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Brussels, 19 December 2008

Quarterly report on the euro area: rapid, forceful and coordinated action is key to support the economy

Swift and coordinated implementation of the European Economic Recovery Plan is key to restore confidence and mitigate the effects of the crisis on the real economy, recalls the Quarterly Report on the Euro Area (QREA). The financial crisis has intensified during the past three months, taking an increasing toll on the real economy. The Report examines to what extent financing costs have increased for the corporate sector since the summer of 2007 and how this is impacting economic activity. It also finds that the current contraction in non-residential investment points to a sharp cyclical correction ahead.

"A rapid and forceful action by Member States is key to support the economy and the Economic Recovery Plan endorsed by the European Council provides a timely, targeted, temporary and coordinated policy response," said Joaquín Almunia, European Economic Affairs Commissioner.

The QREA reviews the main elements of the Recovery Plan, examines the economic effectiveness of the different measures and highlights the importance of the coordinated approach taken by Member States.

Since the October edition of the QREA, the financial crisis has deepened further. Bank rescue packages have prevented financial meltdown but spreads on money and capital markets remain elevated and volatile. Banks have considerably tightened their lending conditions both for corporations and households. The financial crisis has gradually taken its toll on the real economy. In the third quarter, euro-area GDP was down for the second consecutive quarter, contracting by 0.2% compared to the second quarter. Against the background of rapidly deteriorating world markets, a strong drop in euro-area net exports was the main source of the contraction in activity. Investment also contracted – for the second consecutive quarter –, at an annualised rate of 2-3%, as a result of the sharp correction in housing markets but also of some weakness in business investment. Household consumption remained sluggish and its short-term prospects are hampered by continued deterioration on the labour market. The recent ebbing of inflation, which dropped to 2.1% in November, should however lend support to household disposable income. Business and consumer confidence, which have been on a weakening path since summer 2007, have experienced an unprecedented deterioration in the past couple of months, pointing to further contraction in activity in the months ahead.

With the financial crisis intensifying, financing costs in the euro area are rising, especially for the corporate sector. According to two composite financing cost indicators developed by the Commission for private sector debt, the financial costs of non-financial corporations have increased by a substantial 130 basis points (bps) since the summer 2007 and those of households by a smaller 50 bps. The increase reflects the sharp fall in stock prices, higher bank lending rates and increasing corporate bond rates.

While banks' loan provision to non-financial corporations still grows strongly, surveys point at a substantial tightening of credit standards due to the impact of the financial crisis and negative feedback loops from the real economy. The report shows that loans supply is a crucial determinant of short-term economic growth in the euro area and that constraints in loan supply due to the financial crisis could have a substantial negative impact on the real activity. Indeed, a downsizing of banks' balance sheets could exert a significant drag on economic growth, depending on the assumed size of the balance sheet adjustment. In light of these results, the report stresses the strong need for bank recapitalization to avoid serious consequences for the real economy.

While over the past 10-15 years non-residential investment was one of the main drivers of economic growth in the euro area, it has now been contracting for the last two quarters. The report examines recent developments in non-residential investment and assesses the risks linked to the ongoing economic downturn. It finds that in the short run, the cyclical correction in investment is likely to be much sharper than in the previous downturn of the early 2000s as the corporate sector faces a marked risk of a credit retrenchment due to a weakened banking sector. In the medium term, the financial turmoil is likely to lead to a general re-pricing of risk that will push the cost of capital durably up. This will further impact investment demand both through the capital cost and the balance sheet channels.

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