work to accumulate larger buffers in its oil stabilisation funds. The establishment of an independent fiscal council would enhance the credibility of Mexico’s fiscal framework, as would the publication of the budget and debt data in line with internationally accepted standards.

Risks are mainly on the downside

Mexico’s economic outlook would be stronger than projected should the world economy recovery earlier or oil prices be stronger than expected. However, with significant uncertainties regarding the European debt crisis and the prospects for the US economy, risks are mainly on the downside.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms, which, while desirable in any case, would become essential to raise growth.

• With inflation expectations well anchored and still substantial unused capacity, there is room for cutting policy interest rates if the economy were to weaken more than projected.

• Fiscal tightening could be delayed a bit further in the event the economy proves significantly weaker than now projected.

• The parliament should urgently adopt the proposed labour reform that would reduce the cost of labour court procedures, making hiring on long-term contracts more attractive. This would help avoid a decline in job quality in a future downturn associated with significant worker turnover.

• Stronger product-market competition will also be needed. Building on its recent competition reform and its measures to enhance infrastructure competition in the telecommunication sector, the government should further reduce barriers to entry in network industries, including for foreign firms.

The economy has slowed over 2011

The economy contracted in the second half of 2011 as a result of decelerating world trade, fiscal consolidation and subdued household income growth. Financial turmoil affected confidence and a combination of falling equity prices and low interest rates dragged pension funds’ average coverage ratio below official requirements. Unless coverage ratios recover, this points to lower future pensions. Headline inflation has risen, as in the rest of Europe, on the back of higher energy prices. Core inflation has also picked up, but wage growth remained stable. Harmonised unemployment, which had been declining since mid-2010, started rising again over the summer, although at 4½ per cent it remains among the lowest in Europe.

Significant fiscal consolidation is underway

Slower economic activity and lower-than-expected tax revenues in the first half of 2011 have induced the government to revise up its deficit estimates without modifying the underlying speed of consolidation. The budget consolidation for 2012 amounts to 1% of GDP, mainly through social spending cuts and higher health care premiums. In 2013, the government foresees a further reduction in the budget deficit of ½ per cent of GDP as part of its medium-term fiscal plan.

Confidence indicators, prices and wages

Netherlands

Year-on-year percentage change.

OECD, Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888932541189

Demand, output and prices

Netherlands

Statlink http://dx.doi.org/10.1787/888932542690

Recovery will be gradual in 2012

In the short term, the economy will go through a period of near zero growth. From mid-2012, accelerating world trade and supportive monetary conditions are projected to increase growth gradually. The rise in unemployment is expected to be limited, reflecting some labour hoarding by companies, and to be more than reversed by the end of the projection period. Wage growth is projected to rise, but only slightly, in 2013. Headline inflation is set to slow as the effects of past oil price increases fade.

Domestic risks are balanced

The ongoing financial turmoil induces important downside risks to this projection. Domestically, construction could prove weaker than projected in case of a stronger payback of last winter’s mild weather induced boom or if credit supply tightens more than assumed. On the upside, the drop in long-term government bond rates may help cushion the slowdown if it is passed through to the rest of the economy.

Policy orientation should downside risks materialise

If downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• In case of a more pronounced slowdown than projected, the automatic stabilisers should continue supporting the economy and the planned fiscal adjustment could be delayed, provided that structural reforms are adopted to contain expenditures in the long-term and boost potential growth.

• Consumer confidence is likely to have been negatively affected by the effects of the ongoing financial turmoil on pension funds’ solvency. To reduce the pro-cyclical effects of market volatility, a more stable long-term interest rate could be used as the discount factor when assessing funds’ solvency.

• Further lowering effective marginal tax rates for low-income workers and second earners and further reforming disability benefits, and increasing job-search incentives for high-skilled unemployed would all stimulate labour supply and raise potential output.

The outlook is comparatively robust

Real GDP growth is projected to increase to 2-3% over the coming two years. Reconstruction from the February 2011 Christchurch earthquake, delayed thus far by aftershocks, should soon gain momentum and continue for a number of years. Incomes will benefit from still high prices for export commodities, in particular dairy products, despite some recent weakening. The recovery in household spending will be restrained by deleveraging, however, especially in light of falling wealth due mainly to house-price weakness. This will be only partly offset by rising employment and low mortgage rates. Business investment will be held back by continuing economic uncertainty and, perhaps, weakened credit supply. In the near term, net exports will be impaired by ongoing impacts of labour cost competitiveness losses.

The withdrawal of monetary stimulus has been deferred

The Reserve Bank has maintained an accommodative stance, holding its intervention rate at 2.5%, as insurance against renewed global risks. Nevertheless, monetary conditions have tightened through rising risk margins, intensified bank competition for domestic deposits and, until lately, exchange-rate appreciation. With core inflation and inflation expectations still above the mid-point of the Reserve Bank’s 1-3% inflation target band, the room for interest rate cuts may be limited. Capacity constraints in the form of skilled labour shortages and wage pressures are already apparent, most notably in the construction sector, and could intensify as rebuilding takes off in 2012. The Official Cash Rate should start to be raised in the first half of 2012.

Sectoral credit growth, commodity prices and exchange rate index

New Zealand

This NZD price index, published by ANZ, summarises the price trends for New Zealand’s 17 main commodity exports.

Reserve Bank of New Zealand and OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932541208

Fiscal consolidation has suffered delays

Some fiscal slippage has resulted from higher earthquake-related spending than expected in the May 2011 budget. Furthermore, costs incurred by the Earthquake Commission have risen sharply, although some offset will be made by a tripling of earthquake insurance premiums paid by households to the government insurance scheme. The government has reaffirmed its commitment to medium-term fiscal consolidation to contain public debt growth in view of a recent ratings downgrade and nervous financial markets. It plans to achieve fiscal balance by 2014/15 mainly by means of spending cuts.

Demand, output and prices

New Zealand

Statlink http://dx.doi.org/10.1787/888932542709

Risks are unusually high

Besides evident global risks, in particular a spread of contagion to major trading partners in Asia, there are important domestic risks. Further fiscal slippage and renewed widening of the current account deficit could provoke sharply increased international funding costs, jeopardising growth prospects and increasing debt service burdens.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• The monetary policy stance is now appropriately accommodative, but should activity slow significantly there would be room for interest-rate cuts.

• Whereas net public debt is low, fiscal space is limited by global financial-market turbulence, given the dependence on external borrowing by banks and, increasingly, the government. Whereas automatic stabilisers should be allowed to work in the event of a sharp downturn, the underlying consolidation programme should continue.

• Strengthening the fiscal framework would, by enhancing fiscal credibility, provide more fiscal room for manoeuvre. A spending rule would underpin the current de facto net debt rule and an independent fiscal authority should be established to enhance adherence to fiscal rules.

• To further ease fiscal constraints, social spending must meet public needs more efficiently, particularly in health and education. This requires stronger accountability incentives for service providers. Access and service quality for minorities should be improved, thereby contributing to their skill enhancement and labour force participation.

• The recession has highlighted the need for structural reforms to unleash productivity growth and address macroeconomic imbalances. Reforms to pensions and taxes would support the medium-term path for fiscal consolidation and boost incentives to work, save and invest. As to product market reforms, public ownership stakes in network industries should be divested. Regulations should be subject to clear net benefit tests and regulators made more independent and accountable. Barriers to FDI should also be relaxed.

The mainland economy has lost some momentum

A weakening of confidence is holding back private consumption and investment. Faltering growth in Europe is beginning to impact exports. But the slowdown has been less pronounced than in other OECD countries, primarily owing to the strength of the petroleum industry and the fiscal stimulus provided by using the returns to the Government Pension Fund Global (GPFG).

Monetary policy will need to stay loose in the coming quarters

Inflation is below the 2.5% target, and inflation expectations are well-anchored. Interest rates abroad are likely to remain very low in the near to medium term, limiting the scope for Norges Bank to raise rates without causing an appreciation of the already strong krone. Given weaker prospects for the world economy, Norges Bank has appropriately maintained a supportive monetary stance. In the current environment, Norges Bank should keep its policy rate stable through the end of 2012 and resume the tightening cycle in early 2013. Signs of imbalances in asset markets, particularly very high house prices and household debt, should be addressed by tightening mortgage lending regulation and unwinding the extraordinary tax advantages favouring housing investment.

Purchasing manager's index, exchange rate and inflaation expectations

Norway

Data refer to the manufacturing PMI (Purchasing Managers’ Index).

Exchange rate is the import-weighted exchange rate (I-44) which is produced by Norges Bank and measures the value of the krone against the currencies of Norway’s most important trading partners. A positive slope means the krone is appreciating.

Inflation expectations are the average year-on-year expectations of consumer price inflation two years ahead by economists and employer/employee organisations.

Bloomberg; Swedbank; Markit and Norges Bank.

Statlink http://dx.doi.org/10.1787/888932541227

The structural non-oil deficit will widen

The projection assumes that the government will fully implement the fiscal plans that are set out in the National Budget published in October 2011. This means taxes will stay at the same level over the next two years and the structural non-oil budget deficit will grow in line with the fiscal guidelines which require that over time it be 4% of the assets in the GPFG.

Demand, output and prices

Norway

Statlink http://dx.doi.org/10.1787/888932542728

Confidence and growth are projected to return to high levels by 2013

The soft patch in the economy is projected to dissipate around mid-2012, when confidence is assumed to strengthen both abroad and at home. Strong increases in private consumption and investment, notably in the construction industry, will drive GDP growth through 2013. Rising domestic demand will spur employment growth, although continued high net immigration will keep wage growth at modest levels. The planned one percentage point hike in the value-added tax on food will cause headline inflation to rise temporarily above core inflation.

Main risks are on the external side

The terms of trade will be sensitive to swings in market sentiment towards the euro area and other major trading partners. A severe worldwide downturn would likely depress external demand and oil prices which would have significant knock-on effects on Norway’s economy and government revenues.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• The government should continue to follow its fiscal guidelines. Should the economy turn out to be substantially weaker than projected, this means providing discretionary fiscal support, in addition to letting the automatic stabilisers work. Contrary to the fiscal expansion of 2009, any such additional discretionary action should not increase public employment, which cannot be easily reversed and is therefore not appropriate as a temporary measure.

• In the event of a worsening global and domestic economy, especially if it triggered interest rate cuts abroad, Norges Bank, the central bank of Norway, should reduce the policy rate and maintain it at a very low level for an extended period. If necessary, measures to boost liquidity in the banking sector should be considered.

• Competition could be increased in many sectors, in particular by strengthening the Competition Authority and reducing public ownership.

• To stimulate labour supply, the rules for the early retirement scheme (AFP) in the public sector should be aligned with those in the private sector. Stricter monitoring of the assessment decisions of doctors would improve the targeting of sickness and disability benefits with no adverse effects on the insurance aspect of the programmes.

The economy is shifting down a gear

Real GDP growth is projected to fall from about 4% in 2010 and 2011 to around 2.5% in 2012 and 2013 due to fiscal consolidation and sluggish external demand, which will in turn weaken private consumption and public and private investment. Weakness in domestic demand is projected to be partly offset by stronger net exports triggered by significant zloty depreciation in 2011 and the 2012 football championships. Unemployment is projected to rise as a result of the slowdown, the increase in the participation rate and the impact of the planned 8% increase in the minimum wage.

Fiscal consolidation is on track for 2011...

The government is on track to meet its budget deficit target in 2011, owing to consolidation measures (a rise in the value added tax, the diversion of social contributions from the second pension pillar to the budget and central government spending norms) and buoyant tax revenues. It is assumed that the government will make continued efforts to keep public spending under control, and that a rise in environmental and property taxes and reductions in tax expenditures will bring the budget deficit to the targeted 2.9% and 2% of GDP in 2012 and 2013, in line with Poland’s EU commitments. This will put gross general government debt-to-GDP ratio on a declining path thereafter.

Public debt and labour market

Poland

GUS; OECD, OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932541246

Demand, output and prices

Poland

Statlink http://dx.doi.org/10.1787/888932542747

... but additional measures are necessary to achieve the 2012-13 targets

Nevertheless, the consolidation measures announced thus far are not sufficient to achieve these targets, especially given the government’s optimistic underlying growth projections. Additional measures must be announced quickly and clearly communicated to strengthen credibility. At the same time, the gap between the Maastricht and national public debt definitions keeps on widening, as public infrastructure spending is being increasingly shifted outside the national definition with a view to keeping it below the intermediate debt threshold of 55% of GDP, which would trigger automatic consolidation measures.

The monetary policy stance is appropriate

Given slow growth and the significant fiscal consolidation, the monetary policy stance is appropriate over the projection horizon. Headline inflation should fall back towards the middle of the central bank’s target band. Real wage growth will be moderate, in line with productivity gains, given rising unemployment.

The banking system is unshaken, despite foreign-currency loans

Polish banks are not suffering from their large stock of foreign-currency (mainly Swiss franc) loans because of sound prudential regulation and because the impact of the Swiss franc’s strength is largely offset by declines in interest rates on such loans.

Risks are mostly on the downside

Budgetary slippage is a concern for 2012. Considering Poland’s limited fiscal space, lower-than-expected economic growth could turn fiscal policy even more pro-cyclical if public debt (on a national definition) goes beyond the threshold of 55%. However, the central bank is in a position to cut its policy rate in such a case. Yet, the risks of rising unemployment and a large currency depreciation triggered by capital outflows might have serious effects on the banking sector.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• A significant deterioration in economic conditions could be met by interest-rate cuts, provided that the zloty does not deteriorate substantially.

• Poland’s fiscal space to respond to a major economic downturn is limited given the debt rule, though automatic stabilisers should be allowed to work.

• The fiscal framework should be strengthened by: introducing a medium-term deficit rule; putting in place detailed multi year budgeting; creating an independent fiscal council to strengthen the transparency and communication of fiscal policy; and harmonising the domestic and Maastricht definitions of debt.

• The tax wedge, lowered considerably in 2007 and 2009, is still slightly above the OECD average, and a further decrease could help stimulate labour demand during an economic slowdown and contain any rise in unemployment and weakening in private consumption. A cut in the tax wedge could be financed by reducing government spending and/or increasing environmental and property taxes, which are particularly low in international comparison.

• Boosting privatisation by focusing on the sales of controlling stakes in state-owned companies would lower public debt and could bolster potential output by raising productivity. Reducing state interference in privatised companies and further easing barriers to entrepreneurship by cutting red tape would have similar beneficial effects.

Domestic demand is contracting strongly

Driven by a contraction of domestic demand of unprecedented magnitude, GDP has been falling in 2011, despite robust export growth. Output losses are estimated to intensify in the final quarter of the year with deteriorating global conditions weakening exports, bank deleveraging continuing and additional tax hikes hitting disposable income. Unemployment has remained high, while increases in VAT and in oil prices have fuelled inflation.

Fiscal consolidation is underway but remains challenging

Important fiscal slippages have gradually become apparent in 2011, with a deficit in the first half of 8.3% of GDP, requiring further measures to get back on track towards the 5.9% target for the whole year. Furthermore, long-standing fragilities in the fiscal framework were again exposed by a recent revision of the 2010 deficit to 9.8% of GDP (from 9.2%), mainly due to previously unrecorded expenditure by the Madeira regional administration (incurred over several years) and, to a smaller extent, to health care spending. To meet the EU/IMF financial assistance programme budget targets, the authorities announced in the summer and in the draft 2012 Budget additional measures for 2011 and 2012, respectively. The former, mostly of a temporary nature, include a personal income tax surcharge (mainly falling on the extra month of salary or pension paid at Christmas), the transfer of banking sector pension funds to the state and bringing forward higher VAT on electricity and gas. Most of the additional savings in 2012 are expected to come from suppressing the two extra monthly payments for civil servants and pensioners (with no or smaller cuts for those earning less than 1000 euros per month), as well as from a broader scope of the VAT standard rate. The projections incorporate these announcements. To sustain the consolidation effort over the medium term, structural reforms in public administration must be carried out to increase its efficiency and the ability to attract high-skilled staff.

Loans and competitiveness

Portugal

Annual growth rates; loans to private individuals have been adjusted for securitisation operations.

Unit labour costs for total economy. Export performance is the ratio between export volumes and export markets for total goods and services.

Banco de Portugal and OECD Economic Outlook 90 database.

Statlink http://dx.doi.org/10.1787/888932541265

The economy is set to contract further

GDP is likely to continue to fall in 2012, and gradually recover thereafter, mainly supported by exports. As internal imbalances unwind, private domestic demand is expected to return to positive, albeit modest, growth towards the end of the projection horizon. Net of tax-induced effects, inflation will remain subdued, while unemployment is set to rise further. The narrowing of the current account deficit should gather pace.

Demand, output and prices

Portugal

Statlink http://dx.doi.org/10.1787/888932542766

Downside risks prevail

The risks surrounding the forecast are mainly on the downside. A sharp deterioration in global conditions or stronger-than-projected demand effects of the required fiscal retrenchment would lead to a more pronounced contraction in activity. Further bad news on the budget front would undermine confidence.

Policy orientation should downside risks materialise

If such downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth:

• Strictly implementing budget consolidation must remain a priority and the government should meet its headline deficit targets. If needed, the authorities should stand ready to take additional measures, preferably on the spending side, to achieve the planned improvement in the fiscal position.

• To shore up the credibility of fiscal consolidation and foster efficiency gains in public spending, a sounder fiscal framework is needed. Prominent features should encompass multi-year programming underpinned by expenditure ceilings, assessment and oversight by an independent fiscal council and strengthened accountability mechanisms covering the whole public sector.

• Growth-friendly tax reforms, calibrated so as not to endanger fiscal consolidation targets, have the potential to yield employment gains relatively quickly, which is important to minimise the risk of rising structural unemployment. A shift from employers’ social contributions to consumption and property taxes is also likely to imply competitiveness gains.

• Reducing labour market dualism by easing employment protection on regular contracts, in line with policy commitments under the EU/IMF financial assistance programme, would make the economy more flexible and attractive for investment.

The economic outlook is deteriorating…

The export-driven recovery has slowed as growth in export markets has weakened and the euro area sovereign debt crisis has undermined the business climate. Domestic demand has remained subdued as fiscal consolidation and inflation weigh on household income growth and thereby consumption.

…undermining fiscal consolidation plans

The fiscal deficit at around 7½ per cent of GDP in 2010 was among the highest in the euro area. In addition, conditions on the sovereign bond market have deteriorated significantly over the past few months. The government has thus rightly planned ambitious consolidation measures to reach its deficit target of 2.9% of GDP in 2013, with efforts appropriately concentrated on the expenditure side. However, without further measures to offset the cyclical deterioration of revenues and higher spending, the consolidation pace is projected to slow, leaving a deficit of 3.5% of GDP in 2013.

The economic slowdown should be temporary…

After a significant slowdown, economic growth is projected to progressively recover during 2012 with the improvement of world trade, long-planned investments in the automotive sector and a higher absorption of EU funds to finance infrastructure in 2012 and 2013. Consumption is expected to contribute positively to growth following some improvement in the labour market, notably as the recent reforms of the labour code, which relaxed employment protection legislation somewhat, will foster employment. Finally, real household income will benefit from lower inflation, not least because increases in regulated prices should be less pronounced going forward.

Industrial production, confidence indicators and retail sales

Slovak Republic

Calculated as deviations from the mean which are expressed in standard deviations.

OECD Economic Outlook 90 database; OECD, Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888932541284

…but uncertainty remains high

The main risks surrounding the projection relate to the outlook in Slovakia’s export markets and the impact of additional consolidation measures on domestic demand. Were domestic confidence to strengthen, saving rates could fall further and consumption would recover more strongly. Overall, however, the risks are predominantly on the downside.

Demand, output and prices

Slovak Republic

Statlink http://dx.doi.org/10.1787/888932542785

Policy orientation should downside risks materialise

If downside risks materialised, the OECD has identified, as part of its Strategic Response, key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth.

• The authorities should ensure that underlying consolidation measures are in place to reach the initial budget targets so as to maintain the confidence of financial markets.

• To enhance the credibility of the budgetary framework, a multi-year expenditure ceiling should be implemented to comply with the structural deficit objective of the Stability and Growth Pact. The planned establishment of an independent fiscal council in charge of monitoring compliance with the fiscal rule is welcome, as it will increase the transparency of fiscal policy and thereby support confidence.

• Due to the impact of ageing on fiscal sustainability, further reforms to the pension system would be urgently needed. In the first pillar, the replacement rate should be adjusted by adding a sustainability factor in the pension formula. Another option would be to increase the retirement age in line with life expectancy gains and to let pensions rise only with the rate of inflation.

• In response to the high level of long-term unemployment, which would most likely rise further in downturn, adequate public employment service capacities should be provided and spending on training measures, which is low by OECD standards, should be increased. Finally, institutions like legal extension of collective wage agreements or the minimum wage should not be allowed to prevent wages from adjusting to local market conditions.

Growth is projected to be very weak

The recovery that had been mainly sustained by the external sector almost came to a halt in the third quarter of the year and the unemployment rate is stuck at a relatively high rate. Real GDP growth is projected to remain weak in 2012 amid sluggish domestic demand and a lack of support from exports. Employment is projected to fall until the fourth quarter of 2012, when the unemployment rate is expected to peak. Activity is projected to pick up again in late 2012, which will bring down unemployment in 2013. As economic slack is set to remain substantial, inflation pressures will remain subdued.

Fiscal consolidation appears to be on track, but there are significant implementation risks

Fiscal consolidation efforts focus primarily on containing the public-sector wage bill and transfers while cutting capital spending. This is expected to reduce the budget deficit to around 3% of GDP by 2013. In September 2011, the government adopted a supplementary budget to address shortfalls in reaching the 2011 target, most notably due to weak macroeconomic outturns, the re-capitalisation of systemic banks and support to the state railway and airline companies. The fiscal outlook for 2012 is, however, uncertain, in large part owing to political uncertainty. Parliament is not expected to discuss any major fiscal legislation until a new government is elected in December 2011.