BRUSSELS, Oct 29 - Germany and France will break EU budget deficit limits for four years running in 2005 unless they change policies, the European Commission said on Wednesday. Such breaches of the deficit cap of three percent of gross domestic product are expected even though euro zone growth should to return to potential by mid-2004, picking up from 0.4 percent in 2003 to 1.8 percent in 2004 and 2.3 percent in 2005. Past and current economic sluggishness is being used to excuse French and German budget slippage in 2003 and should allow them to escape fines but a trend towards such overshoots was worrying, the Commission said as it updated its official economic forecasts. Another year of budget breaches could risk damaging markets' faith in the Stability and Growth Pact on budget discipline, particularly as Italy and Portugal will also end up flouting its rules unless their governments change course. "Besides the three countries currently in excessive deficit (Germany, France, and Portugal), the budgetary situation is showing worrying signs of deterioration also in other euro area countries, notably Italy, Greece and the Netherlands." While France is particularly in the spotlight as it resists the Commission's recommendation to do more to rein in its deficit, the overall policy mix in the euro zone is seen as conducive to growth. However, any sharp rise in the single currency's exchange rate would risk undermining economic activity in the bloc, compounding the pain inflicted on exports by the gains it has already racked up, the Commission said.
HIGH DEFICITS
The Commission is forecasting France will run deficits of 4.2 percent of GDP this year, 3.8 percent next year, and 3.6 percent in 2005. It expects German deficits of 4.2 percent in 2003, 3.9 percent in 2004 and 3.4 percent in 2005. Other countries are also showing budget slippage. Portugal is seen running a deficit of 3.3 percent of GDP in 2004 and an even larger one of 3.9 percent in 2005 while Italy is expected to have a shortfall of 2.8 percent in 2004 and one of 3.5 percent in 2005. Italy is also the only member of the euro zone that is expected to be burdened with debt levels of more than 100 percent of GDP in 2005. Such deficits in some of the euro zone's biggest economies have a knock-on impact for the bloc as a whole. The cumulative euro zone deficit is expected to reach 2.8 percent of GDP in 2003, the highest since 1996, while the bloc's combined debt ratio is expected to increase for the first time in many years in 2003, rising to 70.4 percent of GDP. The Commission is nevertheless expecting subsiding inflation and improved international economic conditions to foster euro zone growth.
EURO FX RISKS
Euro zone inflation could tick up in the coming months as there is a risk of a further increase in unprocessed food prices following damage to crops in summer and is seen averaging 2.1 percent in 2003, the Commission said. But it will subside to the European Central Bank's tolerance threshold of 2.0 percent next year and is seen averaging 1.7 percent in 2005, which would be its first time below the ECB's ceiling since 1999, the year the euro was launched. Core inflation, which excludes volatile energy and unprocessed food costs is also seen subsiding. The euro's rise on the foreign exchanges would continue to curb price rises but also carried risks, the Commission said. "A renewed sharp appreciation in the euro exchange rate could undermine activity mainly in the euro area manufacturing sector, especially in those member states that have recently depended on external demand to generate economic growth." The Commission's official economic forecasts are based on the assumption that the euro's exchange rate will average $1.13 and 130.8 yen in 2003, $1.16 and 125.8 yen in 2004, and $1.15 and 122 yen in 2005. The EU executive said exports acted as a significant drag on growth for the three quarters up the middle of 2003, notably because the euro's rise on the foreign exchanges had eroded the price competitiveness of the bloc's exporters. "Other countries' exports seem to have held up better than euro area exports, and the euro area is likely to have experienced a slight loss in market shares. A reason for this is to be found in euro area price competitiveness, which has deteriorated in the short run."
Euro zone firms that invested in the United States during the phase of dollar appreciation have seen the dollar's subsequent decline erode the book value of such investments and the revenues from their U.S. subsidiaries. The Commission said that strengthening foreign demand in the coming months would help the euro zone economy, and offset the temporary decline in price competitiveness. It sees euro zone exports growing by 5.2 percent in 2004 and 6.7 percent in 2005. It warned that further dollar depreciation could lie ahead: "Global imbalances are expected to widen further, with the risk of a fall in the exchange rate of the dollar." However, it added that global macroeconomic policies were supportive and some Asian central banks appeared to be committed to preventing the dollar from depreciating sharply.///