The global recovery has stalled…

The global recovery has slowed markedly over the past year, with the fragilities apparent at the end of 2011 further accentuated by the recession in the euro area and the unexpectedly strong slowdown in many emerging market economies. The factors behind these developments include the negative spillovers from the euro crisis on global activity and confidence, prolonged deleveraging in the aftermath of the financial crisis, stronger effects from past policy tightening than anticipated and widespread uncertainty, not least about the future stance of fiscal policy but also about the extent of the slowdown in trend growth in some non-OECD economies. In OECD countries outside the euro area, following a pattern that has been common in past years, growth has fluctuated around a modest trend. In some of these economies there remains a risk that endogenous dynamic forces from high unemployment, excess inventories and weak confidence could further undermine activity. Overall, notwithstanding some recent signs of stabilisation, global prospects remain fragile, with strong downside risks, and are heavily dependent on the speed and decisiveness of policy actions.

… and growth is likely to remain subdued for some time

The baseline projection presented here rests on the assumption that policy actions will suffice to avert large adverse risks. Even so, only a hesitant and uneven recovery is projected to occur, with growth struggling to accelerate through 2013 and an unwelcome further deterioration in already-weak labour market conditions (). OECD growth is projected to be only modest in the near term, with growth holding up better in the United States than in Japan, where output has declined in the latter half of 2012 and where the likely resumption of growth will be modest as the boost from reconstruction efforts fades gradually. The euro area is projected to remain in or near recession until well into 2013 and fiscal headwinds and private sector deleveraging are expected to be sizable. Against this background, OECD unemployment could continue to rise until mid-2013 and drift down only slowly thereafter. Widening economic slack is putting downward pressure on inflation in the euro area but, as elsewhere, well-anchored inflation expectations help to moderate changes in inflation. Though differentiated in terms of pace and extent, the recovery in the key non-OECD economies is projected to be a little quicker than in the OECD area, in part reflecting the greater scope for policy stimulus to support activity in many of these countries. If key adverse risks cannot be averted, and especially if the euro area crisis were to intensify significantly, the likely outcome would be considerably weaker, potentially plunging the global economy into deep recession and deflation, with large additional rises in unemployment.

The global recovery will gain momentum only slowly

OECD area, unless noted otherwise

Statlink http://dx.doi.org/10.1787/888932744109

This chapter is organised as follows. After outlining the main economic and financial forces presently acting, the projection is set out and the implications for inflation, labour markets and external balances discussed. Subsequent sections discuss the key risks around the projection, and the policy actions required to resolve the crisis in the euro area. Finally, the main macroeconomic and financial policy requirements that are appropriate given the projections are presented, along with the additional policy measures merited if serious downside risks were to materialise.

Economic conditions are very fragile

The pace of the recovery in the OECD area as a whole continues to be extremely modest. Indeed, activity is lagging well behind the recoveries experienced from past OECD recessions (). There is unanticipated weakness in many OECD and non-OECD economies, and generally soft business and consumer confidence, with slowing demand for consumer durables and capital goods depressing business order books. The forces behind the simultaneous slowdown in activity are hard to identify fully, although the euro area crisis and the slow and uneven progress being made on necessary policy actions are undoubtedly having an adverse impact on the global economy, with other economies inside and outside the OECD being affected through trade, financial and confidence channels (). Widespread fiscal consolidation and, in the emerging markets, past monetary policy tightening have also been a factor. Key activity and demand developments include:

OECD recoveries compared

Quarters; GDP peak at time t

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932742741

Spillovers from the euro area crisis on emerging market economies

Output growth in the major emerging market economies in 2012 has been considerably softer than a year earlier. This slowdown has occurred against a backdrop of significant domestic monetary policy tightening in many countries into early 2012 and the deepening of the euro area crisis. This box provides an overview of the extent to which the euro area crisis might have constrained growth, considering in turn the spillover effects via trade, financial and business sentiment channels as well as estimates of spillovers from macroeconomic model simulations.

The extent to which countries are exposed to the euro area via trade linkages varies markedly. In general, exposure in many Central and Eastern European economies is relatively high, reflecting both the high share of exports to the euro area in total exports, and a high share of total exports in GDP. Outside Europe, exposure  is  comparatively  higher  in  South  Africa  and  many  Asian  economies,  including  China,  compared with other regions. As the crisis has deepened, the total volume of imports by euro area countries from non-euro area countries has fallen, declining by 3¼ per cent (annualised rate) between the first and second halves of 2011, and by a further 2¾ per cent in the first half of 2012 (a.r.). The volumes of goods imported from India and South Africa by the euro area in the first half of 2012 were some 13-14% lower than a year earlier, with declines in import volumes from Russia and Indonesia of some 8-9% and declines in import volumes from China and Brazil of 6 and 3% respectively. In contrast, the volume of imports from all of these countries, with the exception of Russia, had risen steadily over the year to the first half of 2011.

By itself, the direct impact effect of the export declines over the year to the first half of 2012 corresponds to a hit to GDP growth over this period of around ¼ percentage point in India, China and Indonesia, 0.1 percentage point in Brazil and between ½-¾ percentage point in Russia and South Africa.

Allowing for the import content of exports would lower these estimated effects, possibly by up to a half in a country such as China where there is a strong integration into global supply chains. On the other hand, it is likely that there would be negative multiplier effects from the hit to exports, especially on investment. Weaker demand in the euro area will also have lowered exports of services to the euro area from these countries, a factor relatively important for India, and may also have had an indirect impact by reducing third-party demand for exports from these countries.

Going further, by taking export volume growth rates over the year to the first half of 2011 as a benchmark, as shown in the table below, the direct impact of the changes in euro area import volumes corresponds to around three-quarters of the slowdown in output growth in South Africa (comparing GDP growth over the year to 2012H1 with GDP growth over the year to 2011H1), but only for around one-quarter of the slowdown in output growth in China and hardly any of the growth slowdowns in Brazil or India.

The estimated direct impact of exports to the euro area on GDP growth

Statlink http://dx.doi.org/10.1787/888932744204

Financial channels also have a relatively important role in the propagation of shocks. Heightened general risk aversion at times of intensified stress in the euro area places downward pressures on global equity prices and widens credit spreads, with negative effects on aggregate financial conditions. Pressures on euro area banks to re-trench and possibly deleverage can adversely affect credit growth and activity in many countries, especially in Central and Eastern Europe, where euro area banks account for a large proportion of aggregate banking activity.

BIS statistics on the cross-border claims of euro area banks, available only with a considerable lag, point to mixed developments since mid-2011. There was a sharp contraction in euro area banks’ cross-border credit to emerging market economies in the latter half of 2011, when strains in euro area financial markets were very high,  but  little  further  change  in  the  first  quarter  of  2012.  Cross-border claims on China and Brazil rose, offset by further declines in claims on emerging European economies, including Russia. Euro area banks have cut back relatively sharply on loans with high risk weights, such as leveraged loans or project finance, and for loans that often require dollar funding, such as aircraft and ship leases and trade financing (BIS, 2012). With euro area banks providing a high proportion of global trade finance, constraints on their lending could be having an adverse impact on trade growth this year, although there are signs that non-European banks are replacing a considerable part of the shortfall in lending by European banks in some regions, especially Asia (Vause et al., 2012a).

The euro area crisis may also affect activity by simultaneously damaging business sentiment around the world, although this propagation channel is hard to separate from trade and financial spillovers from the crisis. Little empirical evidence exists about potential spillovers via sentiment channels into emerging market economies. To assess these, a monthly vector auto-regression model has been developed, in which the PMI manufacturing indices in Brazil, China, India and Russia are related to the aggregate euro area PMI manufacturing   index,   with   the   PMI   indices   in  the  United  States  and  Japan  included  as  additional  control variables. These suggest that the decline in euro area business sentiment is associated with negative adverse effects on sentiment elsewhere (possibly reflecting trade and financial factors):

• A negative shock of 1 standard deviation in the euro area normalised manufacturing PMI (roughly a decline of 6 points in the headline index,  as  has  occurred  since  mid-2011)  is  found  to  be  associated  with a negative effect on the PMI in each of the four emerging market economies that lasts for between 7-9 months, all else being equal.

• Feedback effects from weakening sentiment in other countries (including the United States and Japan) amplify the initial downward shock to euro area sentiment by up to one-half for a few months.

• By the third month following the initial downward shock to euro area sentiment, sentiment in Russia and China has declined by a similar extent. Sentiment in India and Brazil has declined respectively by around four-fifths and two-thirds of the decline in the euro area. In each of these countries, a 1 standard deviation decline in the normalised manufacturing PMI corresponds to a decline of 3½-4 points in the headline PMI index.

Analyses using estimated macroeconomic models provide integrated estimates of the extent to which shocks in one country are transmitted to others through trade and international financial linkages. Such models usually do not incorporate sentiment variables directly, although such effects are likely to be captured indirectly via the estimated model parameters. In general, the size of spillovers that emerge from these models will vary according to the types of shock considered, the specification of the model and the policy responses that are taken into account. Typically however, there are significant spillovers from euro area shocks (IMF, 2012),

especially once global financial factors are incorporated. Amongst emerging markets, such shocks are relatively high for emerging economies in Central and Eastern Europe.

This pattern also appears in the euro-only crisis simulation reported in , in which euro area GDP growth declines by 2¼ percentage points in the first year of the simulation. The figure below reports the corresponding first-year GDP declines in selected emerging market economies (plus the United States and Japan) expressed as a ratio of the decline in euro area GDP. The negative spillover effects are strongest in Russia – reflecting the strength of bilateral trade linkages – and the Asian economies, with the smallest effects found for Brazil and the United States.

Overall, the evidence suggests that the euro area crisis is having a negative impact on growth in the major emerging market economies, but, as of the first half of 2012, it likely accounted for less than one-half of the observed growth slowdowns in China, India and Brazil, with the bulk of their slowdown reflecting domestic developments. Nonetheless, it is possible that the euro crisis may now be acting as a relatively more important drag on growth, with further weakness in euro area domestic demand, and hence imports, set to persist into 2013, and macroeconomic policies in the major emerging market economies now easing gradually and becoming less of a drag on growth.

First year decline in GDP in euro-only adverse shock

As a ratio of the first-year decline in euro area GDP

Based on the euro-only simulation in below.

OECD calculations.

Statlink http://dx.doi.org/10.1787/888932742665

These calculations make the assumption that the decline in import volumes recorded by Eurostat is mirrored by an equal decline in export volumes from these countries as recorded in their national accounts and use weights based on the nominal share of exports to the euro area in total exports of goods and the nominal share of exports of goods in GDP.

In the first quarter of 2012, cross-border claims by euro area banks in Central and Eastern Europe were equivalent to around 29% of regional GDP, compared with Latin America and Emerging Asia where claims were equivalent to around 11 and 2% of GDP respectively.

A vector-autoregression model is used, estimated on monthly data for 2006-2012, with lags selected using standard tests. Generalised impulse responses were calculated as in Pesaran and Shin (1998), ensuring that the responses to a shock in a given country are invariant to the ordering of the variables in the model. Variables such as oil prices and stock market uncertainty were initially included to control for common shocks, but were not found to be significant.

In a simulation of an euro area fiscal shock, Hervé et al. (2010) report a first year impact on euro area GDP growth of 0.8 percentage points (relative to baseline), with impacts of between 0.1-0.3 percentage points on GDP growth in emerging market economies.

Business sentiment has weakened markedly…

• Business sentiment and order books are weak in many of the major economies (), though they remain noticeably stronger in the United States and Canada than in Japan and the euro area, consistent with diverging activity outcomes. In the euro area, sentiment has softened considerably in all countries, remaining weak even after the ECB announcement of the Outright Monetary Transactions (OMT) programme. The PMI surveys in the major emerging market economies are mixed but generally point to stabilising activity. Inventory levels of finished manufactures remain high in some countries, raising the risk of continued near-term weakness in industrial production if firms try to bring inventory-sales ratios back down to more normal levels.

Business sentiment is weak in many economies

PMI indicators

Markit.

Statlink http://dx.doi.org/10.1787/888932742760

… and global trade growth is weak

• Global trade growth has slowed to very weak rates, reflecting slowing demand for durable and capital goods, and soft activity in trade-intensive global tech. Import volumes in the euro area have declined this year and export growth has slowed around the world, especially in many economies in Central and Eastern Europe and Asia, although recent monthly trade data for several Asian economies have firmed a little. However, indicators such as new export orders and shipping rates point to, at best, only tepid global trade growth in the near term.

Fiscal consolidation is weighing on activity…

• The strong fiscal consolidation underway throughout the OECD (discussed in the policy section below) could be subtracting some 1 to 1½ percentage points from OECD-wide growth in 2012 and more for the euro area. The size of the drag reflects the spillovers that arise from simultaneous consolidation in many countries, especially in the euro area, increasing standard fiscal multipliers by around a third according to model simulations, and the limited scope for monetary policy to react, possibly increasing the multipliers by an additional one-third. It also mirrors the fact that reductions in public expenditure typically account for the bulk of consolidation in most countries. This is likely beneficial for long-term growth prospects, but it implies a bigger drag on near-term growth. In current circumstances, the negative short-term impact of consolidation could be even larger than mentioned above. This is particularly the case in some euro area countries, where pre-existing weakness and dysfunctional financial systems might limit the ability of households and firms to smooth spending in the face of further fiscal tightening.

… with cyclical weakness and uncertainty slowing business investment …

• Sluggish growth and uncertainty are now slowing business investment in the OECD area. Recent indicators of new capital goods orders and shipments in the major economies have been particularly weak and point to subdued near-term outcomes. This partly reflects the underlying weakness of final demand, fading confidence, and, in the euro area, tightening financial constraints (). Anecdotal evidence also suggests that economic policy uncertainty, for example uncertainty over the US fiscal cliff and debt ceiling, may also be delaying investment projects at present, although in contrast to the latter half of 2011, market-based measures of uncertainty, such as stock market volatility, remain at very low levels. Investment growth is likely to remain subdued until a clear cyclical upturn in demand gets underway and financial conditions improve. In the euro area, investment could be softer than elsewhere, damped by weak bank lending. Outside the OECD area, infrastructure spending is boosting public investment in China, but slowing trend growth has raised uncertainty about the strength of business investment.

Financial constraints on euro area business activity are elevated

Normalised survey indicator, units of standard deviations

Weighted average, based on average gross value-added shares in 2009 and 2010, of companies in industry, services and construction stating that financial constraints are limiting activity. All figures taken from January, April, July and October surveys, and normalised over 2004Q1-2012Q4. The series shown is a two-quarter moving average of the normalised measure. Values above zero signify financial constraints tighter than the period average.

European Commission business survey and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932742779

… and household balance-sheet adjustment constraining spending…

• Household demand remains soft in many OECD economies, reflecting subdued growth of real disposable incomes amidst worsening labour market conditions and the need for balance sheet adjustments. Demand for durable goods has eased considerably, especially in the euro area where car sales plummeted by 23% at an annualised rate in the third quarter, though it has held up relatively well in China, Indonesia and some other emerging market economies. Consumer confidence has deteriorated further in the euro area this year, and remains low relative to historic norms in many other OECD economies (). However, despite recent setbacks, stronger equity prices are supporting household balance sheets. Moreover, in a handful of countries, including the United States, rising house prices and progress in debt deleveraging are further improving net worth. In such countries, additional balance sheet adjustment will be able to take place with saving ratios at or just below current levels and consumption continuing to rise modestly. In 2013-14, the US saving ratio is projected to be 1 percentage point lower than in 2012. For the euro area in aggregate, where debt deleveraging has yet to get underway and area-wide house prices are declining, saving ratios seem more likely to rise and consumption is likely to remain weak in the near term, especially in countries with soaring unemployment. Germany may be an exception, with strong household balance sheets and a tight labour market helping to support demand. In Japan, future consumption patterns seem likely to reflect pre-announced indirect tax rises, with expenditure rising immediately prior to the increase and falling immediately after.

Consumer confidence is soft

Normalised survey indicators, units of standard deviations

Data for United States is provided by the Conference Board. Normalised figures over the period 1999M1-2012M10. Values above zero signify levels of consumer confidence above the historical average.

Datastream and European Commission.

Statlink http://dx.doi.org/10.1787/888932742798

… with mixed developments in housing markets

• Recent housing market developments remain generally weak in the OECD (), with declining real prices and subdued housing investment in many countries.*

  In the OECD as a whole, the share of housing investment in GDP is around 1½ percentage points below the share at the most recent cyclical peak, with declines of between 6-10 percentage points in the investment share having occurred in Spain, Greece and Ireland.

  In the euro area, housing investment is now declining, and strong growth in real house prices in Germany is more than offset by large price declines in the countries under market pressure, and declines in the Netherlands and, more recently, Belgium and France, where price-rent ratios remain high (). In contrast, US housing market conditions are now improving slowly, with the price-rent ratio having declined back to its long-run average and builders’ optimism, transaction prices, sales and housing starts all turning up. Real housing investment is now making a positive contribution to GDP growth. Further improvements are projected, with nominal mortgage rates at very low levels, though mortgage lending standards remain tight and a shadow inventory still remains from properties in, or close to, foreclosure. In other countries, such as Canada, Australia, Norway and Sweden, house prices remain very high relative to rents and incomes. In China, widespread recent property price declines have now ended, which should help to underpin activity.

Housing market developments remain mixed

Statlink http://dx.doi.org/10.1787/888932744128

House price-to-rent ratios differ considerably across countries

Long term average = 100

Countries are ranked according to their price-to-rent ratio in 2012Q3 or last available figure.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932742817

Commodity prices have eased

Recent commodity price developments have been mixed, though oil and aggregate non-oil commodity prices have declined since the early part of the year.

Geopolitical tensions have increased oil price volatility

• Even so, oil prices have remained relatively high in the face of weak activity and some strengthening in oil supply. This is likely to reflect risk premia, mainly on account of geopolitical concerns, althought underlying supply-demand forces might have contributed as well. While global oil demand has temporarily weakened, reflecting sluggish economic growth, oil demand by China and other emerging markets will strengthen again in the future as economic activity firms. The projection assumes a moderate upward price movement of $5 per year in nominal terms.

International food prices have risen, but low growth has depressed prices for industrial commodities

• International grain prices have risen since mid-2012, reflecting significant supply shortfalls on account of the drought in the United States and adverse weather conditions in some other parts of the world (). Prices have eased a little very recently, but are likely to remain at a high level in the near future, and could spread to meat and other food products, before coming down when supply conditions normalise. Prices for other agricultural products and minerals and metals are at lower levels than in 2011 and early 2012, mainly reflecting sluggish economic activity. Overall, non-oil commodity prices are assumed to remain constant at recent levels over the projection period.

Non-oil commodity price developments have diverged

2005 = 100

OECD Economic Outlook database.

Statlink http://dx.doi.org/10.1787/888932742836

Financial conditions are supportive but the growth impact will be delayed

In marked contrast to subdued activity indicators, the OECD financial conditions indices (FCI), derived largely from price-based indicators, show an increasingly supportive environment in major OECD economies (). However, the boost to growth expected from this development is likely to be delayed and possibly weaker than it would have been in the past, especially in the euro area. This reflects the impaired transmission of financial conditions to the real economy mainly brought about by ongoing balance-sheet adjustments and uncertainty related to tail risks. In addition, as described above, growth is held back by a number of other headwinds. Outside the OECD area, financial conditions have also eased but to a different degree. This reflects contrasting policy settings: very loose in Brazil and less so in other emerging economies. Key developments in different economies include:

Euro area financial conditions have improved, but there are large intra-area differences

• In the euro area, aggregate indicators of financial market conditions have improved but this masks large differences across member states, with financial strains in vulnerable euro area countries and easy conditions in the core countries. On the positive side, since May, money market rates, credit default swap rates, and sovereign and corporate bond yields have eased and equity markets have improved (). These trends reflect measures to address the euro area crisis (see below) which, at least initially, have diminished perceptions of euro area break-up risks. In addition, strains in bank funding markets eased in the second quarter of 2012 after the 3-year long-term refinancing operations of the ECB earlier in the year. Nonetheless, the proportion of banks reporting tighter credit standards did not ease further in the third quarter and serious problems remain, or, in some cases, still build in the banking system, with annual credit growth turning negative again for virtually all types of borrowers. The overall funding costs of large core euro area banks are at historical lows, but they are high for a number of banks in fiscally vulnerable economies where some financial institutions are excluded from the market and overall financial conditions remain tight. The divergence in bank lending rates for non-financial corporations also remains at very high levels ().

Aggregate financial conditions have improved

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 15 November 2012.

Datastream; OECD Economic Outlook 92 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932742855

The degree of stock market rebound differs

2009 Q1 = 100

Stock indices are based on: US Dow Jones (total) for the United States, FTSE Eurotop 100 for the euro area, Nikkei 225 for Japan, Shanghai composite for China, Emerging MSCI EM for Latin America, and MSCI EM for Emerging Europe, Middle East and Africa (the latter includes: the Czech Republic, Egypt, Hungary, Marocco, Poland, Russia, South Africa and Turkey).

Datastream.

Statlink http://dx.doi.org/10.1787/888932742874

The cost of credit among euro area countries has diverged

Cost of credit is defined as interest rates on new loans to non-financial corporations (all maturities) with the exception of Greece where it refers to new loans with maturity of up to one year. Last observation refers to August 2012.

European Central Bank.

Statlink http://dx.doi.org/10.1787/888932742893

Financial conditions have improved further in the United States…

• In the United States, financial conditions have improved in virtually all market segments this year. The rally in equity markets up to September took prices to their highest level for five years (), though more recently prices have slipped back. Adjusted for nominal trend growth, price-earnings ratios still remain below historic averages. Stock market uncertainty, as measured by implied volatility, has remained at a surprisingly low level given the amount of policy uncertainty and risks facing the global economy. US government bond yields have remained very low by historical standards, reflecting ample liquidity rather than better credit quality as compared with other countries,*

  Liquidity effects in the United States show up in a much larger decline in sovereign bond yields than in government agencies bond yields (by around 70 basis points) during recent episodes of mounting financial stress. Under such circumstances, investors primarily value liquidity and safety of assets. Sovereign bonds are typically perceived as having both features, whereas government agency bonds benefit only from safety. This contrasts with developments in Canada, France, Germany, Japan and the United Kingdom.

  and mortgage rates have continued to decline. Credit standards for small and large firms are easing and bank lending rates remain low.

… but have become less favourable in Japan

• In Japan financial conditions remain supportive, but have tightened a little since May, reflecting the recent yen effective exchange rate appreciation and higher corporate bond spreads. In contrast, credit conditions have eased.

Emerging market financial conditions have generally improved

• Financial market conditions in most emerging economies have improved recently, with rising equity markets, declining sovereign bond spreads and lower policy interest rates (especially in Brazil – see below). Developments in China are mixed. Stock markets have declined and underperformed those in other economies, amid concerns that the economic slowdown may be prolonged, uncertainty about monetary policy and doubts about the strength of potential growth. On the other hand, liquidity supply has been eased, credit growth has picked up and the renminbi has remained broadly stable in effective terms since May.

Economic prospects are very uncertain...

Economic prospects are very uncertain and highly dependent on the risks associated with the nature and timing of policy decisions related to the euro area crisis, the US fiscal cliff and debt ceiling, the extent to which growth can rebound in the emerging market economies given uncertainties about potential output growth, and the possibility that self-reinforcing endogenous dynamics might slow demand even further. Particularly challenging fiscal sustainability conditions in some euro area countries also create an event risk. The projection presented here rests on the assumption that the key risks identified above can be reduced successfully and that other downside risks do not materialise, although, in the euro area especially, progress in implementing the necessary policy measures to achieve this outcome may remain slow and hesitant.

… with growth likely to recover only slowly…

On the basis of these assumptions, only a muted and uneven upturn in activity is projected to occur in the major OECD economies through 2013-14, with growth picking up only slowly from very weak near-term outcomes, especially in the euro area where recessionary conditions are projected to persist into 2013. Ongoing support from accommodative monetary policies (), firming confidence and relatively supportive financial market conditions should all help to eventually underpin growth in most major economies, despite the ongoing drag from fiscal consolidation and persistent high unemployment. The key features of the economic outlook for the major economies are as follows:

… in the United States…

• Growth in the United States has held up this year, despite the temporary drag exerted by drought-related losses in farm output and disruptions from Hurricane Sandy, and is expected to strengthen gradually through the projection period. Private consumption growth should be supported by improving labour market conditions and a decline in the household saving rate, reflecting past balance-sheet improvements. Business investment growth should rebound as policy uncertainty fades, and housing investment should continue to rise quickly from its current low level as the housing market recovers. With external demand expanding less rapidly than domestic demand, net exports are likely to be a modest drag on the recovery through 2013-14. Employment growth is projected to strengthen over the next two years, with the unemployment rate declining to just below 7½ per cent by the end of 2014, still leaving significant, albeit diminishing, labour market slack.

… in the euro area…

• The euro area economy remains very weak, with area-wide indicators of activity at very low levels and widespread fiscal consolidation and faltering confidence exerting a significant drag on activity. Aggregate financial conditions have improved a little and monetary policy is increasingly accommodative, but the impact of this on area-wide activity will appear only slowly, reflecting the impaired transmission mechanism. Deleveraging is expected to occur in those member states with very high levels of household and corporate debts, raising household saving rates and damping investment. Provided policy actions suffice to diminish the risk of destabilising euro area developments, and as the strength of area-wide fiscal consolidation eases, confidence should begin to recover and activity strengthen gradually. However, growth is not projected to reach trend rates until late in 2014, with a large negative output gap widening further and already weak labour market conditions deteriorating even further, as unemployment rises to just over 12%.

… in Japan…

• In Japan, robust growth in the first half of 2012 has been followed by output declines in the latter half of the year. Export volumes have fallen sharply and domestic demand has slowed, in part because of the ending of subsidies for the purchase of eco-friendly vehicles. GDP growth is set to pick up once more from early 2013, but to only modest rates. Domestic demand will be held back by the waning of post-disaster reconstruction expenditures and the increasing drag exerted by fiscal consolidation, which gets underway next year and intensifies strongly in 2014 as the planned increase in the consumption tax rate is implemented. Some expenditure switching is projected to occur in 2014, with private consumption brought forward to before the tax increase, although offsetting changes in the household saving rate and stockbuilding could help smooth the overall activity profile. A recovery in export growth, as external demand strengthens, and a corresponding improvement in business investment are likely to be the main forces supporting the recovery, with the unemployment rate falling marginally through the projection period.

… and in emerging market economies

• After a period of greater than expected softness, output growth is now beginning to pick up slowly in the major emerging market economies, with increasingly supportive monetary and fiscal policies offsetting the drag exerted by weak external demand. In China, output growth has begun to edge up on a quarterly basis, helped by the acceleration of public infrastructure spending. Growth is expected to stabilise at just below 9% by 2014, with macroeconomic policy easing, an improving housing market and increased outlays on social spending supporting domestic demand. In India, annual GDP growth is expected to strengthen gradually, to around 6% in 2013 and 7% in 2014, with improving financial conditions and a normalisation of agricultural output boosting activity, and diminishing inflationary pressures providing greater scope for monetary easing and reducing the drag on household real incomes. In Brazil, the period of weak growth appears to have ended, helped by strong and timely monetary and fiscal stimulus, and GDP growth is projected to be close to potential rates, at around 4% per annum in both 2013 and 2014. Domestic demand is expected to remain robust, amidst strong investment growth and a tight labour market, offset in part by small net export declines. In Russia, GDP growth is expected to strengthen to around 4% per annum in 2013-14, helped by the near-term effects of fiscal easing, the high level of oil prices and the gradual fading of headwinds from the euro area crisis.

Inflationary pressures remain weak…

Inflationary pressures are weak at present, with core inflation rates in most major economies either stable at low levels or drifting down. Higher food prices will continue to push up headline inflation a little until early 2013, especially in emerging market economies. Long-term inflation expectations in the OECD economies remain reasonably well anchored, although market-based measures have drifted up a little in the United States since the introduction of the QE3 programme. The anchoring of inflation expectations should help check disinflationary pressures, though substantial spare capacity in many OECD economies will keep price inflation below official inflation objectives in the coming years (), notwithstanding uncertainty about the precise degree of slack at the current juncture. Core inflation is set to remain subdued in the United States, edging up eventually to around 2% during 2014, broadly in line with the projected growth of unit labour costs. In the euro area, widening slack could push core inflation down to around 1¼ per cent by 2014.*

Past rises in administered prices and indirect taxes are currently adding around ½ percentage point to the annual rate of headline inflation in the euro area, allowing for possible double counting from indirect taxes levied on administered prices. In September, the latest month for which comparable data are available, the euro area annual rate of headline inflation was 2.6%; the annual rates excluding administered prices and indirect tax increases were 2.4% and 2% respectively. The annual rate of core inflation is likely boosted by the same factors and was running at 1.5% in September.

Inflation pressures are likely to remain 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 92 database.

Statlink http://dx.doi.org/10.1787/888932742912

… with different measures of economic slack all pointing to disinflationary pressures

Judgements about the extent of economic slack at the current juncture, and thus the extent of disinflationary pressures, are very uncertain. In the OECD this arises in part from uncertainty about the impact of both the crisis and the subsequent prolonged period of sub-par growth on potential, with the near-term output gap possibly estimated to be more negative than it actually is. In such circumstances, judgements about prospective inflationary pressures need to pay greater attention to survey-based measures of slack and to the gap between actual and potential growth (Orphanides, 2003; Pain and Röhn, 2011).*

Long-lasting one-sided errors are less likely to occur in such measures, with potential growth estimates not affected persistently by past shifts in the difficult-to-estimate level of potential.

Labour market conditions have deteriorated...

Labour market conditions generally remain weak, especially in the euro area countries under market pressure. Elsewhere, the gradual reduction in unemployment in Germany has stalled as growth has eased, though unemployment has continued to drift down in the United States despite only modest job growth, with the labour force participation rate having fallen to its lowest level since 1980. Estimates derived using simple equations relating the change in the unemployment rate to output growth (), suggest that unemployment outcomes in recent quarters in the United States and the United Kingdom have been persistently better than might have been expected on the basis of past relationships with output growth. An implication is that unemployment could rise quickly in these countries if growth were to weaken. In contrast, the increases in the euro area unemployment rate have been somewhat stronger than might have been expected given output growth, suggesting that firms anticipate a sustained period of weakness and also possibly reflecting a pay-back from a muted unemployment response earlier in the crisis.

Actual and predicted changes in unemployment rates

Quarterly change, percentage points

Predicted change is a dynamic forecast of the change in the unemployment rate from 2011Q1, using an equation estimated over 1994Q1-2010Q4 in which the change in the unemployment rate is regressed on lagged changes in the unemployment rate and current and lagged output growth.

OECD Economic Outlook 92 database and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932742931

… and seem likely to improve only modestly in the next two years…

Unemployment is set to remain high or even rise further in many countries. Indeed, weak survey measures of hiring intentions, the likelihood of a further period of sub-par output growth and uncertainty possibly postponing hiring decisions (Leduc and Liu, 2012) are all suggestive of weak employment prospects, with adverse effects on income growth, confidence and activity. Total OECD employment is projected to rise by around ¾ per cent in 2013 and 1% in 2014 (), with job growth in the United States and many other non-European economies offset in part by employment declines in the euro area and Japan, where the population of working age is declining. The already high OECD-wide unemployment rate is projected to edge up next year before dropping back in 2014, with the number of unemployed at end-2014 being only marginally lower than at present ().

OECD labour market conditions are diverging

Statlink http://dx.doi.org/10.1787/888932744147

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 92 database.

Statlink http://dx.doi.org/10.1787/888932742950

…unless structural measures are used to foster near-term employment growth

At the OECD-wide level around 16 million more people are out of work than at the end of 2007, just before the crisis began. Furthermore, high long-term unemployment in some countries raises concerns that the persistent cyclical increase in unemployment could increasingly become structural. A related concern is that the increase in the number of discouraged workers could also become permanent. In some countries, including the United States, the United Kingdom and Sweden, the Beveridge curve (an indicator of efficiency of job matching in the labour market relating the unemployment rate to the vacancy rate) has recently shifted to the right (implying a higher unemployment rate for a given vacancy rate), possibly suggesting that matching frictions have risen (OECD, 2012c; Hobijn and Sahin, 2012).*

Possible reasons include: a reduction in job search intensity due, for example, to extensions in benefit duration or less-intensive searching by the long-term unemployed; or a reduction in recruitment intensity (Davis et al., 2012), with firms more willing to wait for suitable workers during a period of soft demand.

External imbalances remain elevated…

The sum of all external balances in absolute terms is now between 3¾-4 per cent of world GDP, well below the level immediately prior to the financial crisis. Over the next two years, it is projected to decline by around ½ percentage point, helped by relatively robust import demand in China and the lagged effects of past effective exchange rate movements in the United States, China and Japan (; ). Key developments across major external surplus and deficit economies include:

… with the euro area surplus likely to rise further…

• The euro area external surplus has risen by just under 1 percentage point of GDP this year, with soft domestic demand in the peripheral countries, not least reflecting ongoing fiscal consolidation, not being offset by stronger demand in the core countries. Over the next two years the area-wide surplus is expected to rise by a further ¾ percentage point, with domestic demand growth remaining subdued relative to elsewhere. Developments in intra-area imbalances are discussed further below.

… the US external deficit set to broadly stabilise…

• In the United States, the trade balance has been broadly stable this year, with an increasing non-oil deficit, reflecting the relative strength of domestic demand, being offset by rising exports of petroleum products, on the back of domestic supply developments. A deterioration in the terms of trade and relatively robust domestic demand growth over 2013-14 are projected to result in the US current account deficit widening by around ¼ per cent of GDP.

World trade will strengthen only gradually

Statlink http://dx.doi.org/10.1787/888932744166

Little further progress in reducing global imbalances is foreseen

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, Republic of Congo, Equatorial Guinea, Gabon, Nigeria and Sudan.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932742969

… the Japanese surplus to persist…

• In Japan, the current account surplus has declined further this year, by close to 1% of GDP, reflecting rising energy imports, as well as slower exports as a result of the strength of the effective exchange rate and sluggish overseas demand. Whilst some of these factors may persist, notably the recourse to energy imports to replace domestic nuclear power, the overall current account balance is projected to remain positive, at around 1¼-1½ per cent of GDP over 2013-14, reflecting strong and rising income flows from Japan’s net external assets.

… the Chinese external surplus declining…

• In China, the overall current account surplus is projected to be just over 2¾ per cent of GDP in 2012, around ½ per cent of GDP higher than in the latter half of 2011, with some imported commodity prices having softened and domestic demand growth having moderated, although remaining robust relative to that in China’s trading partners. Thereafter, a modest further decline in the surplus is projected, to around 2¼ per cent of GDP in 2014, reflecting solid domestic demand growth and declines in the terms of trade as Chinese exporters price to market.

… but the oil producers’ external surplus remaining high

• The high-saving oil-producing economies are continuing to run large external surpluses of just under ¾ per cent of world GDP. Going forward, with only limited re-spending of oil revenues, the external surpluses of oil-producing economies are projected to remain elevated. The resulting outward financial investments are exerting some downward pressure on the yields of perceived safe assets in other countries, especially government bonds.

Structural reforms would help narrow imbalances

The current account projections over the next two years largely reflect cyclical developments. Durable reductions in global imbalances (including in China), as well as in intra-euro area imbalances, require greater adjustment of real exchange rates as well as structural reforms and fiscal adjustments, with actions undertaken in both external-deficit and external-surplus economies (OECD, 2012b).

Risks are high and mainly to the downside…

Risks around the baseline scenario remain extensive and are predominantly on the downside. The main risk, discussed further below, continues to come from the euro area, with the crisis being intensified by adverse debt dynamics, banking sector stress (including possible bank failure), weak growth and a collapse in confidence or the exit of a member state. In addition, there are a number of other specific risks that could affect growth outcomes if they materialised:

… self-reinforcing dynamics could cause a marked slowdown…

• In some economies output growth is now close to or below estimated stall-speed thresholds (; ), with a risk that self-reinforcing endogenous dynamics could push them into outright recession. High and rising unemployment, excess inventories and weak confidence in some economies could all result in higher household saving rates and sharp cutbacks in production and new investment. Output is already declining in the euro area and GDP growth over the year to the fourth quarter of 2012 in the United States and Japan is projected be in or close to the range in which there is estimated to be a strong chance of an outright decline in GDP over the following year given the stall-speed thresholds estimated by Sheets and Sockin (2012).

GDP growth and estimated stall speeds

Year-on-year percentage changes

The dotted lines represent the upper and lower stall speed thresholds from Sheets and Sockin (2012). If GDP growth over a rolling 4-quarter period is within these thresholds there is a statistically significant chance of an outright decline in GDP over the following 4-quarter period. The series are shown for 1987Q1 - 2012Q4. Values for 2012Q3 and 2012Q4 are projections.

OECD Economic Outlook 92 database, and Sheets and Sockin (2012).

Statlink http://dx.doi.org/10.1787/888932742988

… as would a sharp fiscal contraction or hitting the debt ceiling in the United States…

• As discussed below, current legislation implies that, in the absence of a bipartisan agreement, there will be an extremely sharp US fiscal tightening in 2013, amounting to close to 4% of GDP, and failure to lift the debt ceiling in a timely manner could also be very disruptive. Based on recent estimates of multipliers at the zero bound (CBO, 2012; DeLong and Summers, 2012), the additional consolidation of around 2½ per cent of GDP relative to the baseline could push the US economy into or near to recession in 2013.

… a large disruption to oil supply…

• With continued geopolitical tensions, there remains a risk of a temporary supply disruption generating a sharp spike in oil prices and in general price developments. Emerging market economies are particularly exposed to this risk, given the comparatively high energy-intensity of their production. For each increase in the oil price of $10 per barrel relative to the assumption used for the projection, OECD GDP growth could be reduced by around ¼ percentage point over 2013-14 and headline inflation raised by a little under ¼ percentage point in both years.

… a large correction in equity prices…

• Although they have recently fallen back, equity prices are relatively buoyant and, especially in the euro area, appear to be at odds with broader economic conditions, as reflected in growth prospects, and very weak sentiment. This raises the risk of a sudden deterioration in financial market sentiment and a marked tightening of financial conditions via weaker equity prices, checking the pace of the recovery.

… and a slower than expected pick-up in the emerging market economies

• There are several factors that may combine to bring about a slower growth pick-up in emerging market economies than projected. In many emerging market economies, with Brazil a notable exception, there has yet to be aggressive policy easing as growth rates have slowed below recent trend rates. One possible factor behind this is uncertainty about the true extent of economic slack and downward reassessments of recent and future potential output. In China, the labour market remains tight, despite the easing of growth, limiting the extent to which future growth can be met by increased hiring. Moreover, as with many other emerging markets, there is also a possibility that potential growth rates may be over-estimated as a result of an excessive investment rate in the past fuelled by strong credit growth, resulting in investments with very low economic returns being undertaken. A further downside risk in China, with negative spillovers to other countries (Ahuja and Nabar, 2012), arises from the difficulties of sustaining a stable, high GDP growth rate in the context of the ongoing process to lower the share of fixed investment in aggregate demand and raise the share of household consumption significantly.

Upside risks stem from swift policy actions to resolve the euro area crisis and the US fiscal cliff…

Upside risks emanate from swift policy actions to resolve the euro area crisis and establish agreed fiscal plans in the United States that address both the near-term fiscal cliff and the necessary budgetary consolidation required in the medium-term. Other specific upside risks include:

… pent-up demand pressure…

• Against the backdrop of relatively favourable financial conditions, there is a potential for stronger recovery in the United States from pent-up demand pressure. Car sales have been rising steadily in recent months, but remain well below trend levels and the ageing car fleet will need to be replaced. This process could gather force over the projection period. More generally, durable goods consumption as a share of GDP remains extremely low by historical standards. Also, family formation in the United States has been well below normal in recent years and an eventual return to normal patterns would give a boost to the housing market.

… and structural reforms that could improve growth prospects earlier than anticipated

• The implementation of structural reforms in labour and product markets has accelerated in recent years in several OECD economies, especially in the euro area countries under market pressure (OECD, 2012a). Over time, these reforms should help to boost activity levels (OECD, 2012d,f), with the impact possibly emerging earlier than assumed in the projection if financial market conditions improve more rapidly than presently seems likely, thereby helping to bring forward the output effects from reforms.

The euro area crisis remains the most important downside risk to the global economy

With the euro area in recession and weighing on global growth through trade, financial and confidence effects, it is urgent to resolve the crisis in the monetary union. Ultimately, this will require further progress being made to address the imbalances that built up prior to the crisis. In the short run, however, it requires blocking various adverse feedback mechanisms between public finances, bank solvency and exit risks that threaten the survival of the single currency area. Failure to do so could result in much weaker outcomes than in the baseline projection. In addition, the monetary union faces potential challenges from the difficulties of some existing EU/IMF programme countries in observing conditionality at a time when activity is much weaker than initially assumed.

Rebalancing calls for changes in domestic demand and real exchange rates…

The origins of the present crisis lie in the economic and financial imbalances that gradually built up amongst the euro area economies (OECD, 2012e). For these imbalances to be durably reduced, growth-friendly adjustments and reforms are needed in both external surplus and external deficit economies. Illustrative estimates of the extent to which structural reforms and medium-term fiscal consolidation might contribute to the required rebalancing process are discussed in .

Policies to ease euro area rebalancing

The large imbalances that built up in the euro area during the decade or so preceding the start of the global financial and economic crisis — in relative prices, current accounts, external debt, fiscal deficits and public and private debt — have reversed only partially since then. This box provides indications of the scale of the challenges faced to achieve rebalancing and of the policies that could facilitate the further reduction of imbalances (see Guillemette and Turner, 2013 for the methodology).

The analysis makes use of a simple econometric framework in which current account balances in euro area countries are linked to economies’ cyclical positions, total-economy unit labour costs relative to other euro area economies and, separately, to economies outside the euro area, structural fiscal balances and the oil price. Calculations using this framework suggest that much of the widening of current account imbalances between the introduction of the single currency and the start of the crisis is associated with divergences in relative cost competitiveness within the euro area. In a simulation that maintains relative unit labour costs at their 1998 levels, aggregate current account imbalances (measured as the sum of absolute current balances of individual euro area countries divided by two) increase from 1% of euro area GDP in 1998 to a maximum of 1.8% in 2007 just prior to the crisis, as compared with an actual maximum of 2.6%. These calculations are illustrative only, as the direction of causation between competitiveness and the current account runs both ways.

Since 2007, total-economy relative unit labour costs of euro area countries under financial market stress have come down, bringing current account deficits down with them. Greece and Ireland are already back to their 1998 competitiveness levels relative to the rest of the euro area – that is, back to the level prevailing at the beginning of monetary union. Portugal and Spain need only an extra 5-7% reduction in relative unit labour costs to reach this benchmark. Italy has not reduced relative unit labour costs since the crisis, and they remain 15% higher than in 1998, though a small decline in absolute unit labour costs is projected to occur in 2014. Much of the falls in total-economy unit labour costs may be due to cuts in public-sector employment and wages, however, with smaller adjustments in tradable sectors and thus in external competitiveness. Also, a significant part of the improvement in external balances in these euro area countries since 2007 is related to a collapse in economic activity. Correcting for its much weaker cyclical position as compared with its trading partners, Spain’s cyclically-adjusted current account deficit in 2012 is estimated to be 3.3% of GDP (as opposed to a projected 2%), with similar adjustments for Greece, Ireland, Italy and Portugal (see chart). Thus, a generalised recovery in the euro area with no further changes in competitiveness and relative domestic demand would imply some re-emergence of current account imbalances.

Current account balances in euro area countries under financial market pressure

In per cent of GDP

Under the hypothesis of 3% nominal GDP growth.

OECD Economic Outlook 92 database and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932742684

Despite the relative competitiveness of countries under market pressure approaching 1998 levels, not only do cyclically-adjusted imbalances remain, but external debt has increased substantially in these countries. Hence, simply attaining relative competitiveness positions within the euro area at 1998 levels would probably be insufficient to restore sustainable external positions. Only Ireland has a current account balance that, once adjusted for its relative cyclical position, is consistent with reducing net external debt to 35% of GDP in the next two decades, assuming nominal GDP growth of 3%. Being based on a simple framework, this assessment leaves out other important considerations in the sustainability of external positions, such as the evolution of relative competitiveness outside the euro area, the interest rate paid on foreign liabilities, or the influence of non-price competitiveness. It also abstracts from the contribution that fiscal consolidation will make to external adjustment, which is set to be large in the countries concerned. Even so, adjustment costs are likely to be substantial before external balances are sustainable, even if much adjustment has already occurred.

Improvements in competitiveness relative to countries outside the euro area, achieved through a depreciation of the euro exchange rate, might do little to help imbalances within the euro area as they would probably boost the pre-existing imbalances in surplus countries by more than they would reduce the imbalances in deficit countries. Even so, euro depreciation would contribute towards the external sustainability of Greece, Portugal and Spain, although estimates from this framework suggest that the boost to the current account from an improvement in competitiveness relative to countries outside the euro area is only about one-third of that from an equivalent percentage improvement in competitiveness relative to countries within the area.

Being relative adjustments, changes in competitiveness within the euro area could occur through further reductions in unit labour costs in countries under financial stress, but they could just as well occur through increases in unit labour costs in the rest of the euro area, or a combination of the two. Higher inflation in surplus countries, together with a rebalancing of spending toward domestic demand, would indeed help reduce euro area imbalances with or without further declines in unit labour costs in deficit countries. A 23% increase in unit labour costs relative to the rest of the euro area would be needed in Germany to restore 1998 relative competitiveness levels, for instance. If rebalancing takes place only in the countries under financial market stress, the costs would be very high as downward adjustments to relative wages and prices in these countries are currently occurring through economic weakness and high unemployment.

Euro area countries experiencing financial market pressure can reduce such adjustment costs by making their labour market more flexible. Studies indeed show that the output/employment costs of reducing inflation tend to be lower in countries that have more flexible labour markets, for instance less restrictive employment protection laws. Greece, Portugal and Spain have relatively inflexible labour markets (Venn, 2009), so efforts already under way in these countries to make labour markets more flexible are steps in the right direction, although greater labour market dynamism could lead to larger employment losses in the short term.

More broadly, other structural reforms can also help improve competitiveness by boosting productivity. Employment protection legislation reforms, in addition to lowering the employment costs of restoring competitiveness, could raise productivity by between ½ and 1¾ per cent over 10 years in Italy, Spain, Greece, Portugal and Ireland (Bouis and Duval, 2011). The scope for product market reform in many of the euro area countries where competitiveness needs to improve further is also considerable. OECD estimates suggest that for Italy, Spain, Greece and Portugal, fast implementation of product market reforms could raise productivity by 3-4% over five years and 7-8% over 10 years. For productivity improvements to be reflected in lower unit labour costs, wages would have to rise by less than productivity, but this is more likely to occur in economies where demand conditions are very depressed and unemployment high, as is the case now where financial market pressures are greatest.

Finally, and as mentioned above, the countries with the largest current account deficits also tend to be those with the largest fiscal deficits. Ongoing fiscal consolidation in these countries has already reduced current account deficits substantially. While fiscal consolidation efforts must be balanced against growth concerns in the short term, ambitious medium-term fiscal targets would help to ensure a continued reduction in current account imbalances once recoveries are under way. Relative to a scenario in which all countries undertake up to ½ percentage point of GDP of fiscal consolidation per year to stabilise debt-to-GDP ratios, an alternative scenario in which gross debt-to-GDP ratios are gradually reduced to 60% – with up to 1 percentage point of GDP of consolidation per year – could improve current account balances by 1½ percentage points of GDP in Spain, 2 percentage points in Italy, 4 percentage points in Ireland, 4½ percentage points in Portugal and 7½ percentage points in Greece. Such current account improvements would come only gradually, but would make a substantial contribution to external sustainability and reduce the need for further adjustments to cost competitiveness.

While the simple framework used here does not allow for the likely interaction between policy channels, it does suggest that a combination of reforms in Greece, Ireland, Portugal, Spain and Italy to make both product and labour markets more flexible, inflation well in excess of 2% in the rest of the euro area over several years, and ambitious fiscal adjustment could substantially facilitate the rebalancing process and so reduce the extent to which the burden of adjustment is reliant on further prolonged demand weakness.

… in both external deficit economies…

• For those countries in which large external deficits have built up, durable adjustment requires both a reduction in domestic spending and a depreciation of the real exchange rate. Against the backdrop of low inflation in the euro area as a whole, the required relative price changes and expenditure switching will likely take time, but can be expedited by structural reforms that enhance product and labour market flexibility, and facilitate the necessary reallocation of resources and adjustment of prices and wages required to regain external competitiveness. Structural reforms are also essential to boost productivity growth and enhance the quality and variety of exportable goods and services. In addition, higher trend growth will help ease debt dynamics.

… and external surplus economies

• For countries with long-standing external surpluses, domestic spending needs to increase and resources to be switched from tradable to non-tradable sectors via an appreciation of the real exchange rate and higher relative returns on capital in the service sectors, driven by structural reforms. Adjustment will likely imply higher domestic wages, private consumption and residential investment. It will also imply higher inflation than in the run-up to the crisis, given the need for improved competitiveness in the external deficit economies and close to target area-wide inflation.

The required economic adjustment has begun…

The required adjustment process is underway in most deficit countries, with spending being reduced by increases in household saving, reduced housing investment and fiscal consolidation. This has been accompanied by an acceleration of structural reforms.*

There is a strong cross-country correlation between the intensity of ongoing fiscal consolidation efforts and responsiveness to structural reform priorities in recent years (OECD, 2012a).

… with cost competitiveness adjusting…

The necessary adjustment in intra-area cost competitiveness is also underway, although not yet complete. The unit labour costs of many of the external deficit countries have started to decline and by 2014 relative costs within the euro area are projected to be more closely aligned with those in 1998, when the value of national currencies against the euro were fixed (). Even so, to bring relative costs in external deficit countries to levels consistent with external debt stability during normal cyclical conditions (), further adjustment in relative costs in the external deficit economies is needed, either through domestic developments or developments in surplus countries, to regain competitiveness against other euro area members and against increasingly important potential competitors from emerging markets (Chen et al., 2012).

Euro area unit labour costs are adjusting

1998 = 100

The figures shown are for whole economy unit labour costs. If wage developments in the public sector diverge from those in the rest of the economy, changes in private sector costs may differ from those shown. This may mean that economy-wide labour costs are falling more sharply than private sector costs in the EU/IMF programme countries.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743007

… and imbalances starting to unwind

The adjustment that has taken place in relative costs has contributed to the signs of progress in reversing cross-border imbalances. Intra-area trade imbalances have continued to narrow in the first half of 2012, with sharp declines in domestic demand in the EU/IMF programme countries and Spain helping to bring about a marked improvement in their aggregate external trade balances and the private sector involvement in debt restructuring in Greece reducing net income payments abroad. Some of these developments stem from structural factors, with Ireland, Spain and Portugal broadly maintaining or improving their export market share between 2009 and 2014, and a gradual stabilisation of Italian and Greek export performance after losing market share for many years (). Nonetheless, the underlying external balances of the traditional external deficit countries are somewhat weaker than their headline balances, given the depressed state of domestic demand in these economies relative to their trading partners (see ).

Export market performance is improving in some countries

2004 = 100

Export performance refers to the ratio of export volumes and export market growth.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743026

EU-wide initiatives could help to foster growth

The political and social challenges involved in the adjustment process would be smoothed if adjustment could take place against a background of stronger area-wide growth. Structural reforms underway in some of the deficit countries could increase output significantly, with OECD estimates for the ultimate increase in GDP due to reforms in Italy and Greece amounting to about 4½ and 10 per cent, respectively (OECD, 2011, 2012f). Actions at the European level to foster area-wide potential growth could help to speed up rebalancing and generate a more propitious environment in which to undertake structural reforms. Several initiatives were announced in the Compact for Growth and Jobs at the end-June European Council meeting. The additional financial assistance in the package,*

The financial measures comprise: additional capital to raise the lending capacity of the European Investment Bank; new Project Bonds worth up to EUR 4.5 billion for key infrastructure projects; and a commitment to reallocate some structural funds to support innovation projects, SMEs and employment initiatives.

Adverse feedback loops need to be blocked

Deep imbalances within the euro area and weaknesses in its institutional set-up have led to several adverse feedback loops that threaten the survival of the monetary union. Firstly, solvency fears for banks and their sovereigns have fed on each other due to implicit or explicit government guarantees for banks and bank holdings of government bonds. Secondly, concerns about the possibility of exit from the euro area have pushed up sovereign yields, which in turn have reinforced breakup fears and increased yields further. Thirdly, worries about government debt levels have driven yields up and growth down, which has weighed further on debt dynamics. To terminate the crisis, it is essential to overcome all three interactions.

The bank-sovereign loop can be arrested…

The negative feedback loop between banks and government finances reflects a number of serious weaknesses in the euro area financial system and its robustness. In particular, European banks are often heavily reliant on non-deposit sources of funding and not sufficiently well capitalised to deal with large negative shocks, although the situation has improved a little this year as a result of the successful EU-wide exercise to raise capital buffers in the banking sector. Banks thus depend on explicit and implicit guarantees from national authorities. This forces individual governments to inject capital into their banks to save the banking system when large negative shocks occur, but the accompanying weakening of public finances raises yields on government bonds, which in turn impose losses on bank holdings of sovereign debt on top of the operating losses associated with weaker activity.

… by strengthening bank balance sheets…

The feedback loop between sovereign and bank balance sheets would in principle cease to operate if banks were seen to be so well capitalised that they could withstand further sovereign weakness. Even though EU banks have brought their ratio of Core Tier-1 capital to 9% of risk-weighted assets as requested by the European Council in October 2011, confidence in the euro area banking system remains weak. Indeed, the ratio of Core Tier-1 capital to un-weighted total assets in euro-area banks falls well short of 5%, identified as a benchmark for well-capitalised banks (see e.g. Blundell-Wignall and Atkinson, 2012). If the largest banks in the euro area were all to respect such a minimum standard, which is more demanding than the minimum Basel III leverage ratio scheduled to become mandatory in 2018, they would need to raise additional capital at some stage. At the present time, the capital shortage with respect to a 5% standard is estimated at around EUR 400bn (4¼ per cent of euro area GDP), with large capital increases necessary in banks in both core and vulnerable countries (see ). Raising capital through retained earnings may be made harder by bad loan losses, which may increase substantially from current surprisingly low levels in some countries. Hence, it is likely that national governments would have to provide some of the extra capital if such a capital standard is to be achieved and especially if it is to be achieved quickly. However, in the current environment, such capital injections by national governments may not be feasible in countries where public deficits and debt are high, limiting the scope to use such measures to block the bank-sovereign loop in the near‑term. Nonetheless, it remains essential to address the capital shortage of euro area banks in the coming years.

Estimated additional capital needs in large euro area banks

This box presents estimates of additional capital needs of large banks in the euro area so as to attain a minimum leverage ratio in each bank of 5%, i.e. Core Tier-1 capital being at least equal to 5% of total assets not weighted by risk. A 5% leverage ratio has been recommended by the OECD and is close to the median leverage ratio of the largest US and European banks (Blundell-Wignall and Atkinson, 2012; Blundell-Wignall and Roulet, 2012). To derive the estimates, a bottom-up approach is employed by first assessing the capital addition required for each individual bank to reach a leverage ratio of 5% and then adding up the needs for the banks that are currently under-capitalised based on this yardstick to obtain national and area-wide estimates of additional capital needs. The estimates are based on consolidated bank balance sheets which are prepared on an IFRS basis and refer to the latest available information. It should be underlined that a 5% leverage ratio does not currently form part of the internationally agreed Basel III framework, which expresses capital requirements in terms of risk-weighted assets, with a 3% leverage ratio to be introduced as a backstop from 2018.

On the basis of the 5% leverage ratio, the capital shortage in the large banks in the euro area amounts to around EUR 400bn or 4¼ per cent of GDP in the euro area (see figure below). Relative to GDP, the required injections are 6% or more in Greece, France and Belgium, whereas additional capital needs are estimated to be less than 2% of GDP in Portugal, Italy, Austria and Spain.

The euro area banking system: Core Tier-1 capital additions required to reach 5% of total assets in each large bank

In per cent of GDP

Based on around 200 euro area banks. The number of banks in the sample for each country displayed and the corresponding number of banks with less than 5% leverage ratio (in brackets) are as follows: Austria 19 (8), Belgium 9 (4), Finland 5 (3), France 8 (8), Germany 60 (30), Greece 9 (4), Ireland 10 (2), Italy 33 (8), Netherlands 9 (5), Portugal 8 (0) and Spain 27 (8). The euro area refers to the countries displayed.

Company Reports, OECD.

Statlink http://dx.doi.org/10.1787/888932742703

There are some caveats to these estimates. For example, a 5% leverage ratio calculated on the basis of IFRS standards is a more demanding benchmark for banks in the euro area, because derivative positions are accounted for on a gross basis, than is the 5% leverage ratio considered by the US Federal Deposit Insurance Corporation (FDIC) as a criterion for well capitalised banks in the United States, where these positions are netted out. Also, these estimates do not incorporate additional capital to cover potential future losses nor do they incorporate increases due to changes in the definition of Core Tier-1 capital under Basel III to be implemented by 2018.

The Basel III leverage ratio is based on Tier-1 and not Core Tier-1 capital.

… but will most likely require a full multi-pillar banking union

A banking union of the euro area countries would be desirable even with better capitalised banks. At current levels of capital it is indispensible to overcome the bank-government feedback loop at the national level. For this purpose, a banking union would have to consist of 4 pillars and go well beyond the steps currently being discussed:

• Joint bank supervision to counter the moral hazard embedded in joint fiscal backstops and to reduce the risk of excessive risk taking in the banking system as a whole.

• A joint bank resolution framework so that the same rules and processes apply to the closing or restructuring of failing banks throughout the euro area once a single supervisor decides that corrective action is needed.

• A joint deposit guarantee scheme to limit the risk of national bank runs.

• A joint fiscal backstop so that in the event of a corrective action being needed, the possible associated fiscal costs are shared among all members and not limited to the sovereign where the bank is located. Various options for a backstop of this kind can be considered, including pre-funded schemes, ex-ante agreements on burden sharing and contingent taxation. The possibility for the ESM to directly recapitalise banks represents an embryonic backstop (see below).

The planned single supervisory system will not break the loop…

The decision in June to create a single supervisory system for euro area countries is a first step towards a banking union. The European Commission’s proposal from September was for a transfer of key supervisory authority, starting on 1 January 2013, and encompassing all banks in the euro area by the start of 2014, to a Single Supervisory Mechanism, with the ECB having the ultimate authority. The subsequent decision of the European Council on 18 October was that the relevant legislative framework would be agreed by the start of 2013, with work on the operational implementation required to ensure centralised supervision taking place in the course of 2013. Although it remains uncertain how this system would work in practice, notably the interaction between the ECB and national supervisory authorities, and how quickly effective central supervision can be implemented, it should strengthen effective supervision of banks inter alia by reducing the risk of supervisory forbearance at the national level. However, the centralisation of supervision is unlikely on its own to block fully the feedback loop between weak banks and weak sovereigns.

… and the direct recapitalisation of banks by the ESM has yet to be made effective

On the other hand, the decision taken in June, and reinforced at the October European Council meeting, that the ESM could possibly recapitalise banks directly (rather than via the government) once an effective single supervisory mechanism is established could sever such links. In practice, potential procedural hurdles, such as the required unanimity of all Eurogroup members on any action, and uncertainty over interpretation, such as whether the agreement covers only new banking problems or also legacy problems and when an effective single supervisory mechanism can be said to be in place, cast some doubt on whether it will do that.

A complete bank union is needed for the long term; direct ESM injections into banks are necessary in the short term

The Single Supervisory Mechanism and an effective joint fiscal backstop need to be complemented by adding a joint bank resolution regime and a joint deposit guarantee scheme. Such institution building should be expedited but will inevitably take time. In the meantime, to block the adverse feedback between national government finances and bank balance sheets, it is necessary to swiftly implement the decision on direct capital injection by ESM into banks in such a way that it can address problems inherited from the past. Even then, there are some doubts about the adequacy of available resources for bank recapitalisation by the ESM, given other commitments.

The feedback loop between exit risk and bond yields can be stopped…

As long as investors believe that exit is possible or even likely, sovereign bond yields will include a currency-conversion risk premium which will go up with – and raise – the exit probability. This instability is likely to be a key reason why the bond yield spreads of fiscally stressed euro area countries have increased considerably more than might be expected given past relationships between public indebtedness and risk premia. It has also counteracted monetary policy transmission in the fiscally weak countries, as indicated by very high bank lending rates in some of the vulnerable countries (see ) despite very low monetary policy rates.

… by the ECB’s OMT scheme…

These deleterious effects of exit risks prompted the ECB to introduce the Outright Monetary Transactions (OMT) scheme. For eligible countries, the scheme involves purchases of short-term (up to 3 years maturity) sovereign bonds without limits in order to remove the exit risk premia in bond yields and without seniority claims. Eligibility is limited to countries that have established either a macroeconomic adjustment programme or a precautionary programme with the EFSF or ESM; in either case the programme could involve primary bond market purchases by the EFSF/ESM. Continued ECB bond purchases in the secondary market would be dependent on countries fully respecting programme conditionality. It remains to be clarified how the mechanism would operate if there was a failure to comply with conditionality, as interruption of support would spark financial instability in the sovereign debt market with possible contagion effects.

... but vulnerable countries need to enter programmes for it to be fully effective

Sovereign bond yields in Spain and Italy fell sharply after the announcement of the OMT scheme in early August, especially at shorter maturities. Even though the benefits of programme entry should have increased with the OMT, the Italian and Spanish authorities have not indicated that they will seek a programme, although this would be likely in the case of Spain if yields were to move up again significantly. Apart from possible stigma effects and political costs, reluctance to enter programmes might also reflect concerns about hardening attitudes of would-be creditors and the potentially more onerous conditionality required for programme entry. The unanimity required for an EFSF/ESM programme gives those advocating strict conditionality a strong hand. In contrast, programme applicants have little bargaining power since they have to publicly instigate discussions. However, even in the absence of actual programme entry, the OMT scheme has reduced exit risks by creating the option of programme entry. It has accordingly put limits on how far the feedback between exit risk and bond yields can go, but as long as vulnerable countries do not enter a programme their bond yields will remain higher than otherwise. The benefits of programme entry, including sizeable cuts in borrowing costs for the public and private sectors alike, and the costs of abandoning a programme should increase its credibility. At the same time, the decision-making process for a programme should be made as quick and smooth as possible to avoid adding uncertainty and possibly sparking negative market reactions.

The feedback loop between high debt and yields can be arrested by the Fiscal Compact

Debt levels that are large and seen as set to grow further normally translate into high yields. In usual circumstances, such reactions by markets provide a useful disciplining mechanism, but this feedback can also become destabilising because higher bond yields will make debt dynamics more unsustainable. In the context of the euro area, this may create area-wide spillovers. Destabilisation is particularly likely because market discipline had been largely absent for many years, leading some countries to run up high debts, before it asserted itself with a vengeance. Indeed, more recently markets may have over-reacted in pricing risk. Over the long run, explicit means of coordination such as the Fiscal Compact and the updated Stability and Growth Pact (SGP) should in principle ensure that debt does not reach levels raising questions about sustainability – though past experience with the SGP suggests caution. In the near term, given the high level of legacy debt and the limited resources available through the EFSF/ESM, the temporary mutualisation of debt above a certain threshold, subject to conditionality, might be a means of impeding this feedback loop (Sachverständigenrat, 2012).

The costs of inaction are high

Inaction, or weak and chequered progress in implementing the measures necessary to instill greater confidence in the survival of monetary union, would intensify the adverse feedback mechanisms discussed above. The resulting heightened sovereign and banking stress could plunge the euro area into a deep and protracted recession, with serious implications for the world economy. These developments are discussed below against the background of a stylised scenario.

Bond yields would rise significantly in many countries…

• The intensified concerns that would appear about sovereign debt sustainability in countries already under market pressure would have potentially dire consequences for public finances and the banking sector. The stylised scenario set out below incorporates a rise of 300 basis points in 10-year government bond yields in the countries under greatest market pressure in the euro area relative to the baseline projection. This is broadly consistent with the scale of the increase in yields seen in recent episodes of significant deterioration in market sentiment,*

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

  but could be an over-estimate if market participants, and hence market prices, already assign a non-zero probability to such an outcome.*

  There might also be an offsetting effect from a decline in the 10-year government bond yields in Germany, reflecting a flight-to-safety, but this is not incorporated in the scenario below.

… with adverse effects on debt dynamics, credit growth, output and confidence…

• Intensified sovereign stress would significantly worsen debt dynamics in the euro area and further weaken confidence in public finances and growth prospects. Banks’ balance sheets would be hit by the large decline in the market value of sovereign bonds issued by the countries affected, likely resulting in widespread bank deleveraging and very tight credit conditions. Economic growth would weaken further, accentuating the already elevated social costs of high and rising unemployment in the euro area, and private sector confidence would plummet. Repeated interaction of these forces would result in a deep downward spiral in the euro area economy.

… triggering similar effects around the world

• An intense euro area crisis would have large adverse spillover effects around the world through trade, confidence and financial channels (see also ). On the financial side, equity prices would fall elsewhere, especially for firms with large sales in the euro area and financial institutions that face losses on their investments in the euro area. In turn, this would damp credit growth elsewhere and heighten risk aversion, putting downward pressure on all assets seen to be relatively risky and reducing the willingness to be exposed to all but the most safe counterparties.

The global consequences would be large

Some illustrative estimates of the possible impact effects of one particular euro area scenario are set out in . Although highly stylised and only illustrative, with many simplifying assumptions, this scenario highlights the potential scale of the counteracting policy action required if it were to occur (such actions are not included in the scenario), and the urgency of implementing fully the policy actions necessary to minimise the chances of it occurring. Key features of the stylised scenario include: large falls in the level of output in the OECD economies relative to the baseline projection (), especially in the euro area where GDP levels could decline by over 6%, with declines of around 5% in GDP levels in the United States and Japan if worldwide financial stress resulted; further large increases in unemployment; the level of world trade plummeting by up to 11% relative to the baseline projection by the latter part of 2014; and likely deflation in many OECD economies by 2014. In a worst-case situation, this downside scenario could be strongly amplified by the turmoil that would likely result if one or several euro area countries were forced to (re-)establish their own national currencies.

A stylised downside scenario in the euro area

The scenario set out in this box provides some illustrative indications of the possible economic effects resulting from one particular stylised downside scenario in the euro area. It assumes that sovereign and banking stress in the euro area intensifies significantly relative to that in the baseline projection, with confidence and financial conditions deteriorating, intensifying financial stress in the rest of the world. The scenario does not allow for the exit of any member state from the euro area, which would further deepen the economic impact.

Given the likely global nature of the downturn and likely widespread financial market contagion that could result, the 2008-09 crisis provides a basis for calibrating possible developments in the downside scenarios. 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. 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 conventional 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 300 basis points in the countries under greatest market pressure in the euro area, broadly in line with past experience following major changes in financial market sentiment.

A broad picture of the possible near-term outcomes and effects if such a downside scenario were to occur is provided by simulations on NiGEM, the global macroeconomic model of the National Institute of Economic and Social Research. The model permits 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. However, it does not allow for possible additional effects that might arise were private sector confidence to plummet throughout the world.

In simulations 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. The simulations also incorporate a 40% decline in equity prices (again reflecting the pattern of changes between the latter half of 2007 and the first quarter of 2009) and the stylised rise of 300 basis points in long-term government bond rates in the countries under greatest market pressure in the euro area. 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) and inflation expectations are held constant. Budget solvency rules are turned off, so that the full effect of the downturn is reflected in the automatic stabilisers in all economies. Two sets of results are shown below. In the first, the shocks are applied only to the euro area, with spillovers to other countries primarily stemming from trade linkages. In the second set of results, global financial contagion is incorporated as well, magnifying the impact of the euro area shocks.

Given the very-weak projection for area-wide activity in the forecast baseline, the simulation results (see table below and ) point to a likely prolonged and increasingly deep recession in the euro area in the absence of any discretionary counteracting policy responses, with additional increases in unemployment adding to the already-high social costs of adjustment in many countries. The OECD as a whole would move into recession, with marked declines in activity in both the United States and Japan, with the adverse impact of the euro area shock on US activity rising considerably if it is accompanied by global rather than localised financial market weakness. Business investment would be particularly weak in the worldwide shock, declining by around 20% over two years in the United States and Japan, and by more than a quarter in the euro area. China and other emerging market economies would not be immune from this shock, with global trade volumes some 10 to 11% lower than baseline after two years, and the value of their international asset holdings being hit by weaker equity prices.

Disinflationary forces would intensify, with deflation likely occurring in many OECD economies by 2014, given the already low level of inflation in the main projection and the gradual extent to which rising economic slack generates disinflationary pressures. Unemployment would also rise sharply, by over 2 percentage points in the OECD economies by 2014. If euro area governments made efforts to stick to their announced fiscal objectives for the headline budget balance, the necessary further ex-ante fiscal tightening would exceed 1% of GDP in 2013 and 2¼ per cent of GDP in 2014. If such a policy was pursued, the large adverse multiplier effects would intensify the adverse near-term effects on growth considerably.

If exchange rates were allowed to adjust in these simulations it could change the balance of the different activity effects for different economies somewhat. In particular, the euro exchange rate could be expected to depreciate, which would ease the adverse activity effects by the raising external competitiveness of euro area exporters. In contrast, the activity impact would be likely higher in other economies, given the appreciation of their currencies relative to the euro.

In a situation of extremely high financial stress and heightened risk aversion it might also be that a generalised flight to safety could lower government bond yields somewhat in the United States and perhaps Germany. Such effects are not incorporated in the simulations presented here, but could alleviate the overall hit to activity in these countries a little.

A stylised euro area downside scenario: macroeconomic model simulation results

differences from baseline

Statlink http://dx.doi.org/10.1787/888932744223

GDP growth in the baseline and a downside scenario

Per cent

OECD calculations.

Statlink http://dx.doi.org/10.1787/888932743045

The monetary policy stance has been eased

In the large OECD economies where short-term policy rates are at near-zero levels and where the recovery has faltered or has only moderate momentum, central banks have recently further expanded the scale of already adopted unconventional tools and introduced some new measures. Central banks in several other OECD and non-OECD economies have cut short-term interest rates.

An accommodative policy stance will need to be maintained…

Looking forward, and as described above, inflationary pressures seem likely to be weak, with economic growth only moderate relative to potential in most OECD and many non-OECD economies, and serious downside risks looming large. This warrants at least the continuation of the current accommodative monetary policy stance, with interest rates close to zero in most OECD countries and asset purchase programmes implemented as planned. Further monetary stimulus is warranted in the euro area and also in some emerging economies.

... but in a downside scenario more monetary stimulus would be necessary

If severe downside risks to growth and inflation were to materialise, further monetary stimulus would need to be implemented, using unconventional and, where possible, conventional policy measures. Large-scale liquidity provision with a long maturity could help to support financial markets and asset purchase programmes should be expanded. In countries with already low government bond yields, additional purchases of government debt are likely to have diminishing returns and moves to purchase additional private sector assets might be needed. In view of the near-fiscal nature of such intervention, it should, if it becomes necessary, be accompanied by government guarantees and be undertaken in a transparent way, with principles being established for the types of assets to buy. Programmes which directly incentivise banks to lend, like the fund-provisioning measure undertaken in Japan and the UK Funding for Lending Scheme, could also be introduced to expand credit supply.

Monetary policy should remain highly expansionary...

Outside such a downside scenario, the key policy requirements in the major economies consistent with the projection are as follows:

... in the United States…

• In the United States, given the modest economic outlook and the risk of a more negative outcome, the Federal Reserve’s current quantitative easing programme and the lengthening of the period at which current low interest rates are expected to be maintained are appropriate.*

  In June, the Federal Reserve decided to continue through the end of 2012 the programme to extend the average maturity of its holdings of securities (known as Operation Twist) which was scheduled to end in June. The Federal Reserve’s first and second asset purchase programmes and Operation Twist amount together to 20% of GDP. In September, it committed to purchase mortgage-backed securities at the rate of $40 billion per month (3% of US GDP per year) until the outlook for the labour market improves substantially.

  However, if the economic situation were to turn out significantly worse than expected, the Federal Reserve should further expand the size of its purchases of government and mortgage-backed securities and start purchasing other types of assets if necessary to ease financial conditions.

… Japan…

• In Japan, the current zero-interest-rate policy needs to be maintained until inflation is firmly positive. To speed up this process, the Bank of Japan should also undertake further measures, including expanding the scale of the asset purchase programme beyond its current size of 91 trillion yen (19% of GDP) after the cumulative 21 trillion yen increase in September and October. More forceful action would be required if further downside risks were to materialise.

… the euro area…

• In the euro area, there is a need for easier monetary conditions given the prospects for weak economic activity and growing disinflationary pressures. Hence, the ECB should lower its refinancing rate by a further 25 basis points, possibly in conjunction with a negative deposit rate, and issue forward guidance on maintaining the accommodative policy stance for a long period. The effectiveness of lower policy rates will be enhanced if large differences in intra-euro area financial conditions can be diminished, including via the OMT programme. In case of severe turmoil, liquidity provisions and broad-based purchases of assets should be expanded.

… and the United Kingdom...

• In the United Kingdom, following the expansion of the asset purchase programme by £50 billion (taking the total to £375 billion – 25% of GDP) and the introduction of the Funding for Lending Scheme,*

  The scheme is intended to boost lending to households and businesses. It involves swapping UK Treasury bills for less liquid assets, thereby allowing banks and building societies to obtain funding for up to 4 years at below currently elevated market rates.

  the current monetary policy stance is appropriate to help reduce slack in the economy and ensure that the inflation target is met in the medium term. If growth were to deteriorate significantly, a further expansion of the asset purchase scheme would be required.

… and ease further in China…

• In China, where monetary policy easing has so far been relatively modest*

  Since May, the benchmark rate and the required reserve ratio have been cut in China by 56 and 50 basis points respectively. In addition, large liquidity injections have been provided, reducing short-term market rates.

  given recent declines in inflation and likely moderate inflation pressures ahead, there is scope to ease monetary conditions further. In conjunction with moves to allow more flexibility of the renminbi, this should help reduce the risk of activity being weaker than projected and help to rebalance the economy. The rebound of the property market signals a potential need for macro-prudential policies to avoid future overheating in housing markets. There would be considerable scope to ease monetary policy forcefully in case of much weaker growth, even if potential growth rates are in the process of declining.

... and India but not in Brazil

• In India, the central bank could adopt a more accommodative stance, looking through temporary increases in regulated petroleum prices, unless inflation remains elevated and signs emerge that potential growth is lower than previously thought. In Brazil, following interest rate cuts over the past year (5¼ percentage points in total), the current monetary stimulus appears appropriate to ensure GDP growth close to potential and hence to sustain inflation close to the middle of the target band over the medium term.

Risks related to unconventional policy should be addressed

Even though unconventional monetary stimulus is currently required and may have to be expanded further in the future, it involves negative risks. Keeping long-term rates very low for a long period could delay necessary deleveraging, prompt excessive risk taking and resource misallocation, and also allow zombie banks and enterprises to survive. Furthermore, purchases of private-sector assets might entail additional risks, such as greater public concern about fairness and the increased vulnerability of central bank balance sheets to asset price fluctuations. The materialisation of these risks might eventually jeopardise public support for central bank independence. Some of the risks could be contained by prudential policies and stricter financial supervision (see below), and central banks could prepare for possible losses on the purchased assets in co-operation with governments, for example by raising net assets or obtaining guarantees against the losses. Even so, in event of a severe downturn, the benefits from expanded unconventional monetary policy measures would most likely be higher than their potential future costs.

The consolidation path needs to depend on the state of the economy

With the recovery of economic activity projected to be weak and surrounded by significant downside risks, fiscal policy decisions over the next two years need to balance two main challenges. On the one hand, there is an urgent need for a large majority of OECD countries to implement credible fiscal consolidation programmes that put government finances on a sustainable path and reduce financial vulnerabilities. At the same time, the pace of consolidation must take into account the state of the economy and the adverse effects of fiscal policies on aggregate demand, with fiscal multipliers at present likely to be higher than in normal times (see above). Thus, budgetary outcomes should be allowed to deviate from announced consolidation plans if economic activity turns out to be temporarily weaker than assumed, with the scope for deviation depending on fiscal positions and market pressures. For countries with impaired public finances acting alone, there is only limited scope to stretch out the path of consolidation without further losses to credibility in financial markets. However, it may be both possible and desirable to let automatic stabilisers work around the structural adjustment path as part of a more general and co-ordinated approach. At the same time, there is some scope for fiscal easing or postponement of structural adjustment in countries with relatively healthy public finances. In particular, there would be a need to temporarily ease fiscal tightening or even provide fiscal stimulus if serious downside risks materialise. The projection discussed above is based on the assumption that, where announced, consolidation plans will be implemented in structural terms in all countries, but not necessarily in nominal terms.

Fiscal consolidation will be widespread but debt ratios are likely to continue drifting up in many countries

In the baseline projections, the OECD area-wide fiscal deficit is expected to fall by about 1% of GDP in both 2013 and 2014, with the improvement more than accounted for by planned consolidation measures, partly offset by rising interest payments (). Gross government debt in terms of GDP is set to continue drifting upwards in most OECD countries, although at a declining rate, with 2014 debt-to-GDP ratios projected to reach 114% in the United States, 103% in the euro area and 230% in Japan. Earlier calculations by the OECD indicate that, based on plausible assumptions about medium-term growth and interest rates, reducing debt ratios to pre-crisis levels or to more comfortable levels of some 60% of GDP would require improvements in underlying primary balances of several percentage points in most OECD countries, with consolidation episodes likely to extend over several more years.*

See Chapter 4 in OECD (2012b).

Fiscal positions will improve only slowly

Per cent of GDP / Potential GDP

Statlink http://dx.doi.org/10.1787/888932744185

The key fiscal policy requirements are...

The fiscal policy assumptions employed in the projections are based on government programmes in most cases, though normative assumptions have been made, conditional on the projections, where there is particular uncertainty about the likely evolution of budget policy, which mainly concerns 2014 (see ). The policy requirements in the United States and Japan are as follows:

... in the United States, removing policy uncertainty...

• In the United States, budgetary policy in the short and medium term remains uncertain. Current legislation still implies an extremely sharp fiscal tightening in 2013, amounting to close to 4% of GDP, with the extensions of the 2001-03 tax cuts set to expire and automatic expenditure reductions set to be implemented, lowering GDP growth by at least 2 percentage points compared with the projection (CBO, 2012). Thus, there remains an urgent need to avert a potential sharp negative shock and remove risks that would undermine private spending. At the same time, the constitutional debt ceiling needs to be raised in a timely and orderly way to avoid serious disruptions. The assumption adopted here is that a bipartisan agreement in Congress brings about fiscal consolidation amounting to 1½ per cent of GDP in 2013. Against the background of very large consolidation needs, and with the economy projected to strengthen further, consolidation amounting to 1½ per cent of GDP would appear to be justified, and has been assumed, in 2014. However, if downside or upside risks materialise, the automatic stabilisers should be allowed to work fully. Potentially adverse reactions in financial markets would be reduced if political stalemate on the appropriate design of the needed medium and long-term fiscal retrenchment could be overcome. It is in any case necessary to establish agreed detailed medium-term consolidation plans to maintain confidence in fiscal probity and thereby avoid the risk of destabilising increases in government bond yields.

... in Japan, establishing a detailed and credible programme to attain the authorities’ medium and long-term fiscal goals...

• In Japan, on currently announced government policy, the underlying primary deficit is projected to decline in 2013 by ½ per cent of GDP, with the headline deficit increasing to around 10% of GDP. In 2014 the underlying primary balance is projected to strengthen very substantially, by 2½ per cent of GDP, mainly due to the increase in the consumption tax rate and a freeze in non-reconstruction spending by the central government in fiscal year (FY) 2013-14. While in itself such abrupt tightening may seem undesirable, this should be seen as a step towards Japan meeting its FY 2015 target of bringing the primary budget deficit of local and central governments, excluding reconstruction spending, to 3.2% of GDP. However, additional measures are required to attain the long-term goals of achieving a primary budget surplus by FY 2020 and putting the public debt ratio on a downward path from FY 2021. Given the risks associated with the extraordinarily high sovereign debt ratio, a more detailed and credible medium-term fiscal consolidation programme needs to be established. High indebtedness limits the room for manoeuvre in event of a negative shock to allowing automatic stabilisers to work.

... in the euro area, implementing planned structural consolidation and allowing the automatic stabilisers to work...

In the euro area, fiscal policy is set to be very tight in the current and coming years in the countries under market pressure. Fiscal consolidation in 2013 and 2014 combined is largest in Greece, Ireland, Portugal and Spain, totalling 3¼, 3¾, 4½ and 3¼ percentage points respectively. Fiscal consolidation plans have been reinforced by new consolidation measures, mostly on the spending side, in some of the programme countries in order to meet deficit targets against lower growth prospects (). These measures will create additional headwinds to activity in the short run. Such pro-cyclical fiscal tightening is in principle undesirable, but each programme country has, on its own, little room for manoeuvre. Moreover, the weak growth that is projected in the OECD’s baseline scenario undercuts the growth assumptions embedded in the current consolidation programmes of many other European countries, notably the national Stability and Convergence Programmes presented at the level of the European Union. In this environment, it would be appropriate for the economies in the euro area to consolidate in line with the improvement in underlying balances embedded in current programmes while taking no action to offset budgetary shortfalls arising from weaker economic activity than assumed in current plans. This departure from current nominal plans should be agreed at the level of the European Union for all countries concerned; a series of separate national announcements would be much more likely to trigger adverse market reactions. In a number of countries, including Portugal and Spain, nominal consolidation targets have already been revised, in agreement with the European Commission, amid the economies’ deep recession and shortfalls in tax receipts.*

In Portugal, targets for headline fiscal balances under the EU excessive deficit procedure have been relaxed by 0.5 and 1.5 percentage points for 2012 and 2013, respectively, so as to reach a general government deficit of 3% in 2014. Similarly, in Spain, the targets were relaxed by 1 and 1.5 percentage points for 2012 and 2013 so as to reach a general government deficit of 2.8% in 2014. In Italy, the government has announced that it aims to attain the 2013 consolidation target for the structural general government balance rather than the nominal target.

Expenditure versus revenue-based consolidation plans¹

2013-14, 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 92 database.

Statlink http://dx.doi.org/10.1787/888932743064

... which is equally relevant for the United Kingdom

In the United Kingdom, with the budget deficit and government debt still high, fiscal policy remains appropriate. The present stance has secured credibility as demonstrated by very low government bond yields. If growth underperforms expectations, the automatic stabilisers should be allowed to operate around the structural consolidation path in line with the fiscal framework, even though this may imply pushing out the debt target.

Fiscal policy needs differ across emerging economies including…

In emerging market economies, fiscal policy settings and requirements differ:

… China…

• In China, fiscal policy has become more supportive of demand this year, with the general government budget deficit projected to amount to 2% of GDP in 2012, compared with approximate balance in 2011. Public expenditure has grown more rapidly this year, reflecting both higher social spending and rising government infrastructure spending, as local authorities commence implementing projects agreed under the current Economic Plan. With the general government budget deficit projected to remain around 2% of GDP in 2013-14, and given the low public debt ratio, there remains much scope for counter-cyclical fiscal policy action in case of a weakening of the economy.

… India…

• In India, the government has planned for modest fiscal consolidation in fiscal year 2013. With the government deficit projected to remain close to 8½ per cent of GDP, consolidation appears necessary to help reduce inflation, ease current account pressures and promote more balanced growth. The high deficit limits the scope for fiscal stimulus if serious risks were to materialise. The room to manoeuvre could be even more constrained if potential growth rates turn out to be lower than hitherto assumed.

… Brazil...

• In Brazil, the effects of strong fiscal stimulus are helping to gradually lift the economy out of a patch of below-trend growth. Over the projection period, fiscal policy is expected to be guided by the government’s overall primary surplus target, with the aggregate general government budget deficit settling at around 1¾-2 per cent of GDP in 2013-14. There appears to be space for further fiscal stimulus if serious risks were to materialise.

… and the Russian Federation

• In the Russian Federation, the draft budget for 2013 includes a rule intended to constrain spending by limiting the use of oil revenues to those generated at a reference price of $91 per barrel. On this basis, a balanced budget is projected for both 2013 and 2014. In case of a serious negative shock, there would be sufficient space for a discretionary fiscal stimulus.

The composition of consolidation needs to take account of equity implications

Continued consolidation is increasingly being challenged on the grounds that spending cuts and tax increases are considered inequitable, highlighting the need for fiscal retrenchment to be seen as being fair. Indeed, some of the most frequently employed consolidation instruments tend to widen the static income distribution if not designed carefully (OECD, 2012h). This applies in particular to spending on welfare, pensions, health care and education and to consumption taxes. Concerns about equity impacts have already prompted changes in the composition of consolidation. For example, in France a shift has taken place from spending restraint and indirect tax increases to income tax increases, in particular for higher incomes. In Portugal, the government has had to revise consolidation measures so as to avoid raising employees’ social security contributions. These changes reflect the necessity for balancing the immediate impact of consolidation on the distribution of income and its effect on growth in the long term. Some consolidation instruments, notably reducing distortionary tax shelters that benefit high-income and wealthy individuals, could be employed more extensively to achieve a fair, growth-friendly consolidation. However, such instruments apart, it is a challenge to calibrate the composition of policy packages so as to attain the best balance between near-term activity, long-term efficiency and equity objectives ().

The redistributive impact of tax and transfer-based consolidation

The overall redistributive impact of taxes and transfers depends on the progressivity of each instrument, the weight of each instrument in the tax and transfer system and the overall size of the tax and transfer system. Thus, governments can exercise a certain degree of discretion about the redistributive impact of their consolidation strategies by choosing particular combinations of spending reductions and revenue increases, or by changing the progressivity and size mix of transfers and taxes.

This is illustrated by the redistributive impact of two polar consolidation strategies. For both strategies it is assumed that the government targets a deficit reduction of 3% of GDP. The first strategy relies entirely on raising  direct   household   taxes   and   the   second   on   cutting    cash    transfers    to    households.   The   exercise   is based on the size and progressivity of taxes and transfers as of the late 2000s (see Joumard et al., 2012). It is assumed that the change in taxes and transfers is proportional across all deciles in each of the two calculations and that market income is not affected. More generally, no behavioural response is considered. As the example shows (see figure below), the required tax increases reduce income inequality, measured by the Gini coefficient, in all OECD countries, although to varying degrees. Similarly, if the same consolidation outcome is to be achieved via reductions in transfers, inequality increases in all countries, to different degrees and with absolute changes in inequality usually higher than in the case of tax increases. Cross-country differences in impacts reflect pre-existing differences in the progressivity of individual instruments and in their relative size. Any combination of changes in taxes on the one hand and transfers on the other hand would moderate the redistributive impact of consolidation in comparison with exclusive changes in either taxes or transfers, respectively. Changes in progressivity of particular instruments would also change the redistributive impact of the consolidation package.

Impact of 3% consolidation on income inequality

The impact of the tax change on the Gini coefficient for Switzerland is slightly positive but has been set to zero.

OECD calculations based on Joumard et al. (2012) and OECD Income and Poverty Distribution database.

Statlink http://dx.doi.org/10.1787/888932742722

In some cases, cuts in transfers can be designed and supplemented by structural measures in a way that minimises adverse distributive impacts or even avoids them entirely, though possibly at the price of a delay in consolidation. In particular, raising the effective retirement age would be a preferential consolidation measure, as it will increase labour force participation and thus boost income for some persons who otherwise would have received a pension instead, but will produce budgetary savings only very gradually. Reform in the education and health care systems should also rank high on the policy agenda in that it can produce large consolidation gains without compromising equity or service quality. However, such reform would require meticulous programme planning and implementation to be effective and avoid disadvantaging the less well-off. Cuts in unemployment-related benefits and disability benefits would likely hit poorer people in the first place, especially if weak economic activity prevents an offsetting rise in employment. However, if designed properly and supplemented with coherent activation strategies, such adverse effects can be offset by higher employment once the economy adjusts.

On the revenue side, cutting certain tax expenditures can increase both equity and economic growth and should be given high priority. Higher taxation of immovable property, which is taxed at a lower rate than other assets in most countries, appears broadly consistent with equity objectives and belongs to the tax increases that are least harmful to long-term growth. However, to be effective, additional measures might be needed that could increase near-term administrative costs, such as proper valuation of property. Raising other property taxes would be beneficial for equity, although potentially at the cost of negative growth effects. Increasing consumption taxes would be regressive from the perspective of the static income distribution, although much less so from a lifetime perspective as over their lifetime people spend more of what they earn. If increases are broadly based, little damage might be done to lifetime income equity and growth. Higher capital income taxes would be positive for equity. They can be distortive with respect to growth, but are more worth considering when capital income is taxed at a significantly lower rate than labour income. Raising labour income taxes can enhance equity in the short run, but would likely reduce growth in the long run.

It is necessary to complete international commitments in the areas of...

It is essential to keep up the momentum of making the global financial system more transparent, less complex and less risky. Progress so far has been uneven and more remains to be done.

... banks’ capital adequacy...

• The implementation of new Basel III capital regulations is progressing, and the additional capital needed to ultimately meet this requirement has fallen, though it still remains large (BIS, 2012b). However, there are concerns that national and regional implementation will be weaker than globally agreed standards in some key areas, such as the definition of Core Tier-1 capital. The discretion of banks in determining their capital needs through the use of their own internal risk models is another concern.*

  For large banks, risk weights are derived at discretion from banks’ own internal risk models which allows banks to use derivatives to shift financial assets and liabilities to avoid capital and obscures comparison across banks. There is a growing empirical literature showing the predictive superiority of leverage over capital ratios – see for instance Haldane (2012) and Blundell-Wignall et al. (2010).

  Indeed, risk-weighted asset calculations create extensive scope for regulatory arbitrage. Greater emphasis on a minimum leverage ratio, which is only a backstop measure in Basel III once it becomes mandatory in 2018, and increasing the ratio from 3% to a more demanding standard*

  For instance, Haldane (2012) argues that a ratio of above 7% would have been needed for the world’s largest banks to protect them against failure in the current crisis. See also .

  would limit the scope for such regulatory arbitrage. That said, on its own, such a standard may strengthen incentives to engage in high-risk, high-return activities.

... too-big-to-fail institutions...

• Notwithstanding some progress in developing living wills, national resolution regimes for too-big-to-fail financial institutions often fall short of the international standard set by the Financial Stability Board. At the same time, structural separation between low-risk retail banking activities and riskier banking activities is being pursued at the national and regional level. While structural separation is welcome, the diversity of opinions on the most appropriate structural separation, as reflected in three recent proposals,*

  In the United States, the Volcker rule bans proprietary trading. In the United Kingdom, the Vickers report proposes a separation of deposit-taking from investment banking. In the euro area, the Liikanen report advocates legally separating certain particularly risky financial activities (those closely linked with proprietary trading of securities and derivatives) from deposit-taking banks in the European Union.

  could lead to an undesirable fragmentation of the global financial market.

... shadow banking institutions...

• Global and national oversight of shadow banking institutions has been strengthened and work is in progress to tighten regulation of money market funds and other shadow banking institutions. However, more transparency is needed in this area.

... OTC derivatives reforms...

• Some progress has been made in OTC derivatives reform, especially in countries and regions where most derivatives trading takes place. However, the G20 commitment that all standardised derivative contracts should be traded on exchanges or electronic platforms and cleared through central counterparties by end-2012 is set to be missed.

... and accounting standards

• Progress in convergence of accounting standards for the valuation of financial instruments is taking longer than expected in some areas. No progress has been made on harmonising accounting standards on the netting/offsetting of derivatives contracts.

The recovery remains sluggish

Economic activity increased at an annual rate of about 2 per cent in the first three quarters of 2012. Private consumption increased moderately, but growth in business investment softened noticeably, likely owing to caution in the face of uncertainty about the US fiscal outlook and developments in Europe, as suggested by weak business confidence indicators. By contrast, household confidence has been relatively buoyant, moving up close to its pre-recession average. GDP growth in the second half of this year will be held back by drought-related losses in farm output and disruptions related to Hurricane Sandy, but these effects should be reversed early next year.

Labour market and wealth

OECD Economic Outlook 92 database, U.S. Federal Reserve and the Bureau of Economic Analysis.

Statlink http://dx.doi.org/10.1787/888932743862

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744242

Conditions in the housing sector have improved noticeably…

The housing market has shown noticeable improvement, with home sales rising steadily and house prices up more than 7% since the start of the year. Although stronger housing demand will boost residential investment, the still-high levels of vacancies and foreclosure sales are likely to restrain construction activity for some time.

… but foreign demand has weakened

After rising at a solid pace in the first half of this year, both exports and imports decelerated sharply in the third quarter. The slowing of exports is in large part due to weaker foreign demand, although the temporary effects of the drought may also have played a role.

Budget deficit and inflation

Includes all levels of government as well as social security funds and non-profit institutions that are controlled and mainly financed by government.

OECD, Economic Outlook 92 database and Datastream/ Michigan Surveys of Consumers.

Statlink http://dx.doi.org/10.1787/888932743881

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744261

The labour market recovery has proceeded slowly

Recovery in the labour market has been slow, with payrolls expanding below their long-run average pace. The unemployment rate was little changed for most of the year before dropping below 8% in October, more than 2 percentage points below the peak in 2009. The modest pace of job creation so far this year has occurred against a backdrop of continued weakness in the participation rate, which stands near its lowest levels since the 1980s.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744280

External indicators

Statlink http://dx.doi.org/10.1787/888932744299

The withdrawal of fiscal support will weigh on the recovery…

Further reductions in the large federal budget deficit are necessary to restore fiscal sustainability, but the pace of consolidation should be gradual so as not to derail the already weak recovery. The projection assumes that current law is amended to limit the reduction in the underlying primary deficit to about 1½ per cent of GDP in each of 2013 and 2014. Even so, growth in disposable income will be restrained significantly by the withdrawal of fiscal support.

…and accommodative monetary policy is warranted

In September, the Federal Reserve extended to at least mid-2015 its conditional commitment to keep the policy rate close to zero and announced a further round of quantitative easing focused on mortgage-backed securities. With significant slack in resource utilisation and inflation expectations appearing well anchored, this highly accommodative stance of monetary policy is warranted.

Improvements in financial conditions will support aggregate demand

Household balance sheets continue to improve, with equity values recently returning to near cyclical highs and home prices showing a sharp and sustained upturn. The gains in net wealth, coupled with low interest rates and a continued easing in lending conditions, should contribute to a pick-up in aggregate demand going forward.

Growth will pick up after next year and inflation will remain low

The pace of output growth is projected to be little better than potential next year but then to strengthen gradually to above 3% in mid‑2014. The output gap is projected to narrow to 2½ per cent by the end of 2014, and improvements in the labour market to bring the unemployment rate down to 7½ per cent over the same period. Given the abundant slack in the economy, underlying price inflation is set to remain below 2%, although wages may move up a bit more rapidly as the labour market continues to firm.

The looming fiscal cliff and euro area risks are of major concern

If unresolved, the fiscal cliff would generate a significant drop in activity in 2013. In addition, the potential credit market disruptions associated with the ongoing crisis in the euro area remain a major concern. On the other hand, the continued easing in financial conditions could release pent-up demand that drives a quicker than expected normalisation of economic activity.

The economic recovery following the earthquake paused in mid-2012...

The deceleration in world trade in the third quarter of 2012 and the persistent strength of the yen stalled exports, one of the main drivers of the recovery from the March 2011 disaster. Domestic demand also slowed, in part as the phasing out of government subsidies to promote car purchases weakened private consumption. The worsening external and domestic conditions led to a fall in business sentiment among large manufacturers.

Industrial production and confidence indicators

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

A survey of workers, such as taxi drivers and shop clerks, whose jobs are sensitive to economic conditions. The index ranges from 100 (better) to 0 (worse), with 50 indicating no change.

Diffusion index of ''favourable'' minus ''unfavourable'' 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 economy watchers index where there are no projections, numbers for the fourth quarter are companies' projections made in September 2012.

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

Statlink http://dx.doi.org/10.1787/888932743596

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744318

... despite support from public reconstruction spending

The expansion has been underpinned by the 17 trillion yen (3.6% of GDP) allocated for public reconstruction spending. Such spending, though, is expected to peak in 2012. Although planned tax increases over the next 25 years, as well as spending cuts and non-tax revenues, will eventually cover the cost, reconstruction outlays are exacerbating the current fiscal predicament. The budget deficit is projected to remain close to 10% of GDP (excluding one-off factors) in 2012-13, pushing public debt further into uncharted territory.

The government plans to raise the consumption tax rate to 10% by 2015

In August 2012, the Diet approved a hike in the consumption tax rate in two stages, from 5% to 8% in April 2014, and to 10% in October 2015, conditional on an improvement in economic conditions. The additional revenue will partly go to financing swelling social spending due to population ageing and partly to reducing the budget deficit. Combined with ongoing spending restraint, the government may achieve a consolidation of more than 2% of GDP in 2014, enabling it to meet its objective of halving the primary budget deficit (for central and local governments, excluding reconstruction spending) from 6.4% of GDP in FY 2010 to 3.2% in FY 2015. However, additional measures are needed to achieve the government’s goals of a primary budget surplus by FY 2020 and putting the public debt ratio on a downward trend from FY 2021. The large increase in the consumption tax rate is welcome, but is just a first step to restore fiscal sustainability.

Car sales and deflation

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

Japan Automobile Dealers Association and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743615

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744337

The Bank of Japan has taken further steps to support the economy

The Bank of Japan has maintained the policy interest rate at close to zero, while expanding quantitative measures to counter the economic slowdown. By October 2012, it had increased the size of its asset purchase programme to 91 trillion yen (19% of GDP) to be attained by the end of 2013. Nevertheless, deflation continues, as the core consumer price index (excluding food and energy) fell by 0.6% in the third quarter of 2012 (year-on-year). In October 2012, the government and the Bank of Japan released a joint statement expressing their commitment to pursuing policies, notably measures to boost Japan’s growth potential and monetary easing, to overcome deflation.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744356

External indicators

Statlink http://dx.doi.org/10.1787/888932744375

Japan’s expansion is expected to resume from 2013…

As world trade growth rebounds, output growth is projected to pick up to around ¾ per cent in both 2013 and 2014, despite the waning contribution from reconstruction spending. Domestic demand will be restrained by the planned hike in the consumption tax rate as well as temporary surcharges on income to finance reconstruction spending, although the economic impact of higher tax rates is likely to be partially offset by a fall in the household saving ratio. Deflationary pressures are also likely to remain headwinds for growth through 2014.

… although there are many risks, both domestic and external

Any decision to delay fiscal consolidation could result in a run-up in long-term interest rates, with risks for both the banking sector and fiscal sustainability. Japan’s future energy supply also remains a question mark, as 48 nuclear reactors (out of a total of 50) remain closed for the time being. On the external side, developments in the euro area crisis, which has contributed to the yen’s strength, and in China, Japan’s largest trading partner, pose both upside and downside risks.

The economy is in recession

Output is falling owing to weak confidence in the ability of policy makers to take decisive action to resolve the sovereign debt crisis. Household consumption, business investment and government spending are all contracting, and export demand is weakening. Headwinds created by simultaneous fiscal consolidation in almost all euro area countries and private sector deleveraging in high-debt economies have spread through the financial system to weaken confidence in all euro area countries.

GDP and loan interest rates

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

Interest rates on new loans up to EUR 1 million and for one year.

Datastream and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743330

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744717

Financial conditions are difficult

The sovereign debt crisis in the euro area has led to an adverse feedback loop between sovereigns and banks. This has impaired credit in some euro area countries and reduced the effectiveness of monetary policy transmission.

High debt burdens will prompt deleveraging

The high burden of household and corporate debt in some euro area economies requires deleveraging, holding back consumption and investment. House prices are still falling in many euro area countries. These pressures coupled with high exposures to sovereigns will continue to create difficulties for domestic banking systems so long as bank balance sheets have not been strengthened sufficiently.

Unemployment and foreign assets

2010 for Belgium, France, Ireland, Portugal and the euro area.

IMF, International Financial Statistics and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743349

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744736

A rebalancing of demand is underway but is incomplete

High-debt economies experienced a significant decline in competitiveness in the run up to the crisis. This needs to be reversed to shift resources from domestic to exporting sectors. Some progress has been made in the necessary adjustment of relative prices in both debtor and creditor economies. However, adjustment is far from complete, raising unemployment rates, especially in countries with rigid labour markets.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744755

External indicators

Statlink http://dx.doi.org/10.1787/888932744774

The financial system needs to be repaired

A robust pick-up in growth will require strengthening the financial system. The ECB Outright Monetary Transaction (OMT) programme provides an instrument to stabilise sovereign debt markets, but will only be fully effective if vulnerable countries rapidly fulfil the conditions required for it to operate. A full banking union, including progress towards common financial backstops and crisis resolution, would reduce the sovereign-bank feedback loop. To block this pernicious link until a banking union is established, direct capital injections into banks by ESM should be swiftly implemented in a way that legacy assets can be addressed. Further measures are required to clean up bank balance sheets and ensure that the banking system is well capitalised.

Fiscal consolidation should proceed

The projection assumes that all euro area countries reach their fiscal consolidation targets in terms of the structural deficit. Should growth fall short of what is assumed in budget plans, the automatic stabilisers should be allowed to work around the structural consolidation path, implying that headline deficit targets would be missed. If serious downside risks materialise, countries with fiscal space should engage in temporary discretionary stimulus.

Weak inflationary pressures warrant further policy easing

Weak growth is projected to increase unemployment rates from their high levels. The large margin of excess capacity will put downward pressure on underlying inflation, while headline inflation is also set to fall in the near term as the effect of past energy price increases dissipates. Weak inflationary pressures and on-going financial market tensions warrant a further reduction in monetary policy rates. Moreover, the ECB should issue forward guidance that, subject to growth and inflation developments, it will hold rates low for a long period. If downside risks materialise, further non-standard measures will be necessary.

The period of economic weakness is likely to persist

The economy is projected to remain in recession into 2013, as domestic demand continues to fall. Growth will return in 2013, but only slowly as private demand will remain fragile and fiscal consolidation will continue.

An insufficient policy response remains a major risk

The risks around this projection are on the downside. The main risk is that policy makers will not make sufficient progress in addressing the crisis, including: a failure to create the conditions to mobilise OMT; a failure to restore the financial sector; and insufficient progress on structural reforms in both debtor and creditor countries. Unexpected events could cause a crisis in individual euro area countries, with incalculable consequences. More rapid progress on policy measures, however, might lead to an improvement in financial conditions and a stronger turnaround in consumption and business investment.

Activity is slowing as export markets weaken

Economic activity weakened in the second half of 2012 as foreign demand, especially from other euro area economies, fell markedly. Demand for investment goods, in which German manufacturing is specialised, has been especially weak, reflecting the scaling back of investment plans both domestically and abroad. While incoming orders and confidence indicators point to subdued business prospects in manufacturing and retailing in the near term, low mortgage interest rates and rising house prices are boosting residential construction.

Wage growth and easy monetary conditions will sustain domestic demand

Job creation has slowed, although unemployment remains close to historic lows. The share of long-term unemployment in total unemployment remains large and supply shortages for some skills have emerged, indicating that labour markets have tightened. This is boosting wage growth, which should support household demand over the projection period. While stock market indices have risen markedly, lending growth has so far remained modest, as uncertainty about the resolution of the euro area debt crisis has kept confidence low. The spread between lending rates and policy rates is relatively high and commercial banks raised their reserve holdings at the European Central Bank following the increase in euro area sovereign debt tension in July. However, very low monetary policy rates and the abundant liquidity generated by the safe haven character of German financial assets are expected to support domestic demand over the projection period, as confidence strengthens and short-term interest rates decline further.

Manufacturing and housing market

Seasonally adjusted inflow of manufacturing orders in volume terms.

Statistisches Bundesamt ; Deutsche Bundesbank and OECD calculations.

Statlink http://dx.doi.org/10.1787/888932743235

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744394

Labour market and stock market

Population aged 15-74 years. Based on the German labour force survey.

Percentage of unfilled job vacancies relative to the labour force.

Deutsche Bundesbank ; Statistisches Bundesamt.

Statlink http://dx.doi.org/10.1787/888932743254

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744413

Some budget consolidation is expected in 2013

The budget deficit is expected to be close to zero in 2012. Although the weak pace of economic activity is projected to raise the deficit slightly in 2013 and 2014, underlying consolidation is expected to continue in 2013, as stimulus measures introduced in earlier years are phased out and spending on pension and active labour market policies falls. These spending cuts are to be offset by reductions of social security contributions in 2013 as well as by transfers to families who chose not to use publicly funded childcare facilities and some reductions of personal income taxes to offset the impact of past inflation on tax burdens, to be introduced in 2013 and 2014.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744432

Exports and domestic demand are projected to strengthen gradually

Economic growth is projected to pick up gradually in the course of 2013 as export markets recover. Improving export prospects and confidence as well as favourable financing conditions will boost investment. Consumer spending will benefit from real wage increases and solid household balance sheets. The unemployment rate is projected to rise somewhat in 2013 but will remain close to 5½ per cent. The costs of producing renewable energy as well as strengthening domestic demand and wage growth are projected to keep consumer price inflation close to 2% in 2013 and 2014, while the current account surplus may fall to 5¼ per cent in 2014.

The euro area crisis poses the main risk to the outlook

If stress in euro area sovereign debt markets remains high, German exports may not recover to the extent projected and domestic bank balance sheets could deteriorate, tightening financing conditions. By contrast, as confidence returns the rebound in German manufacturing and exports could be larger than projected.

Economic activity has stalled

Real GDP has been almost flat for more than a year. Despite labour hoarding, unemployment is rising rapidly, which is weighing on private consumption. Business surveys paint a bleak picture, but hard indicators are less gloomy. External imbalances persist, with both the trade and current account deficits at about 2% of GDP, reflecting structurally weak competitiveness.

The construction sector is particularly affected

The construction sector continues to deteriorate. Lower credit demand is driving a sharp decline in new mortgages. Having already fallen about 3% from their 2011 peak, house prices are likely to retrench further. As lending policies have been cautious, the quality of mortgages is good, but could weaken substantially as unemployment rises.

GDP and investment

Year-on-year growth rates.

6-month moving average of year-on-year growth rates.

OECD Economic Outlook 92 database; INSEE; Banque de France.

Statlink http://dx.doi.org/10.1787/888932743387

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744451

The new government is committed to restoring public finances

Despite renewed cyclical weakness, the government is set to meet its 2012 target for the general government deficit of 4.5% of GDP. The fiscal framework has been substantially strengthened, including through the creation of a fiscal council to be tightly integrated with the Court of Accounts. This, together with the government’s resolve to correct the deficit, strengthens credibility. However, how the council’s influence develops will be important in the longer run.

Fiscal consolidation and trade

Maastricht definition.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743406

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744470

Its short-term goals are ambitious

Based on the budget law, which relies on optimistic growth assumptions of 0.8% and 2%, respectively, in 2013 and 2014, the headline deficit would fall to 3% of GDP in 2013 and 2.2% in 2014, and the structural deficit would be close to zero. However, the implied cumulative reduction in the structural deficit of 2.6 percentage points of GDP, which is built into the OECD projections, is ambitious, given current headwinds, and automatic stabilisers should be allowed to play fully.

The 2013 consolidation relies on higher taxes...

According to government plans, the 2013 deficit reduction results almost exclusively from higher household and business taxes. Those on personal income are targeted at the top end of the distribution, which may limit their negative effects on demand. Although tax increases might be easier to implement and less prone to social turmoil that might unnerve financial markets, ultimately public spending must be curbed.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744489

... while restraining spending is crucial

The ratio of public spending to GDP is very high, and reducing it will be an important part of a strategy to rebalance the economy towards exports. Extending the government’s overview of public-sector efficiency to all levels of public administration will be key. Considerable savings could be made on health care without impairing quality. Streamlining the structure of sub-national governments and increasing incentives to better control local governments’ spending could also generate substantial savings.

Deep reforms would boost confidence

Fiscal efforts, ECB action and more serious problems elsewhere in the euro area have helped to reduce the cost of debt financing. Implementing broad structural reforms covering education and product and labour markets would help maintain confidence and strengthen France’s economic prospects. There is also ample room to rebalance the tax structure by lowering social contributions, eliminating inefficient tax expenditures and increasing property, inheritance and environmental taxes. The recently announced Competitiveness Pact is an important first step in this direction and would support job creation, investment and exports as of 2014.

Growth will be weak and unemployment will rise

Real GDP is projected to increase only slowly. Residential investment is likely to be a drag while low profit margins and high levels of firms’ indebtedness could limit the pick-up in business investment. The unemployment rate may rise sharply in the coming quarters before stabilising at the end of 2013 at 11¼ per cent. Extended slack should reduce inflation below 1½ per cent in both 2013 and 2014. With automatic stabilisers allowed to play fully, the fiscal deficit is projected to be 3.4% of GDP in 2013 and 2.9% in 2014.

Uncertainty remains huge

Targeting the headline (rather than the structural) deficit might have significant adverse effects on activity in the short term, compounding any further growth weakening, especially if insufficient structural reforms cast doubt on France’s ability to reduce its imbalances. On the other hand, should confidence improve, a faster decline in the household saving rate from its currently high level would quicken the recovery.

Reforms have improved Italy’s long-term prospects

The government has taken action to tackle the twin problems of low economic growth and high public debt. Recent reforms of product and labour markets, once fully implemented, should help to lift the economy out of the stagnation it has experienced over the past decade. The ongoing spending review will contribute to needed fiscal consolidation, and the constitution has been amended to provide for a balanced-budget rule. Actions on the euro area level have helped, too. The announcement by the European Central Bank of the Outright Monetary Transactions scheme for countries that have established a programme with the EFSF or ESM had the immediate effect of reducing excess risk premia related to exit risks in Italian sovereign bond yields.

Output and confidence indicators

Excluding Cyprus and Malta.

Excluding construction.

ISTAT and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743558

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744508

But the economy is now in a double-dip recession

While these actions have been able to avert downside tail risks so far, Italy entered its second severe recession in three years. Fiscal consolidation of nearly 3% of GDP this year weakened domestic demand, and private consumption has been falling at the steepest rate since the Second World War. Business confidence is low. The economic slowdown has put pressure on the financial sector: non-performing loans are high and rising, liquidity conditions are tight and lending standards have become stricter.

Interest rates and unemployment

The vertical line indicates the date of the European Central Bank's OMT announcement (6 September 2012).

10-year benchmark government bond yields. Last observation: 14 November 2012.

Datastream and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743577

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744527

Public debt is projected to rise significantly through 2014

Several measures during the second half of 2012, including raising municipal property tax and enacting recommendations of the spending review, should help to reduce the deficit from last year’s 3.8% of GDP. However, it is set to exceed the 2.6% of GDP projected by the government. For 2013 and 2014, the projection assumes that the government will meet its target of structural balance. Nevertheless, given the OECD macroeconomic outlook, both the deficit and public debt will continue to rise over the projection period.

The recession is likely to continue into 2013

With confidence and financial conditions gradually improving, GDP is projected to begin to rise in the course of 2013. Fiscal consolidation, the rebuilding of household savings and low business confidence will hold back growth. Since the beginning of the double-dip recession, the current account balance has improved, reflecting primarily falling domestic demand and, therefore, imports.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744546

Slowing wages and prices will improve competitiveness

Despite the large fall in output over the past year, employment has stayed remarkably robust so far, although unemployment has risen on account of higher participation. Continued economic weakness is projected to raise the unemployment rate to close to 12% by 2014. This will slow wage growth and reduce consumer price inflation. This improvement in competitiveness will, over time, boost exports.

Risks to the outlook are mainly tilted to the downside

One major source of uncertainty relates to the commitment of the post-April 2013 government to maintain the course on fiscal consolidation and growth-friendly structural reforms. Backing off either would damage market sentiment and growth. Another risk is that the fiscal balance improves less than projected in 2012, despite measures introduced in the second half of the year. Furthermore, an intensification of financial stress and unduly rapid bank deleveraging might accentuate the credit squeeze and further damp growth. On the upside, the improvement in the orientation of structural policies may lift confidence, investment and labour market performance earlier than envisaged.

The economy faces strong headwinds

Continuing weakness in the global economy and deep, but necessary, fiscal consolidation, continue to drag down growth. The sharp depreciation of sterling over recent years has failed to rebalance the economy and lift exports by as much as expected, as the euro area has fallen back into recession. Weak demand and confidence, tight credit conditions and the bleak world economy translate into low investment. Household deleveraging, and income gains that have been eroded by inflation, have weighed on household spending. The considerable slack in the economy is projected to keep inflation below 2%.

Confidence indicators and unemployment

Quarter-on-quarter.

Refers to domestic orders.

Real GDP divided by total employment.

OECD Economic Outlook 92 database and the British Chambers of Commerce.

Statlink http://dx.doi.org/10.1787/888932743425

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744565

The labour market shows surprising resilience

While unemployment has increased since mid-2011, the rise is moderate relative to output losses and employment growth has been strong in 2012. Falling productivity has been accompanied by subdued real wage growth and increased part-time employment, which has limited job losses. High youth unemployment is nonetheless of great concern, notwithstanding some recent declines, and continued stagnation of the economy could worsen the situation. Active labour market policies are focused on the necessary prevention of young people not in employment, education or training from dropping out of the labour force, with lasting economic and social consequences.

Earnings and savings

1. Year-on-year percentage changes.

2. Refers to compensation of employees divided by hours worked.

3. Four-quarter moving averages. Corporate net lending excludes the transfer from the Royal Mail pension fund to the government.

OECD Economic Outlook 92 database and Office for National Statistics.

Statlink http://dx.doi.org/10.1787/888932743444

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744584

The flexibility of the fiscal framework should be utilised if growth disappoints

With the budget deficit (excluding temporary factors) at over 8% of GDP and gross government debt at over 80% of GDP, fiscal consolidation is necessary to restore the sustainability of public finances and will strengthen medium-term growth prospects. The fiscal stance remains appropriate, and is supported by the strong institutional framework. The flexibility of the fiscal framework should be utilised if growth significantly underperforms expectations. With clear plans for medium-term fiscal consolidation in place, the fiscal mandate allows automatic stabilisers to play and potentially leaves room for changing the composition of expenditure to focus further on long-term growth-enhancing public investment, including in infrastructure. The government’s fiscal policy stance and strong institutions have secured the confidence of financial markets, as evidenced by the near-record low government bond yields.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744603

External indicators

Statlink http://dx.doi.org/10.1787/888932744622

Monetary policy should remain supportive

With the policy rate at 0.5% and quantitative easing at £375 billion (25% of GDP), monetary policy is appropriately providing strong support to the economy. The Funding for Lending Scheme in place since July 2012 is expected to provide incentives to banks to increase domestic lending through cheap funding. Reserve and collateral requirements have also been reduced to increase credit supply. However, constrained aggregate demand and house price uncertainty continue to limit credit demand.

The economy is projected to gradually accelerate in 2013

Output growth has been broadly flat over the past year, but strong headline growth in the third quarter of 2012 was consistent with moderate underlying expansion. Real GDP growth is projected to rise gradually during 2013 as falling inflation boosts purchasing power and private consumption, and a brighter international environment supports exports and investment. Notwithstanding strong employment growth in 2012, unemployment is expected to rise slightly to 8.3% in 2013 owing to the subdued recovery and high uncertainty.

Structural reforms should boost growth over time

The government has committed to implementing a number of reforms which, if implemented fully, will boost both short and long-term growth. Increasing the state pension age in line with longevity will foster long-term fiscal sustainability. Implementing the recommendations of the Independent Commission on Banking will strengthen the financial system. The Universal Credit will reduce disincentives to work, and government training and apprenticeship programmes will contribute to a better integration of young people into the labour market and enhance the availability of skilled workers. The planning reform and further support to the housing market and infrastructure should allow construction to grow.

Risks are mainly on the downside

A weaker world economy would endanger export growth at a time when domestic demand is still weak. Global financial turmoil might result in tighter financial conditions, while blows to household and business confidence may lead to increased precautionary saving and lower investment. Higher food and energy prices would lower purchasing power, hindering the recovery in consumption. A stronger than expected world economy would revive exports, investment and confidence. Corporate balance sheets are strong and households’ leverage has been reduced, providing scope for rapid expansion should economic prospects improve.

Growth has slowed but may be rebalancing...

Activity moderated in the second half of 2012 to below the estimated potential growth rate. This reflected a softening of commodity prices, which curtailed profits and investments in the fast-growing resource sectors. The strength of the housing market, which had been hardly interrupted at all during the global economic and financial crisis, has by most measures started to diminish following recent regulatory tightening of mortgage lending terms. Tight budgets have also begun to kick in. At the same time, the high Canadian dollar and ongoing global weakness have undermined exports and manufacturing in particular. Employment growth has held up well, however, and remained concentrated in full-time work, although productivity gains have been correspondingly small. The main growth driver is expected to continue to be non-housing investment, given highly favourable financial conditions and increasingly healthy corporate balance sheets.

GDP and housing market

Downward movements in the FCI capture tighter financial conditions, which are therefore consistent with weaker economic activity; upward movements represent improving financial conditions, consistent with stronger economic activity.

Bank of Canada, Teranet - National Bank National Composite House Price Index and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743140

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888932744641

… and inflation is muted

Given slower growth and the strong exchange rate, core consumer price inflation has softened so far this year. Headline inflation has moderated even more, thanks to some easing in prices for oil and other non-food commodities. The recent drought in the United States and neighbouring Canadian regions points to upward pressures on Canadian food prices (which are expected to rise by 3-4% in 2013), but their impact on headline inflation should be limited by the small weight (16%) of food in the Canadian consumer basket. Inflation is projected to rise to near 2% by the end of the projection horizon, as slack is used up.

Household income and government spending

Change in real government spending on goods and services divided by real GDP in previous year.

Statistics Canada; OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743159

Financial indicators

Statlink http://dx.doi.org/10.1787/888932744660

Fiscal consolidation is largely on track

Budgetary consolidation is underway, and the federal and most provincial governments appear to be on track to achieving their medium-term targets, although with a slight delay because of slower economic growth. The federal government is seeking to return to surplus by 2016-17, one year later than initially budgeted, while Ontario intends to move from a deficit of 2.2% of provincial GDP to a small surplus by 2017-18. Most of the federal and provincial adjustments are taking place on the spending side. Federal direct programme spending will be virtually frozen in real terms over the five-year planning period and federal employment will fall by nearly 5%. Provinces with large structural deficits will face a more difficult task. The Ontario government has negotiated two-year pay freezes with 10 000 public service managers and the province’s 25 000 doctors, and is pursuing similar agreements with teachers and other unionised public sector workers. Public sector spending restraint at all levels will be a significant drag on growth but is necessary to bring the government’s spending share of GDP back to pre-crisis levels and to put public debt back on a sustainable path.

Demand and output

Statlink http://dx.doi.org/10.1787/888932744679

External indicators

Statlink http://dx.doi.org/10.1787/888932744698

Monetary policy remains highly supportive

Monetary policy and financial conditions continue to be highly accommodative. With a well functioning policy transmission mechanism, output has grown comparatively rapidly through much of the recovery, and Canada’s estimated output gap is the smallest in the G7 countries. Hence, above-trend growth could cause inflation pressures to re-emerge. The Bank of Canada has indicated that some withdrawal of the currently considerable policy stimulus may become appropriate to ensure the medium-term inflation target of 2%. Signs of stress in household balance sheets following the prolonged period of low interest rates are also a matter of policy concern. Given the central projection, the Bank should begin to tighten in the latter half of 2013.

Downside risks preponderate

If the euro zone crisis continues unresolved, Canadian growth could be negatively affected via the trade, financial market and confidence channels. But the US economy is critical for Canada, and the risks there appear to be better balanced. The dominant domestic risk is that of renewed momentum in housing demand and house prices, aggravating existing imbalances. Continuing high household debt levels could lead to a sharp deceleration in household spending, while a sudden weakening of the housing market could have sizable negative spillover effects.

Although solid, activity has slowed down

Sustained at the beginning of the year by rebounding production in the wake of natural disasters in 2011, growth moderated in the second half of 2012, probably settling at roughly 3¾ per cent in 2012. Economic conditions remain disparate from sector to sector. The mining investment boom continued despite the receding terms of trade. Apart from the mining and transport sectors, the business climate is challenging, particularly in construction. Job creation has slowed, and the unemployment rate increased slightly, to 5½ per cent in September 2012. Despite the introduction of a carbon tax in July, headline and core inflation remained contained between 2 and 2½ per cent in the third quarter of 2012 because of low import prices and under-utilisation of resources, including in the labour market.

Monetary conditions continue to ease

The central bank has lowered its base rate since May 2012 by half a percentage point, to 3¼ per cent in October, and is expected to further relax monetary conditions in the OECD projections. Credit growth has remained subdued, partly reflecting households' reduced appetite for housing debt because of rising global uncertainties. Despite this easing and the receding terms of trade, the effective exchange rate has remained strong since the end of 2011. The recent recovery of real estate prices and the stock market, along with continued historically low long-term interest rates, are improving financial conditions.

Prices and exchange rates

RBA index of commodity prices reflecting the prices received by Australian exporters.

Reserve Bank of Australia and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743083

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744793

Fiscal tightening should weaken growth

Fiscal tightening of around 3% of GDP is planned to bring federal accounts back into balance by 2012/13, though this should be less restrictive than it would first appear. This fiscal consolidation stems partially from advancing expenditures between the fiscal years 2011/12 and 2012/13, changes in the accounting treatment of unclaimed financial assets, which will boost government revenues, and restrictions in defence spending and international aid, which will have limited impact on domestic demand.

Growth is expected to remain moderate in 2013 and 2014

Activity should remain sluggish in many sectors that must adjust to a strong dollar, and budget-tightening will damp demand in 2012/13. These factors will be partially offset, however, by easier monetary and financial conditions, which should stimulate housing investment. Mining investments should continue to expand vigorously in 2013 in view of announced plans. Furthermore, export growth should gather pace with the expansion of mining capacities, and the expected improvement in the external environment in 2014. With production below capacity in some sectors and an unemployment rate hovering around 5½ per cent, inflation should remain low, at 2¼ to 2½ per cent.

Risks are on the downside reflecting the negative external outlook

A pronounced slowdown in China would hamper exports and the terms of trade. An increase in the overall world supply of commodities would also weaken raw materials prices as well as, in all likelihood, the real exchange rate.

The economy is stagnating

Since spring 2012, business and consumer confidence have fallen markedly, leading to destocking and a further reduction of private consumption and investment growth. Both export and import growth picked up over the course of the year but remain moderate.

The labour market is weakening

Employment growth remained robust in the first half of 2012 but was outpaced by labour force growth, leading to a moderate increase in the unemployment rate to 4.4% in September, slightly above its estimated structural level. With activity likely to stay weak in the near term, employment growth is expected to slow down and unemployment to rise further. Inflation abated from the high levels in 2011 as it is no longer affected by indirect tax increases, and is projected to decline further as spare capacity increases. Gains in real disposable income in 2012 should support consumption once confidence improves. Financing conditions are also supportive as banks have passed on low funding costs to customers without significantly tightening lending conditions. But credit demand remains moderate, likely reflecting high uncertainty about the recovery.

Confidence indicators and employment

Deflated by the consumer price index.

Datastream; OECD, Main Economic Indicators database; OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743102

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744812

The consolidation path is appropriate but fiscal risks remain

The pace of the envisaged consolidation path in structural terms appears appropriate. The automatic stabilisers should be allowed to operate freely, even though this might imply missing headline budget deficit targets in 2013 and 2014. Nevertheless, envisaged expenditure savings after 2013, in particular related to health care and subsidy reform, should be more concretely specified, as should the contributions of states and municipalities to fiscal consolidation. Additional measures to support the banks, which are in the pipeline, should also be made fully transparent.

Growth should pick up in 2013

As confidence and external demand gradually improve, and financing and income conditions remain broadly supportive, growth is projected to pick up gradually to 0.8% in 2013 and 1.8% in 2014.

Risks are broadly balanced

Downside risks relate mainly to a renewed deterioration of the sovereign debt crisis in the euro area and a weaker outlook in central, eastern and south-east Europe, which would harm export growth and exacerbate financial sector and fiscal risks. On the positive side, a quicker restoration of confidence could lead to stronger domestic demand in the near term.

The economy contracted in 2012

In 2012, the economy experienced a broad-based contraction, owing to depressed private domestic demand, fiscal consolidation and, as export market growth slowed and competitiveness deteriorated, weak exports. Employment contracted and unemployment increased notwithstanding a falling labour supply. Headline inflation was higher than in neighbouring countries as automatic wage indexation translated rising oil prices into nominal wage increases, while underlying inflation remained around 2¼ per cent.

Fiscal consolidation is progressing

Fiscal consolidation of about ¾ per cent of GDP is assumed in both 2013 and 2014, consistent with the stability programme, with equal weight on spending and revenue measures. Fiscal consolidation has contributed to the halving of interest rate differentials vis-à-vis Germany since end-2011 to around 100 basis points. Looking ahead, it is important that consolidation is continued to secure fiscal sustainability. Emphasis should be on spending measures to avoid negative effects on potential growth.

Unemployment and inflation

Year-on-year percentage changes.

OECD, Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888932743121

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744831

Economic activity should slowly gather pace

A slow recovery is expected as world trade growth gathers pace and supportive monetary policy eventually stimulates domestic demand. On the other hand, ongoing fiscal consolidation will restrain demand. Only after mid-2014 will growth be sufficiently strong to narrow the output gap and stabilise unemployment.

Domestic risks go both ways

Additional confidence shocks, such as a house price correction, could have substantially negative and prolonged effects on domestic demand. On the upside, the reforms now in place to boost the effective retirement age and effectively limit the unemployment benefit period to 4 years could have faster and stronger positive effects on employment than now thought.

The economy has performed well

The economy has expanded at robust rates in 2012, supported by strong and resilient domestic demand. Real wage and employment growth have raised consumer confidence and boosted consumption, while tensions on production capacity and favourable financial conditions have led to buoyant investment activity. In particular, investment has been strong in the mining, energy and real estate sectors. Inflation has eased during the year and inflation expectations remain well anchored. Some components of core inflation have remained high, especially non-tradable services where the inflation rate has hovered near 5%, but overall headline inflation has been kept low by energy prices and peso (CLP) appreciation.

GDP and current account

Year-on-year percentage change.

Central Bank of Chile.

Statlink http://dx.doi.org/10.1787/888932743197

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744850

The current account deficit persists despite favourable terms of trade

The current account has been deteriorating, reflecting weaker foreign demand, even though the terms of trade have been favourable, if falling. Improving external conditions in 2013-14 should help to increase export volumes and reduce the current account deficit somewhat.

Fiscal policy has remained relatively neutral

Fiscal policy has been conducted in line with the government objective of achieving a structural deficit of 1% of GDP in 2014. Latest government estimates project a small headline deficit of 0.2% of GDP, and a structural deficit of 1% already in 2012. The 2013 budget proposal projects near 5% increase in real spending focused on education, raising the headline deficit by ½ per cent of GDP, although the structural deficit would remain at 1%. While this is consistent with the government achieving its objective, further measures to close the structural deficit would contribute to strengthening the government’s financial buffer, which has been useful in the recent past in the face of adverse developments.

Growth is projected to weaken somewhat in the short term

With a more adverse external environment expected for next year and some constraints on domestic production capacity, overall activity is projected to ease somewhat in 2013. A pick-up in growth is expected in 2014 as global conditions improve, and export volumes pick up. Inflation should stabilise near the centre of the target band, and may start rising again in 2014.

The main risks are external

A downside risk to the projection is that a deeper global slowdown would damp exports and copper prices, further weakening growth. Inflationary pressures could come from rising energy and non-energy commodity prices, especially considering current capacity constraints.

The economy has been contracting

Real GDP has been falling, as government consumption has declined and private consumption has been damped by indirect tax increases related to fiscal consolidation. Large uncertainties in the euro area have depressed investment, but exports have held up well. The average real wage has fallen since last year and unemployment has been increasing.

The budget impact of fiscal consolidation will be offset by the weak economy

The general government deficit will stagnate at 3.3% of GDP in 2013 as cyclical weakness will offset the impact of planned indirect tax hikes and on-going reductions in government spending. The government deficit is projected to fall in 2014, thanks to structural budget improvements and stronger economic growth.

Indirect tax increases are temporarily raising inflation

The 4 percentage points increase in the preferential VAT rate in 2012 caused a jump in the price level, and the planned hikes in both standard and preferential VAT rates by 1 percentage point in 2013 will again temporarily boost the headline inflation rate. Given that inflation expectations are well anchored, the monetary authorities have rightly cut the main refinancing rate to 0.05%.

Consumption and fiscal deficit

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743216

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744869

Improving demand for exports will support growth

A strengthening of international trade and a brighter investment climate should result in stronger growth in 2013 and 2014. Recently legislated labour and product market reforms are expected to gradually manifest their effects in stronger job creation once business conditions improve.

There are domestic and external risks

Political uncertainty surrounding indirect tax increases proposed by the government threatens headline fiscal targets and may reduce confidence. Other major risks to the projections stem from positive or negative developments in the euro area that would alter the pace of export growth.

Domestic demand remains weak

With both exports and domestic private demand weakening, output growth slumped during 2012. Residential investment contracted sharply, while business investment remained anaemic. Despite the boost from the pay-out of past contributions to the early retirement scheme as part of its phasing-out, private consumption has been weak, held back by continued uncertainty and stagnant housing and labour markets. The unemployment rate rose in 2012 reflecting falling employment, including in the public sector. Wage growth continues to be subdued and below inflation.

Monetary conditions are accommodative

In July, in response to upward pressure on the krone, the Danish National Bank cut its lending rate to 0.2% and the rate on certificates of deposits to -0.2%. Long-term interest rates have fallen below Germany’s due to Denmark’s safe haven status, which reflects sound public finances and a more limited exposure to the euro area crisis. However, lending conditions are tight due to low risk appetite by banks. The housing market shows signs of stabilisation, but remains weak, with high supply and modest turnover.

Labour and housing market and long-term interest rates

House prices are deflated by the private consumption deflator.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743273

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744888

Fiscal policy will be less supportive in 2013-14

In 2012, a burst of public investment and a one-off payout from the early retirement scheme (linked to its phasing-out) resulted in a temporary fiscal impulse. The fiscal stance will therefore tighten somewhat in 2013, although some stimulus effect may remain as delays in project implementation may shift some investment backward and households may spend some of their pension rebate in 2013. The fiscal stance is set to be broadly neutral in 2014, which is appropriate.

Recovery will be gradual, driven by private demand

As world trade regains momentum and confidence returns, private demand is projected to pick up gradually, replacing public spending as the driver of growth. Investment will also be supported in 2013 by a temporary budget provision for more generous depreciation allowances. The recovery in exports is likely to fall short of export market growth, despite recent improvements in competitiveness. With higher imports in 2013-14, the current account surplus will edge down. Stronger labour demand will push down the unemployment rate in 2013-14 and re-invigorate private consumption. Wage growth will gradually pick up, but remain moderate. With persisting economic slack, core inflation should stay subdued.

Risks are mainly on the downside

An intensification of the euro area crisis or smaller–than-expected improvements in competitiveness would depress private demand and exports. However, pent-up private consumption and investment demand could materialise faster than projected were confidence to improve swiftly.

External conditions for growth remain challenging…

The economy slowed down in the first half of 2012 as the global environment deteriorated, weakening industrial production and exports, but growth picked up in the third quarter. Bottlenecks in the labour market have led to upward pressures on inflation, but these have been offset in the headline numbers by weaker commodity prices.

… but domestic demand growth remains solid

Domestic demand has been robust in 2012. Public investment linked to earlier sales of Kyoto emission permits and EU-financed projects provided important stimulus to the economy. While this source of growth is fading out, energy and transport sector modernisation plans, increasing capacity utilisation and a pick-up in credit to enterprises point to an acceleration in private investment in the future. Continued growth in employment and real wages has boosted retail sales and consumption, even though credit to households has yet to bottom out. Both business and consumer confidence remain strong.

Employment and inflation

Headline refers to the harmonised index of consumer prices (HICP) and core excludes food, energy, alcohol and tobacco.

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743311

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744907

The fiscal position will improve further

The phasing out of large one-off operations linked to Kyoto permit-financed investments will bring the budget close to balance in 2013 and further improvement is planned in 2014 despite compensatory payments to the second pillar pension system. Gross debt will remain low.

Growth will accelerate as external conditions improve

Growth is projected to pick up in 2013 as external conditions strengthen. The labour market will continue to improve, but further employment gains are likely to be more modest due to skill mismatches and wage pressures are likely to intensify. Inflation is projected to fall slowly on a year-on-year basis despite a one-off price increase due to the opening of the electricity market in January 2013.

Estonia remains vulnerable to external shocks

The risks to the projections are roughly balanced. A further intensification of the euro area crisis would check the pace of exports and investment. Banking sector stress in the euro area, affecting funding conditions for parent banks would undermine domestic demand. On the other hand, a faster resolution of the euro area crisis might easily turn investor confidence around and spark a new boom.

Falling exports and weak domestic demand have slowed growth

Subdued demand for capital goods from trading partners, coupled with ongoing structural losses in export market shares in the forestry and electronics sectors, continue to depress export growth. With falling confidence in Finland, the euro area debt crisis is feeding through to the domestic economy. Higher unemployment and weaker real wages are slowing household consumption and residential investment. Inflation will remain above the euro area average until the effect of the indirect tax increases wears off in 2014. But more fundamentally, the relatively rapid rise in unit labour costs is eroding competitiveness.

Fiscal consolidation should continue

Despite weaker than expected growth, the deficit is projected to be almost eliminated by 2014. Given Finland’s relatively strong fiscal position, if growth proves slower than projected in the government’s fiscal plans the automatic stabilisers should be allowed to work, even if this means deficit targets are missed. To deal with the long-term fiscal challenges from one of the most rapidly ageing populations in Europe, further reforms are needed to raise the retirement age and enhance public sector efficiency, especially in health and other municipal services. In this context, the envisaged municipal reform towards larger units is welcome.

Private consumption and exports

Year-on-year growth.

Ratio of real exports to export markets (trade-weighted average of trading partners' imports).

OECD Economic Outlook 92 database and Statistics Finland.

Statlink http://dx.doi.org/10.1787/888932743368

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744926

Growth depends on global trade picking up

Global trade is projected to recover in 2013 and to accelerate in 2014, driving a solid recovery in exports. This should improve confidence, strengthen consumption and investment, and reverse the recent increase in unemployment.

Structural reforms are needed to boost growth

Growth would benefit from further reforms to increase competition in the retail sector, through loosening planning restrictions, and in network industries by easing regulations. Opening health provision further to competition could increase efficiency. Enhanced active labour market policies would facilitate labour reallocation and reduce incentives to retire early.

Risks are mainly linked to the global economy

Risks are mostly on the downside. Finland is exposed to developments in the euro area. While persistent weakness in external demand would hamper growth, a global trade recovery would boost the economy rapidly. A strong recovery in global fixed investment would benefit Finland particularly, as its export product mix is tilted towards capital goods.

Economic activity continues to shrink

Output fell sharply in 2012 due to falling real incomes and confidence, rapidly rising unemployment, limited access to credit and weak tourism. The overall unemployment rate reached 25% by mid-2012, and youth unemployment rates exceeded 50%. Reflecting the very weak economy, consumer price inflation fell below the euro area average and wages are declining. Competitiveness remains a major challenge, however, as gains in export performance have yet to materialise despite falling costs in Greece relative to its trading partners.

Consolidation should continue

The 2012 fiscal target, a 2 percentage point of GDP consolidation, appears to be on track despite the underperformance of tax revenues due to weaker growth and delays with implementing fiscal reforms. For 2013 and 2014, the government has adopted a new frontloaded consolidation package of around 7½ per cent of GDP relative to a deteriorating baseline. It relies largely on expenditure restraint, including through restructuring of the public sector and further cuts in pensions and social expenditure. The agreed consolidation programme should be implemented, but if growth turns out weaker than assumed the automatic stabilisers should be allowed to operate, even if this means missing the nominal fiscal targets.

Economy and fiscal imbalance

Year-on-year percentage change growth rate.

Hellenic Statistical Authority and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743463

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744945

Further consolidation will still not be sufficient for debt sustainability

The OECD projections for the headline deficit are in line with those set by Greece’s third EU/IMF adjustment programme. However, they are lower for the primary balance for 2013, and especially, for 2014 due to weaker projected growth and the assumed operation of the automatic stabilisers. The projections incorporate the two-year extension of the adjustment period granted to Greece in November 2012. The financing of the extension is assumed to be partly borne by Greece’s creditors in terms of lower interest payments. The assumed cut in interest payments would, however, not be sufficient to secure debt sustainability.

Output losses are set to continue until end-2014

The economy is projected to remain in recession until end-2014, due mostly to fiscal retrenchment. As confidence returns, competitiveness improves and structural reforms take effect, growth is projected to pick up after that. A healthier banking system, competitiveness-enhancing product and labour market reforms, greater use of EU structural funds, and strengthened external demand would all boost investment and exports. Prices and wages will continue to fall over the projection period, given the substantial economic slack and very high unemployment. The current account deficit, which narrowed in 2012 partly due to the write-down of private debt, is likely to decline further to around 2¼ per cent of GDP in 2014.

Risks to the outlook remain heavily skewed to the downside

The implementation of the new austerity package and agreed structural reforms remain a challenge, given potential social resistance and weak administrative capacity. Lack of bank liquidity poses additional risks to the outlook, although forthcoming bank recapitalisation and restructuring should help mitigate this risk. The expected recovery will be delayed if improvements in competitiveness, investment and confidence take more time to materialise.

The economy is shrinking

The economy has entered its second-dip recession since the outbreak of the global crisis, driven by further contraction in domestic demand and decelerating exports. Business confidence has been weak and lending to the non-financial sector has continued to drop, while deleveraging of households has weighed on consumption. The employment rate has risen, which is to some extent due to a large-scale public works programme. The government also adopted a job protection action plan aimed to boost private sector employment through targeted reductions in social security contributions for groups weakly attached to the labour market, and by alleviating tax burdens on small businesses.

Monetary policy easing has been premature

The central bank cut the policy rate by 25 basis points in August, September and October to 6.25%, despite high and raising headline inflation and still elevated risk premiums. Even though higher inflation appears to be due to hikes in indirect taxes and higher fuel and food prices, which should have only temporary effects, inflation expectations have become detached from the central bank’s inflation target of 3%, rising to between 6 and 9%. Under these circumstances, monetary accommodation risks compromising price stability and undermining policy credibility. This projection assumes an interest rate cut of 25 basis points, but only at the end of 2014 and only once headline inflation eases off close to the central bank’s inflation target.

Inflation and long-term interest rate

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

OECD, Main Economic Indicators database and Magyar Nemzeti Bank.

Statlink http://dx.doi.org/10.1787/888932743482

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744964

Fiscal consolidation should be pursued

Fiscal consolidation continues, with a projected reduction in the structural deficit of over 2% of GDP in 2012 and of 1.5% of GDP in 2013. This consolidation should help Hungary to exit from the excessive deficit procedure and avoid losing access to EU cohesion funds, worth 0.5% of GDP, in 2013. Adopted measures will more than offset the budgetary effect of the job protection action plan. They include ending the ceiling on social security contributions, more efficient tax collection and the continuation of the wage and headcount freeze in the public sector. Another fiscal package for 2013 delayed the halving of a large and distortive bank crisis tax by one year, doubled a recently created tax on financial transactions, broadened the base of a local business tax and introduced a new levy on the network of utility companies. Progress has been made in the negotiations with multilateral organisations by scrapping plans to impose a financial transaction tax on monetary operations of the central bank, but long-term interest rates remain high.

Growth is projected to resume gradually

Assuming that a new programme is agreed with multilateral organisations, a modest revival in growth is projected from mid-2013, and a further pick-up in 2014. The continuation of public and private sector deleveraging is expected to restrain the recovery in domestic demand, compounded by large tax burdens on banks weighing on lending, but external demand is projected to gather pace over the projection period.

Risks are broadly balanced

Failure to conclude a financial agreement with the multilateral organisations could undermine already weak confidence, endanger fiscal sustainability and destabilise the exchange rate. On the upside, an agreement coupled with greater predictability and transparency of policymaking could have a stronger positive impact on confidence, and hence growth, than assumed in these projections.

Economic recovery is continuing at a steady pace

Growth is being led by private consumption, which has been boosted by debt write-downs and high wage settlements, and by residential and business investment. While household balance sheets have improved, firms are still deleveraging. The central bank has started to withdraw monetary policy accommodation, but its policy rate is still low after adjusting for inflation. The unemployment rate fell to 5.7% in the third quarter of 2012, partly owing to a temporary programme to employ long-term unemployed persons. Following large collective wage increases at the end of 2011, wage growth has slowed and is likely to continue doing so. Inflation has fallen sharply, as the effects of the earlier increase in commodity prices and exchange rate depreciation pass, but remains well above the central bank’s 2.5% target.

The drag from fiscal consolidation is set to decline

The primary balance should improve by 4% of GDP in 2012. The government plans consolidation amounting to 1½ per cent of GDP in 2013 and 1% in 2014, which would increase the primary surplus to 4% of GDP in 2014 and reinforce the declining trend in the government debt-to-GDP ratio.

Household balances and exchange rates

End of year and for 2012, end of June.

Without pension assets.

Central Bank of Iceland and Statistics Iceland.

Statlink http://dx.doi.org/10.1787/888932743520

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932744983

The modest pace of recovery should continue

Consumption expenditure and business investment, notably in power plants and energy-intensive industry, are projected to remain the mainstays of the recovery, sustaining the growth rate at just over 2½ per cent. Unemployment is projected to fall to its structural rate by 2014 and inflation should fall to 3.5%. As economic slack is taken up, monetary policy accommodation should be withdrawn gradually to stave off the emergence of inflationary pressures and to prepare for the gradual liberalisation of capital controls

There are mainly downside risks

The main risk to the outlook is that energy-intensive investments could be delayed owing to structural difficulties in the global aluminium industry. Capital account liberalisation might lower short-term growth if it weakens balance sheets but it could also increase growth should it raise business confidence.

A slow recovery is underway

Ireland has returned to growth but risks remain. The weak European economy is likely to further damp Ireland's main engine of recovery, exports, and to postpone an improvement in domestic sentiment. However, as a result of strong export growth to date and subdued domestic demand, the current account has moved into surplus, while core inflation is only about 0.5% and the unemployment rate is steady, but high, at around 15%.

Ireland is doing its homework

The government is on track to reach its fiscal consolidation objectives in 2012, thanks to steady progress in addressing the fiscal deficit and tax revenues that have exceeded targets. This has been rewarded with a marked fall in bond spreads. Planned structural improvements in the budget positions in 2013 and 2014 need to be implemented. If growth turns out to be weaker than expected, however, this should be allowed to show up in slower improvements in the headline fiscal balance. Reductions in absolute and relative labour and other costs have helped restore competitiveness of the economy. Combined with a timely recapitalisation of the banking sector, Ireland is on its way to addressing the main imbalances that had built up prior to the crisis.

Interest rate spread and credit

Central Bank of Ireland and Datastream.

Statlink http://dx.doi.org/10.1787/888932743501

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745002

Credit availability is a concern

Credit availability has fallen sharply since the onset of the banking crisis, and is now excessively tight. Non-performing loans are still around 21% of total loans and advances, although banks hold significant provisions against them, and 50% of mortgages holders have negative equity. As a result, credit institutions are reluctant to lend, hampering the recovery, especially of SMEs. Bank lending survey evidence shows that access to credit in 2011 was two-thirds more difficult than in 2009 and that Ireland suffers the second worst lending conditions for small businesses in Europe, after Greece.

A moderate recovery is in the pipeline

Reflecting a slowdown of the world economy, especially in Europe, ongoing fiscal consolidation and tight credit conditions, the recovery is expected to proceed at an only moderate pace. GDP growth is projected to gradually strengthen to 1.3% in 2013 and 2.2% in 2014. Employment growth is therefore likely to remain subdued and the unemployment rate stubbornly high. Inflation will remain moderate.

Risks remain but Ireland is well positioned to rebound

The intensification of the euro area crisis remains a worrisome negative risk. On the other hand, Ireland is well positioned to take advantage of a turnaround in global and European sentiment. Two developments could contribute to a more positive outlook: a steady resolution of the euro-area crisis, including the activation of debt-relief mechanisms at the European level; and alleviation in the government debt-servicing burden stemming from a retroactive recapitalisation for Irish banks by the European Stability Mechanism.

Indicators point to weakening economic activity

Growth in real GDP stopped slowing in the first half of this year. However, anticipation of a VAT hike in September is likely to have temporarily boosted private consumption, implying that underlying growth in demand was somewhat weaker. In addition, indicators point to slower growth in the second half of 2012. Consumer price inflation remains well within the target band (1% to 3%) despite energy and food price hikes. Also, inflation expectations have dipped recently and are close to the centre of the band. However, house prices have picked up. The policy interest rate was reduced by 25 basis points to 2% in November, the fifth cut since September 2011. The nominal effective exchange rate depreciated by around 5% between May and August, but this has since been partially reversed. The Bank of Israel has not intervened in the foreign-currency market since the extreme highs in the value of the shekel reached in mid-2011.

Output and inflation

Year-on-year percentage change.

The simple average of inflation forecasts for the next 12 months of the commercial banks and economic consultancy companies that publish their forecasts on a regular basis.

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

Bank of Israel; Central Bureau of Statistics; OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743539

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745021

Fiscal difficulties have led to a revision of deficit targets

Pressure on public spending, arising partly from the policy response to the social protests of 2011, coupled with lower-than-expected revenues will drive the government deficit for 2012 significantly above original plans. Central government deficit targets for 2013 and 2014 have been raised to 3% and 2.75% of GDP, respectively, instead of 1.5% and 1%. Achieving these revised targets will nevertheless prove challenging, and the authorities have already embarked on revenue-raising measures, such as the aforementioned VAT hike, increases in personal income tax and social contributions, and intensified tax collection. Agreement on a 2013 budget has been postponed until after the election.

Growth will accelerate in 2014

Output growth is projected to drop to 2.9% in 2013 (incorporating a 0.2 percentage-point boost from the new Tamar gas field) but then rebound to 3.9% in 2014. Electricity and food price hikes will continue to push up headline inflation in the near term. Further ahead, underlying inflationary pressures will require a tightening of the monetary stance which is assumed to begin in the second quarter of 2013. If public expenditure rises in line with the legislated ceiling and revenue-raising measures yield the expected results, then the central government deficit should be on target in 2013, but fall short in 2014, implying a need for further consolidation. Reductions in public indebtedness will be modest.

Geopolitical tensions and fiscal uncertainties pose risks

Risks in the global economy present the greatest threat to growth. In addition, geopolitical tensions remain high. There are risks surrounding budget outcomes, as the proceeds of intensified tax collection are particularly uncertain. The budget postponement and the upcoming general election add further risk.

The expansion stalled in mid-2012 due to a slowdown in world trade

Output growth slowed during 2012 as exports fell in the second quarter, reflecting weaker demand from the European Union and China, Korea’s major trading partner. Falling overseas demand led to stagnant industrial production and weak fixed investment growth. By September 2012, business confidence had dropped to its lowest level since early 2009. Private consumption has been damped by household debt, which reached 164% of household disposable income in 2011, one of the highest in the OECD. Slower growth helped to reduce inflation from 4% in 2011 to 1.6% in the third quarter of 2012, when the economy appears to have bottomed out.

Fiscal consolidation remains the government’s priority

Fiscal policy has focused on the medium-term target of a balanced consolidated central government budget (excluding the social security surplus) by 2014. Fiscal stimulus in 2012 was limited primarily to reductions in housing-related taxes in an effort to activate the moribund real estate market. Spending restraint, which helped to reduce the deficit from 2% of GDP in 2011 to around 1% in 2012 (on a central government consolidated basis, excluding the social security surplus), is set to continue, with nominal spending growth of around 5% in 2013. The focus on a balanced budget has contained gross public debt at 36% of GDP. Meanwhile, the Bank of Korea reduced its policy interest rate by a total of 50 basis points in the second half of 2012, to 2¾ per cent.

Household debt and inflation

The target range has been narrowed to 2.5-3.5% for 2013-15.

OECD Economic Outlook 92 database and Bank of Korea.

Statlink http://dx.doi.org/10.1787/888932743634

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745040

A gradual pick-up in growth is projected during 2013-14…

Output growth is projected to reach 4½ per cent by 2014, driven by exports as world trade rebounds. Korea is well placed to gain market share in global markets, given the recent implementation of free trade agreements with the United States and European Union and the low value of the won, which is about one-fifth below its 2007 level in real effective terms. However, private consumption faces headwinds due to the high level of household debt. In addition, wage gains will be constrained by the large number of older workers seeking employment, as the first wave of the baby boomers reach age 57 in 2012, the average mandatory retirement age set by firms for their regular employees.

… although there are a number of risks, both domestic and external

A major risk is financial turbulence in the world economy, which in the past has negatively affected Korea both through trade and financial channels, although Korea is now better prepared for the latter. Economic developments in China, which accounts for a quarter of Korean exports, will also have an important impact. The key domestic uncertainty is the pace of deleveraging by highly indebted households.

Economic activity is stagnating

Economic activity has stalled since the end of 2011 owing to a sharp decline in exports and restrained domestic demand due to weak confidence and the ongoing euro area debt crisis. While employment has increased in the financial sector, unemployment is on the rise among lower-skilled workers due to lower demand in the export and construction industries. Although weak demand and rising unemployment create downward pressures on prices, energy price hikes passed on through wage indexation have kept inflation above the euro area average.

Automatic stabilisers have been allowed to work in 2012

The budget deficit is expected to reach 2% of GDP in 2012, significantly overshooting the target of 0.7% of GDP due to lower growth and the automatic stabilisers. The government should continue to allow the automatic stabilisers to work in 2013-14. Long-term fiscal sustainability would be enhanced by ambitious reforms to the pension system, which has large future liabilities.

GDP and financial activity

Year-on-year percentage change.

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

OECD Economic Outlook 92 database and Commission de Surveillance du Secteur Financier.

Statlink http://dx.doi.org/10.1787/888932743653

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745059

Financial sector regulation is being updated

Financial supervision has been strong and the sector is weathering the crisis relatively well. Luxembourg should continue to upgrade its regulatory and supervisory framework of the financial sector in line with European and international initiatives.

The recovery will be gradual

Output is projected to recover slowly through 2013 and into 2014, driven by a pickup in exports as confidence returns to the euro area and foreign demand increases. Headline inflation will continue to run above the euro area average, as wages are pushed up by the automatic indexation mechanism. Employment is likely to rise slowly, supported by the resilience of the non-banking financial sector.

Risks are mostly on the downside

If the euro area debt crisis continues, confidence will remain low and drag down exports and growth by more than anticipated. At the same time, this may be mitigated by larger safe haven flows that boost financial sector activity.

The pace of external demand drives the cycle

The manufacturing sector has prospered since the 2009 downturn, reflecting improving competitiveness, which has helped Mexico to regain lost market share, and solid export market growth. This has led to sustained gains in formal employment and high rates of private investment. Though weakening external demand is likely to slow activity in the manufacturing sector, domestic demand should remain strong and offset part of this slowdown.

Large increases in food prices have raised inflation concerns

Headline inflation has risen since mid-2012, surpassing the upper limit of the central bank’s variability interval of 3 (+/- 1) per cent. The rise in headline inflation has been caused primarily by a succession of temporary disturbances – most recently an outbreak of bird flu that caused an egg shortage and an international drought. Food price increases tend to fall more heavily on the lower-income population, and thus impose a significant economic and social cost. However, consistent with strong growth, core inflation has also increased, although by less. So far, long-term expectations have remained stable, although short-term inflation expectations have risen markedly.

Exports and inflation

For a horizon of one to four years.

OECD Economic Outlook 92 database; Bank of Mexico.

Statlink http://dx.doi.org/10.1787/888932743672

Fiscal policy is slightly contractionary

The public sector borrowing requirement is projected to decline to 3% of GDP in 2012, with fiscal consolidation set to continue at a gradual pace, with the underlying deficit falling by about half a percentage point of GDP per year. This should balance the budget (under the government’s definition, which excludes oil investment) in 2013.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745078

A slowing of growth next year should be short-lived

Weak external demand and investment is projected to begin to reverse by end-2013 with the gradual pick-up in global growth. Consumption should slow only slightly. Together, this will raise GDP growth from 3.3% in 2013 to 3.6% in 2014. Core inflation should fall towards the central bank’s inflation target by end-2013 as demand eases. However, as the recovery picks up, the output gap will close and the unemployment rate fall. Accordingly, monetary policy accommodation is assumed to have been withdrawn by mid-2014.

Downside risks dominate

Downside risks stem from a more pronounced US slowdown and a worsening of the European sovereign debt crisis, but Mexico has ample monetary and fiscal policy space to respond if needed. Capital inflows, which have been rising, should be monitored closely for abrupt reversals, although the accumulation of foreign exchange reserves and strong macroeconomic fundamentals should help avoid significant disruptions.

Activity has slowed

Activity slowed in the second half of 2012, reflecting slower world trade, fiscal consolidation and much weaker private consumption than in neighbouring countries. The housing market crisis worsened in a context of tight mortgage credit conditions and uncertainty about the medium-term tax treatment of mortgage interest payments. Tax treatment was clarified by the announcement by the government that tax deductibility of mortgage interest payments is to be phased out gradually. Inflation edged down in line with softer activity and lower energy prices. Wage growth is picking up gradually, although from a very low base, and real wages are falling. The unemployment rate is up by 1 percentage point over last year’s level but is still low by international standards.

Households face multiple shocks

Households face declining real incomes, reflecting falling real wages, social spending cuts and a 2 percentage point hike in the VAT rate that took effect in October 2012. In addition, housing prices are declining and private pension cuts are looming as a number of pension funds need to improve their coverage ratio to secure the financing of future pension outlays. However, the pressure for pension cuts has somewhat abated as recent regulatory changes will raise pension funds’ discount rate for actuarial calculations, in a move to make these rates less dependent on market interest rates.

Housing and wages

Year-on-year percentage changes.

OECD, Main Economic Indicators database and CBS, Statistics Netherlands.

Statlink http://dx.doi.org/10.1787/888932743691

Fiscal consolidation is underway

The 2013 budget prepared by the caretaker government should reduce the deficit to 3% of GDP via fiscal consolidation of 1½ per cent of GDP. Consolidation measures are mainly on the revenue side. The incoming government is expected to stick to the broad lines of this consolidation plan. In 2014, an additional consolidation of ½ per cent of GDP is assumed.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745097

Growth will return to potential only in 2014

Activity is projected to gather pace gradually on the back of faster world trade and supportive monetary conditions. In turn, business investment will pick up, but private consumption is set to recover much more slowly as housing prices continue their correction. Unemployment should only stabilise after mid-2014, limiting upward pressures on wages and consumer price inflation should fall.

The main domestic risk is household demand

The main downside risk in the near term is that households react more negatively than anticipated to the combination of shocks they are facing. On the upside, the recovery may be stronger than anticipated in 2014 if confidence returns faster than expected.

The recovery is patchy

Real GDP growth slowed in 2012 as weak foreign demand and persistent strength in the exchange rate depressed exports. Business confidence has slid, and unemployment has risen. Sluggish real household income growth and high debt loads have pared consumer spending. Currency appreciation and falling world commodity prices have pushed headline and underlying inflation below 1%. Meanwhile, low interest rates have supported business investment and allowed households to deleverage through faster mortgage repayments. Reconstruction from the 2010-11 earthquakes is beginning to gather momentum, and the housing market has shown signs of firming. Credit growth has also risen in the agriculture sector, benefiting from the recent rebound in dairy prices.

Substantial fiscal consolidation will weigh on growth

The planned sizeable fiscal contraction to balance the budget by FY2014-15 will imply cumulative tightening of about 6% of GDP since 2011. This is to be achieved mainly via spending restraint, based on reforms to improve public-sector efficiency and measures to reduce long-term welfare dependency. The partial privatisation of five large state-owned enterprises will free up capital to fund public infrastructure and reduce gross public debt.

Exports and investment

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743729

Monetary policy is supportive

The Reserve Bank has maintained an accommodative stance, keeping its policy rate on hold at 2.5% since early-2011. Under the renewed Policy Targets Agreement, the Bank will take more account of asset prices and financial stability in conducting monetary policy and aim to keep inflation close to the 2% midpoint of the target range. As earthquake rebuilding accelerates, however, supply constraints and skills shortages are likely to boost wage and price pressures, especially in the construction sector. The Bank will need to monitor these developments closely and, as slack is taken up, begin removing monetary stimulus in 2014.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745116

Earthquake rebuilding will drive growth dynamics

Real GDP growth is projected to pick up and exceed potential rates over 2013-14, steadily diminishing economic slack. Growth will be powered by buoyant post-earthquake private investment and strengthening household consumption as balance sheets recover and employment conditions improve. Exports will be curbed by soft global growth prospects over the next year, albeit with some firming in 2014. Price pressures are expected to edge up and peak in late-2013 before inflation returns towards the 2% objective over the course of 2014 as monetary stimulus is withdrawn.

Downside risks loom large

In addition to risks arising from the external environment, the impact of earthquake rebuilding on the economy is uncertain. A faster pickup in reconstruction activity may boost inflation more than projected and force the Reserve Bank to raise interest rates earlier. Such a scenario could squeeze heavily indebted households and increase upward pressures on the already strong currency.

The economy has maintained its momentum

The mainland economy has expanded strongly in 2012, supplying particularly strong investment in the petroleum industry. Household consumption growth has been supported by gains in both real income and employment. Strongly rising house prices have stimulated growth in housing investment. Inflation has continued to undershoot most forecasts, due to low import prices but also surprisingly low domestic inflation, even after taking account of falls in energy prices. Unemployment has remained low and steady as immigration continues to increase the labour force.

Monetary policy will remain expansionary, fiscal policy broadly neutral

The central bank has maintained policy rates unchanged since March. Inflation is projected to rise towards, though not reach, the 2½ per cent inflation target, so the central bank is assumed to gradually raise the policy interest rate. After providing some stimulus in 2012, the structural non-petroleum budget deficit is planned to remain broadly unchanged as a share of mainland GDP in 2013, somewhat below 4% of the value of the Government Pension Fund Global. These projections assume that the same approach is applied in 2014.

Inflation and investment

Change over a year earlier.

Investment costs for oil and gas in current prices. Figures for 2012 and 2013 are estimates and projections made by Statistics Norway in Q3 2012.

Statistics Norway and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743710

Strong domestic demand will sustain mainland growth

Industry surveys show a likely fall in the rate of growth of investment in the petroleum industry in 2013, and it is projected to slow further in 2014. However, with little excess capacity in some sectors and strong demand for housing, overall investment demand will remain quite strong. Sustained real wage growth and rising employment generate continuing household income growth and private consumption growth is projected to pick up to around 4½ per cent in 2013 and 2014. Much of the additional labour demand is expected to be met from further immigration, which will probably also be a significant source of demand for housing. Mainland GDP will thus remain strong, with only a slight decline in the growth rate after 2012, while overall GDP will slow rather faster in line with the secular decline in petroleum output.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745135

Risks to growth and inflation risks are symmetrical

Investment in the petroleum industry, which affects the mainland economy, is volatile and could prove stronger than projected if oil prices strengthen further. High household indebtedness might moderate the growth in consumption and housing investment, despite strong income growth. Given the strength of demand, inflation could rise more rapidly than in these projections, but it has been persistently below expectations for some time and could equally continue to surprise on the downside.

A slowdown will be followed by a gentle pick-up

Real GDP growth is projected to fall from 4.3% in 2011 to below 2% in 2013, due to the weak European economy and fiscal retrenchment. The fiscal tightening reflects in part lower public investment as the flow of EU funds is set to plateau. A deteriorating labour market and a rising saving rate will restrain private consumption. A gradual recovery is projected to start in the second half of 2013 with real GDP growth reaching some 3% through 2014. The unemployment rate could rise to about 11% at the end of 2014, which would hold real wage gains below trend productivity increases.

Fiscal tightening will continue

The projection assumes an annual one percentage point discretionary fiscal tightening, which would help stabilise the public debt ratio. As Maastricht debt is below 60% of GDP, the annual costs of the pension reform, estimated at 0.6% of GDP, are allowed by EU rules to be considered for the assessment of Poland’s fiscal consolidation efforts. Nevertheless, the automatic stabilisers are assumed to work, which limits the headline deficit reduction relative to the underlying effort.

Monetary policy and government deficit

OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743748

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745154

There is room for monetary easing

Headline inflation is likely to fall to the lower bound of the central bank’s 1.5-3.5% target band and remain there over the projection period. This and the projected economic slowdown imply that the monetary policy stance should be eased to support activity. The Financial Supervision Authority’s plan to ease regulatory requirements for bank lending is also welcome as a countercyclical measure.

The government should implement reforms to strengthen the recovery

In addition to the planned deregulation of selected professions, the government should implement further structural reforms to help strengthen the recovery by raising long-term growth and reducing the burden of fiscal consolidation. They include: reducing state ownership in the economy, reducing the administrative burden of doing business, improving the tax structure (by reducing the tax wedge on labour), increasing the female employment rate and workers’ internal mobility, phasing out special pension schemes and reforming the farmers’ health and pension insurance system.

Risks are on the downside

Private consumption would be weaker if households decide to increase saving rates faster, given their current low level. A renewal of euro-area tensions would affect Poland via the trade channel, the predominantly foreign-owned banking sector and higher interest rates on sovereign debt, as non-residents hold about half of all government bonds.

The economy is rapidly contracting

The decline of activity has accelerated due to a strong contraction in domestic demand. Unemployment, currently at record-high levels, will continue to rise further in the near term, while inflation and wages are declining. The combination of fiscal consolidation and bank deleveraging has weighed heavily on domestic demand. The steepening decline in credit and a one-off personal income tax surcharge help to explain the accelerating contraction in 2012.

Fiscal consolidation targets are ambitious

Significant fiscal slippage became apparent during the year, jeopardising the achievement of the fiscal target by as much as one percentage point of GDP. This was offset by additional measures to get back on track. To meet the revised budget targets under the EU/IMF financial assistance programme, which are still very ambitious, the authorities have announced additional measures in the Supplementary Budget Law for 2012 and the draft 2013 Budget Law. These include a capital gains tax increase and airport concessions for 2012, and a significant consolidation package of 3% of GDP for 2013, including higher taxes on personal and corporate income, property and specific consumption items. For 2013-14, a comprehensive expenditure review aims at cutting expenditure by EUR 4 billion. However, compliance with the headline deficit targets of 4.5% and 2.5% of GDP for 2013 and 2014, respectively, are likely to require additional consolidation measures due to the weak economy. The government should aim at reducing structural deficits as planned while letting automatic stabilisers operate in case growth turns out lower than expected in government plans.

Labour market and competitiveness

Year-on-year percentage changes.

Exports of goods. Year-on-year percentage change for total exports and contributions to growth by exports to EU and non-EU countries.

OECD Economic Outlook 92 database and Statistics Portugal.

Statlink http://dx.doi.org/10.1787/888932743767

Further output and employment losses are projected

GDP is projected to continue contracting until the latter half of 2013. A weak recovery is then projected as export growth eventually offsets weak domestic demand. Unemployment will recede only slowly, while inflationary pressures will continue to be negligible. Despite deteriorating terms of trade in 2012, the current account deficit is projected to disappear at the end of the projection period, reflecting both declining import volumes and a strong export performance with increasing diversification towards non-EU countries.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745173

Risks are skewed to the downside

The economy will remain sensitive to a further deterioration in credit conditions and worsening conditions in other euro area economies. If the demand effects of the required fiscal retrenchment turn out higher than expected, this could lead the economy into a downward spiral of worsening economic, financial and fiscal conditions. On the upside, competitiveness gains and the benefits of structural reforms could sustain further gains in export market shares and spur private investment.

The economy has slowed

Business confidence has deteriorated sharply over the past few months. The automotive sector and the launch of new factories have slowed. The euro area debt crisis has caused uncertainty among investors and has reduced external demand. Fiscal consolidation and weak labour market outcomes weigh on disposable income, resulting in stagnant private consumption.

Fiscal consolidation is intensifying

Curbing the growth of public debt and ensuring fiscal sustainability require strong fiscal consolidation. Despite the cyclical deterioration, the government is committed to reduce the budget deficit below 3% of GDP by the end of 2013 from almost 5% in 2011. This consolidation effort is to be mainly achieved by revenue increases (including the enlargement of the size of the first pension pillar financed by the reduction in the share of social security contributions put into pension funds). Public spending is also to be contained (including by freezing public wages and restraining public consumption and investment). In 2014, the pace of consolidation will ease, and the deficit is projected to fall to 2.4% of GDP.

Business confidence and labour market

Manufacturing confidence indicator from Joint Harmonised EU Programme on Business Opinion Surveys. Data are shown as deviations from the mean, expressed in standard deviations.

Quarterly real private consumption year-on-year percentage changes.

Annual real wage growth is per employee and deflated by the private consumption deflator.

OECD Economic Outlook 92 database; OECD, Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888932743786

The labour market will improve only slowly

Employment gains are likely to be limited as export-dependent firms are focusing on improving productivity to maintain competiveness rather than expanding jobs. Unemployment will remain higher than its pre-crisis level over the projection period. Although real wages will continue to lag behind productivity gains, household disposable income will increase slightly, providing some support to private consumption.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745192

Growth is set to pick up gradually

After a slowdown at the end of 2012, real GDP growth is projected to progressively broaden and return to its trend rate in 2014. The gradual improvement in the international environment will raise exports and foreign direct investment. Domestic demand should contribute increasingly to growth as business and consumer sentiment improve. Investment should also be boosted by higher absorption of EU funds. Private consumption is expected to gradually pick up in line with real disposable income as employment performance improves, inflation decelerates, and the pace of fiscal consolidation slows.

Downside risks dominate

The euro crisis could lead to a deterioration of the financial conditions, depress investor sentiment and reduce FDI inflows and external demand. There is a risk of FDI moving to locations with greater cost advantages. By contrast, a successful growth-friendly fiscal consolidation would strengthen confidence and thus stimulate domestic demand and, perhaps, foreign investment.

The economy faces renewed weakness

The economic downturn has proved protracted. Falling domestic demand has dominated the positive contribution from exports. Financial conditions have been tightening and lending to the private sector has been contracting.

Fiscal consolidation remains a key issue

After adopting an ambitious fiscal consolidation package in April 2012, in the wake of a larger-than-anticipated budget deficit in 2011 and amid severe tensions in the sovereign bond market, the government has proposed additional consolidation measures going forward. On the spending side, they involve lowering the public sector wage bill further, through cuts in public sector wages and headcount, and in social transfers, including unemployment benefits. Measures to boost revenues include raising intermediate VAT rates for some goods and services, the introduction of a financial transaction tax on commissions on services provided by financial institutions, an extension and broadening of the tax on banks’ balance sheets, and the abolition of some income tax exemptions and tax credits. These additional measures to meet nominal fiscal targets are projected to further weigh on aggregate demand. The authorities also need to put public finances on a sustainable footing in the medium term, notably with a comprehensive pension reform, which is overdue.

Interest rates and GDP

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

Contribution to real GDP growth over previous quarter. The sum of components may not add up to total GDP growth due to balancing and residual items, chain-linking procedures and seasonal adjustment method.

OECD, Main Economic Indicators database and OECD Economic Outlook 92 database.

Statlink http://dx.doi.org/10.1787/888932743805

Efforts to stabilise banks should continue

The sizable deterioration in the quality of Slovenian banks’ asset portfolios is a major concern. It is undermining credit growth and becoming a major obstacle to economic expansion. To stabilise the banking sector the government introduced legislation in October 2012 setting up a Bank Asset Management Company (BAMC), which is to take over problem loans from systemically important financial institutions. The authorities should ensure that asset transfers are transparent and consistent with international best practices. According to official plans, the BAMC will issue government-guaranteed bonds of up to EUR 4 billion (11% of GDP) in return for the transfer of problem loans; additional capital injections are envisaged to cost around 1.3-2.7% of GDP. (The OECD projections do not incorporate a corresponding worsening of the public finances.) The legislation, however, faces considerable opposition, notably from the social partners, and may face a referendum.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745211

A return to growth is not expected before 2014

The contraction in activity is projected to continue until 2014, with the pace tapering off over the next year. Given the substantial economic slack, inflation should remain in check.

Downside risks prevail

Downside risks dominate the outlook. The threat of a referendum on some key policy measures may undermine market confidence, and rejection of key measures could prolong the recession. The swift adoption of structural reforms and resolution of banking sector problems, on the other hand, would improve growth prospects.

The economy is in a deep recession

A large fiscal consolidation effort and tight financial conditions have cut deeply into economic growth. These factors have been compounded by weakening European growth. Labour market conditions have been bleak: employment has contracted rapidly and the unemployment rate has risen above 25%. However, core inflation is subdued and wage pressures have been easing. This has allowed the economy to improve cost competitiveness, facilitating gains in export market shares. Export growth has remained strong outside recession-bound Europe. Reflecting this, as well as declining import volumes, the trade balance recently moved into surplus for the first time since 1998, helping to narrow the current account deficit from a peak of 10% of GDP in 2007 to around 2%.

Employment and exports

INE (2012), Boletín mensual de Estadística, November.

Statlink http://dx.doi.org/10.1787/888932743292

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888932745230

Restoring credit growth is a pre-requisite for sustained recovery

Funding conditions for the government and for Spanish banks improved somewhat following the ECB's announcement of its sovereign bond buying programme in September. This projection assumes the government continues to rapidly recapitalise viable banks and close non-viable banks. This should lead to a gradual restoration of healthy credit supply. Recent independent bottom-up stress testing identified EUR 54 billion in capital needs in an adverse scenario, substantially less than the EUR 100 billion credit line from the euro area member states that the government can use for bank recapitalisation. Bank restructuring plans will aim to minimize the amount of public capital injections. The rapid introduction of common bank supervision and direct recapitalisation of banks with euro area funds would help diminish the negative feedback loops between bank financial positions and sovereign spreads, putting the economy on a faster road to recovery.

Fiscal consolidation will continue to weaken the economy

The government has put in place an ambitious fiscal consolidation plan, which is both appropriate and needed to restore confidence. This projection assumes that the government will fully implement announced consolidation measures of around 2.7% of GDP in 2013 and 1% in 2014. As a result, the headline deficit is projected to decline. However, it will exceed the targets due to weak economic growth, including in 2012. Fiscal consolidation is expected to have stronger than usual effects on growth in this credit-constrained environment, which militates against taking further measures to hit headline targets, especially if growth turns out much weaker than expected in government plans. In this case, the automatic stabilisers should be allowed to operate.