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Brussels, 4 October 2007

Momentum in euro-area economy still strong but downside risks on the rise

After a slowdown in the second quarter, growth in the euro-area economy is expected to remain robust during the second half of the year, indicates the Quarterly Report on the Euro Area published today. Confidence indicators have softened over the summer but economic fundamentals in the euro area continue to look healthy. Despite the recent financial turmoil, growth projections for 2007 have been reduced only marginally. Strong balance sheets and the improved resilience of the economy should help the euro area weather the storm. Nevertheless, downside risks have clearly increased due to the financial turmoil and the possibility of a sharper slowdown in the USA. The report also analyses how financial markets can contribute to a smoother working of the euro-area economy by increased cross-border risk sharing.

GDP growth in the second quarter slowed down to 0.3%, below the 0.6% projected in the Commission spring 2007 forecast. Growth was driven mainly by private consumption, which was supported by a strong labour market, while construction activity weakened, weighing on total investment, which declined for the first time in five years. Thanks to robust – although softening – world trade, the contribution of net exports to growth turned positive.

The growth hiccup in the second quarter reflects to a large extent exceptional weather conditions and statistical effects but might also be a sign that the euro-area business cycle is maturing. Indicators of business and consumer confidence are still well above their long-term average but have weakened noticeably over the summer. Economic fundamentals in the euro area remain strong and growth is projected to stay robust during the second half of the year. The latest Commission's interim forecast projects growth at 2.5% for the year as a whole, only 0.1 pp below the figure forecast in the spring.

Financial markets have experienced a period of serious turbulence over the past weeks caused primarily by the deterioration of the housing market in the USA. The turbulence has spilled over to other segments of the financial markets both in and outside the US. Investor confidence has been undermined by the emergence of exposures in unexpected locations and central banks in the USA and the euro area have been forced to step in. The financial turbulence will inevitably lead to a re-pricing of risk and to some tightening of financing conditions, but strong profits of euro-area banks and non-financial companies should temper the negative impact on the real economy.

Good fundamentals and increased resilience help euro area

The overall impact of the financial turbulence on growth in the euro area should remain moderate in 2007. As one of the focus sections of the quarterly report shows, not only euro area economic fundamentals continue to be strong but the economy has also become more resilient to shocks. The last economic downturn, in the early 2000s, saw smaller output gap losses and stronger domestic demand than the downturns in the 1980s or the 1990s. This increased resilience is due to a number of factors among which the elimination of the exchange rate risk for around half of the exports of the euro area members that are in fact intra-euro area sales, the stability-oriented macroeconomic framework brought about by the Economic and Monetary Union and a monetary policy supportive of growth. There were also some, although small, improvements in the conduct of fiscal policies with less pro-cyclicality in bad times than in previous downturns.

The report also looks into whether the sharing of risk has increased in the euro area, something that would bring benefits for the economy by helping Member States to better adjust to adverse economic shocks by spreading income risks and smoothing consumption patterns. Empirical evidence indicates that risk sharing via financial markets has increased within the euro area in the last ten years. However, progress has been slow and uneven among euro-area members. Moreover, risk sharing still plays a considerably lesser role in smoothing income fluctuations in the euro area than in the USA. This might be the result of an uneven pace of integration of different financial markets' segments with equity markets lagging behind bond and debt securities markets. The report calls for stepping up financial integration in the euro area, which would improve the performance of the euro-area financial sector and the economy as a whole.
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