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Tuesday, February 25, 2003

Euroland: All Numbers Down

All numbers down: this in the opinion of the Morgan Stanley European Team is the likely impact of a war in Iraq, all numbers excepting, of course unemployment, but including a 1 per cent cut in base rates, and eurozone wide economic growth at its lowest level since the recession of 1993.And, in my book, watch out for those downside risks

Two months ago, we cut our EU GDP forecast for 2003 from 1.6% to 1.2%, on the basis of disappointing business surveys and rising uncertainties, both geopolitical and related to unclear economic policy options in the euro zone. Our forecasts were still based on relatively soft oil price assumptions, $24.8 for Brent on average in 2003, and a moderate rise of the euro, from $ 0.95 in 2002 to parity in 2003. Both assumptions now clearly look too low. Our currency team is currently expecting the euro to average $1.08 this year, and our new baseline scenario for oil prices assumes that the barrel of crude Brent should average $28.8 this year, 16% higher than previously assumed. By itself, this increase in oil prices is likely to cost 0.15 p.p. to European GDP growth, the same factor holding for both EMU and non-EMU countries.

In the end, and pricing in a positive effect from additional monetary easing (see below), we estimate the full cost of a war in Iraq at 0.7% of GDP, spread over 2003 and 2004, two-thirds of this impact being concentrated in 2003. Practically, we cut our GDP growth forecast for 2003 from 1.2% to 0.8%, and our forecast for 2004 from 2.6% to 2.3%. For the euro zone only, things are even worse: we now expect GDP growth to reach only 0.6% this year. If our prognosis were correct, this would be the worst year for continental Europe since the infamous 1993 recession.

With a war and even higher oil prices having become our central case, hitting confidence and economic growth further, we now look for a total of 100 bp of rate cuts from the ECB during the first half of this year, taking the refi rate to an unprecedented low of 1.75%. Forecasting the timing and the size of the cuts is trickier than ever, given that the fluid geopolitical situation is likely to loom large in the ECB Council's decision-making process. Assuming a war starts during March, the two most likely rate cut scenarios are as follows. First, the ECB may already be ready to cut rates at the March 6 meeting, even if a war hasn't started yet, justifying the cut with the euro's appreciation, the adverse impact of the prevailing uncertainty on confidence and economic activity, and the likely easing of inflation pressures later this year. In fact, comments by ECB President Duisenberg at the G-7 press conference this past weekend suggest that the Bank no longer believes in a meaningful economic recovery this year and has reduced its sighting shot for inflation further. Following these comments, a rat cut in March would no longer come as a surprise for markets. And if it happens, we continue to think it is more likely to be a 50 bp rather than a 25 bp cut, in order to make an impact on confidence. A second move would then follow soon after the start of a war.
Source: Morgan Stanley Global Economic Forum

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