EU crisis may inflict global damage

Paris: The Organisation for Economic Cooperation and Development (OECD) said Europe's debt crisis risks spiralling and seriously damaging the world economy.

"The risk is increasing of a vicious circle, involving high and rising sovereign indebtedness, weak banking systems, excessive fiscal consolidation and lower growth," OECD chief economist Pier Carlo Padoan wrote in the organisation's semi-annual report on the global economy. Such a downside scenario "may materialise and spill over outside the euro area with very serious consequences for the global economy," he said.

The remarks amount to a warning to European Union leaders who are preparing to gather in Brussels today to discuss how to revive growth and grapple with a political impasse in Greece, where voters rejected austerity measures in elections on May 6. The euro has dropped more than 3 per cent this month on concern that Greece may opt to leave the 17-nation monetary union.

The OECD, which advises its 34 member governments on economic policy, left its 2012 growth forecast for the group unchanged at 1.6 per cent as the gloomier picture in the euro area was offset by improving prospects in the US.

Gross domestic product in the euro region will shrink 0.1 per cent this year and expand 0.9 per cent in 2013 instead of posting growth of 0.2 per cent and 1.4 per cent as predicted last November, the Paris-based OECD said yesterday.

Persistent weakness

"Such persistent weakness reflects underlying economic, fiscal and financial imbalances within the euro area, which have been the root cause of this crisis and barely begun to unwind," Padoan said. "Recovery in healthier countries, while welcome, is not strong enough to offset flat or negative growth elsewhere."

Germany's GDP, adjusted for work days, will expand 1.2 per cent this year and 1.9 per cent in 2013, while France will post growth of 0.6 per cent and 1.2 per cent, the OECD forecast. By contrast Italy's economy will shrink 1.7 per cent and 0.4 per cent, and Spain's will contract 1.6 per cent and 0.8 per cent .

The OECD urged the European Central Bank to stand ready to resume buying government bonds in the secondary market should market turmoil increase. Volatility in sovereign bond markets "could have repercussions for the stability of the banking system and ultimately public finances," the OECD said. That may require a policy response that "could involve further action by the ECB through its government bond purchasing programme."

In any event, given declining inflationary pressures, "there is room for further monetary easing," it said. The ECB has already cut its benchmark interest rate to a record low of 1 per cent.

The OECD warned that voters in euro-area countries struggling with austerity measures may not put up with further budget cuts.

"Tolerance for fiscal adjustment may be reaching its limit," it said.

"With recession in a number of countries in 2012 and 2013, a combination of enduring financial fragility, rising unemployment and social pain may spark political contagion and adverse market reaction."

Given the risks inherent in fiscal adjustment, the OECD called for austerity measures to be "as growth-friendly as possible," arguing "much can be gained in efficiency of public spending and through a composition of taxation that is least harmful to growth."

Europe's fiscal compact, which aims to anchor budget restraint in national law and boost supranational surveillance, should be partnered by a growth compact that could include the issuance of jointly-guaranteed bonds to help recapitalise banks and increasing resources available to the European Investment Bank to fund infrastructure projects, the OECD said.

"Such moves could pave the way to a broader issuance of euro-bonds," Padoan said.

Growth forecasts

The European outlook contrasts with that of the US, for which the OECD lifted its growth forecasts to 2.4 per cent and 2.6 per cent this year and next. In November, the organisation predicted a US. expansion of 2 per cent in 2012 and 2.5 per cent in 2013.

"In the US, growth should continue to strengthen as confidence is picking up in both businesses and households," Padoan wrote. "The risk of excessive fiscal tightening in 2013 remains to be addressed, failing which, growth would be severely affected." The OECD expects the Japan-ese economy to expand 2 per cent this year and 1.5 per cent next year. In China, which isn't a member of the OECD, growth will be 8.2 per cent this year and 9.3 per cent next year, according to the OECD's latest forecasts. That's less than the 8.5 per cent and 9.5 per cent growth rates it projected in November.

"China's slowdown became more pronounced in late 2011 and early 2012 as first exports and then inventories fell," the OECD said. "If growth continues to weaken in the second quarter of this year, the government should speed up implementation of key infrastructure projects."

Padoan warned that five years after the onset of the financial crisis, policy makers have failed to rebuild confidence that is the basis for growth.

"As long as confidence is not rebuilt on a solid basis with the right policy choices, downside risks will prevail," he said. "This is important everywhere but particularly so in the euro area, where crisis management goes hand in hand with the building of the institutions needed for a monetary union to work properly."

ECB should intervene

The ECB should cut interest rates further and the EU take bloc-wide measures to boost growth and ease the fiscal adjustment in the Eurozone where crisis risks are intensifying, the OECD said.

The OECD called for "a further easing in the euro area" despite the ECB having official rates at a record low 1.0 per cent, given that inflation is set to decline to the central bank's target of 1.9 per cent next year.

It warned that the ECB may need to intervene again to stabilise banks and government bond markets.

With EU leaders meeting today in Brussels to contemplate measures to boost growth, the OECD said "credibility and confidence would be enhanced by euro area and EU-wide measures".

While credible medium-term plans to reduce deficits were essential, the OECD said "the speed of consolidation should depend on country-specific circumstances."

New French President Francois Hollande has called for a growth pact to complement the EU fiscal pact, pitting him against German Chancellor Angela Merkel who has pushed for euro nations to pursue austerity policies.

The OECD said growth in Germany was not enough to carry along the rest of the Eurozone, and said higher wages in the country could boost domestic demand and contribute to a less painful readjustment for others.

"EU-wide measures would strengthen activity, both directly and indirectly, by boosting confidence and making it easier to achieve the intra euro area rebalancing effort," it said.