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UNCLAS SECTION 01 OF 04 FRANKFURT 010320 
 
SIPDIS 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS SOBEL 
TREASURY ALSO FOR ICN COX, STUART 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: ECB Staff Projections: Growth to Pick Up in 2004 - 
Forecasting External Sector Is Tricky Business 
 
 
T-IA-F-03-0066 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
¶1.   (SBU) Summary:  The European Central Bank's (ECB's) 
December staff projections suggest real Euro area annual 
average growth of 0.4% in 2003 rising to 1.6% in 2004 and 
2.4% in 2005.  The basic story is that exports will help 
lift growth in the near term followed by a strengthening of 
domestic demand, particularly private consumption.  The 
staff projections carry a larger range of uncertainty for 
exports and imports, understandably so given the euro's 
appreciation against the USD.  While a "rule of thumb" would 
suggest an appreciating euro could be, on balance, a drag on 
EU growth, the strong pick up in US demand suggests that the 
negative growth effects may not be as strong as the "rule" 
implies - at least in the near term.  End Summary 
 
ECB Staff Projections 
 
¶2.     (SBU)  In  its  December  monthly  bulletin  the  ECB 
presented   current  staff  projections  for   macroeconomic 
developments in the euro area. The ECB, which expresses  its 
growth  projections in terms of "ranges," adjusted  expected 
GDP growth downwards for 2003, slipping the mid-point of the 
projection ranges from 0.7% to 0.4%.  This adjustment is due 
to  a  weaker  than expected outcome in the second  quarter. 
However, they left the growth projection for 2004 unchanged, 
with  a mid-point of 1.6%. In their view, the impact of  the 
announced expansionary fiscal measures in the euro  area  is 
limited,  as  the  increase of households'  real  disposable 
income due to tax cuts is expected to be counterbalanced  by 
higher  consumer prices. For 2005 projections show the  mid- 
point of the growth range  rising to 2.4%. 
 
¶3.   (SBU) Inflation, as measured by the Harmonized Index of 
Consumer  Prices  (HICP) is expected to be  around  2.1%  in 
¶2003.  However, the staff shifted upward the range projected 
for  the  HICP  in 2004 from a mid-point of  1.3%  to  1.8%, 
compared to their last forecast in June. The increase is due 
to  various  planned fiscal measures, such as  increases  in 
indirect  taxes  and administered prices,  as  contained  in 
national budget plans. 
 
¶4.    (SBU) The staff projections are based on the following 
main assumptions: 
       short-term  interest  rates are  constant  over  the 
     projection horizon at slightly below 2.2%; 
    EUR/USD exchange rate assumed to be constant at 1.17 
over the horizon; 
    Annual average oil prices assumed to decline from 28.5 
USD per barrel in 2003 to 24.5 USD in 2005; 
    World real GDP growth outside euro area estimated at 4% 
on average in 2003, increasing to 4.5% in 2004 and 5% in 
2005; 
 
 
 
 
ECB projections,                      December 2003 
 y/y in % 
                    2002     2003              2004 
                          2005 
Real GDP            0.9     0.2 - 0.6        1.1 - 2.1 
                    0.5   1.9 - 2.9 
                    2.8     1.0 - 1.4        1.1 - 2.1 
                          1.4 - 3.0 
                    -2.8    0.9 - 2.1        0.6 - 1.6 
                          0.3 - 1.3 
                    1.7 
                           -1.7 - -0.7       0.2 - 3.2 
                    0.0   2.3 - 5.5 
 
                    2.3    -1.6 - 1.2        2.8 - 6.0 
                          5.0 - 8.2 
 
2 
 
                            0.1 - 2.7        2.9 - 6.3 
                          5.1 -8.5 
 
                            2.0 - 2.2        1.3 - 2.3 
                          1.0 - 2.2 
Private Consumption 
Government 
Consumption 
Gross fixed 
Capital Formation 
Exports (goods & 
services) 
Imports (goods & 
services) 
HICP 
 
 
Real GDP Growth Projection 
_______________________________ 
 
¶5.    (SBU)  The ECB expects only a weak GDP growth  between 
0.2  and  0.6%  for 2003 (mid-point of 0.4%), since  in  the 
first  half of the year real GDP stagnated in the euro area. 
For  2004  and  2005,  they project an acceleration  of  GDP 
growth,  reaching values between 1.1 and 2.1% (mid-point  of 
1.6%)  and  1.9  and 2.9% (mid-point of 2.4%), respectively. 
Economic  development will be characterized by a pick-up  in 
export  growth and recoveries in both investment and private 
consumption.   The  ECB  expects  a  significant   rise   in 
employment at the earliest in 2005, as reflecting the  usual 
lag in the cyclical pattern of employment. 
 
Price and Cost Projections 
_______________________________ 
 
¶6.    (SBU) The ECB estimates HICP to be in a range  between 
2%  and  2.2%  in  2003. For the following  years,  the  ECB 
expects lower inflation rates due to the assumed decline  in 
oil prices. Import prices are currently dampened by the euro 
appreciation. They are estimated to remain subdued in  2004, 
not  least because of decreasing energy prices, then passing 
over to a modest increase in 2004. Unit labor cost growth is 
forecast  to decline in 2004 and 2005, which will be  driven 
by  a recovery in labor productivity. After remaining low in 
early  2003, labor productivity would pick up at the end  of 
2003, moving back to rates close to the long-term average at 
the end of the staff projection horizon. 
 
External Sector:  Rule of Thumb and Disconnects 
_____________________________________________ __ 
 
¶7.    (SBU)  Export and import components always  have  been 
difficult to forecast.  The wide range of possible out comes 
for  2004,  i.e.,  exports to grow between  2.8%  and  6.0%, 
reflects  the  difference between actual outcomes  and  past 
projections.  That is, it is a mechanical exercise and  does 
not  reflect any judgments on a range of probability by  ECB 
staff.   With  the euro at 1.21/USD in early December,  4.1% 
higher than its end-October level and 28% stronger than  its 
2002  average,  according  to  ECB  statistics,  forecasting 
external accounts is even trickier business. 
 
¶8.   (SBU) Although the ECB does not present its forecasting 
methodology,  it  has  made  some  specifications   of   its 
macroeconomic  model  available.   From  this,  some  market 
analysts  have derived what they consider a "rule of  thumb" 
for    computing   exchange   rate   effects   on   economic 
developments.   Deutsche Bank Research and  Lehman  Brothers 
both indicate that, using the ECB's model implies that a  10 
percent  rise  in the real effective exchange  rather  would 
knock 0.5 percentage points off inflation and 0.6 percentage 
points  off  growth in the first year.  While  the  ECB  has 
suggested that the appreciating euro's contribution to lower 
inflation  would  contribute to higher real  incomes,  these 
effects  appear  to be overwhelmed by a negative  net  trade 
balance as imports grow while exports struggle. 
 
¶9.    (SBU) To every rule of thumb there are exceptions.  To 
this  one there are many.  First, in any model there is  the 
economists'   favorite  "all  other  things   being   equal" 
assumption.  That  is, the model assumes  that  there  is  a 
"shock"  in the exchange rate market rather than changes  in 
underlying economic activity.  Reality is different. 
 
¶10.  (SBU) In last year's Article IV consultation, IMF staff 
examined  the  Euro  area's experience  when  the  euro  was 
weaker.  They found an apparent "disconnect" in the exchange 
rate  link with trade flows between the euro and other large 
currency areas. During 1996-2001 the real effective exchange 
rate  of the euro declined by almost 30 percent.  IMF  staff 
compared  a simulation using conventional measures of  trade 
elasticities  and  the  linkage  between  trade  flows   and 
exchange rates with actual changes.  The simulation  results 
suggested  that non-oil trade surpluses would have increased 
by  2.3%  of GDP as more competitively priced exports  would 
increase  (2.9%) and more expensive imports decline  (0.6%). 
Actually,  trade  balances declined  by  0.2%  of  GDP  -  a 
deviation of a whopping 2.5% of GDP as exports increased but 
so  did  imports.   The IMF staff observed  that  all  other 
things  "have  clearly  not been  equal,"  pointing  to  the 
effects  of domestic and foreign absorption growth on  trade 
volumes  and  the  effects  of  domestic  and  foreign  cost 
developments   on  domestic  prices.   In  a  more   refined 
calculation,  the  IMF shows that the "disconnect"  was  the 
strongest  for capital goods imports, perhaps  reflecting  a 
rising share of relatively price-inelastic high tech goods. 
 
¶11.    (SBU)  IMF  staff  findings  "suggest  caution  using 
standard  econometric  model  simulations  for  gauging  the 
macroeconomic   effects  of  a  reversal   of   the   euro's 
depreciation."   Specifically they  thought  the  assumption 
that   the  "close-to-one-pass-through"  of  exchange   rate 
changes  to import prices "may no longer match up"  for  the 
EMU as a whole. 
 
¶12.   (SBU) With much faster growth in the U.S. than Europe, 
"foreign  absorption,"  to  use  the  IMF's  phrase,   could 
mitigate the otherwise price competitiveness effects  of  an 
appreciating  exchange rate - at least  for  a  while.   UBS 
Investment  Research has a crude model that suggests  growth 
in   global  industrial  production  is  roughly  twice   as 
important  as changes in the real trade-weight euro  in  the 
short run.  Given the lags between the increase in demand to 
translate  into  exports, UBS expects euro area  exports  to 
pick  up  over the next two (for consumption goods)  to  six 
(for investment goods) months.  Only when global (read U.S.) 
demand cools and the euro continues to appreciate would  the 
effects  of the latter begin to be more of a drag on  export 
performance.   That would be in 2005, in UBS's assessment  - 
by  which  time the euro area should be running on  stronger 
domestic demand. 
 
¶13.   (SBU)  Publicly the ECB does not want to be associated 
with  any  "rule of thumb" on exchange rates.  At his  early 
December appearance before the Economic and Monetary Affairs 
Committee of the European Parliament, ECB President  Trichet 
refused to be tied down, declaring "we are not the prisoners 
of a particularly equation or of a particular way of looking 
at  things."   Informally, ECB staff admit to such  formulas 
but  quickly  point  out that they are  used  to  provide  a 
"perspective" or "orientation" for discussion.  The exchange 
rate   together  with  external  demand  and  profit  margin 
adjustments  and  market shares must  be  taken  account  to 
produce  a  final result.  While the formula are mechanical, 
other elements, in the end, are subjective. 
 
¶14.    (SBU)   ECB  staff  projections  and   the   European 
Commission's  forecast are broadly similar.  The  Commission 
forecasts euro area growth at 0.4% in 2003, 1.8% in 2004 and 
2.3%  in 2005.  With respect to the assumptions, both assume 
a  pick  up in world growth (EC puts it at 4.1% in 2004  and 
2005).    The   Commission's  forecast  sees   net   exports 
contributing to growth in 2004 and 2005, albeit a slight 0.1 
and  0.2  percentage  points, respectively.   However,  both 
assume  a  Euro/USD exchange rate of 1.17.  Some forecasters 
see that as unrealistic - implying that the drag of exchange 
rate  appreciation  could bite faster when  external  demand 
begins   to   flag.   All  the  more  reason  for   European 
governments to concentrate on domestic policies to  generate 
confidence and growth. 
 
¶15.  (U)This cable coordinated with USEU and Embassy Berlin. 
 
¶16.  (U)POC: James Wallar, Treasury Representative, e-mail 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238 
 
Bodde