The euro area started 2007 on a healthy footing, finds the Quarterly Report on the Euro Area. Economic growth in the first quarter reached 3% in annualised terms spurred by domestic demand, particularly investment. Consumption contracted slightly but is expected to recover quickly as consumer confidence approaches an all-time high. Export growth decelerated, but this reflects mainly statistical effects and, possibly, a cooling off of the international environment rather than the appreciation of the euro. The focus section of the report shows that financial integration clearly has positive effects on economic growth and is also important for the smooth functioning of EMU. Therefore, euro-area Member States have even more to gain from financial integration than other EU Member States.

GDP in the euro area grew by 0.6% in the first quarter of 2007, boosted by strong investment growth. Household consumption decreased slightly mainly due to the contraction of German consumption as a result of the VAT increase. The latter had a moderate impact on consumer prices, however, as inflation remained broadly stable at around 1.9%. Unemployment receded further to 7.1% in April, almost a full percentage point lower than a year earlier, as the number of people at work expanded by a robust by 0.4% (533,000 persons) in the first quarter. These favourable developments combined with very high consumer confidence should encourage consumption growth in the next quarter. Looking ahead, the overall economic prospects for the euro area remain bright (in the spring the Commission forecast euro-area growth of 2.6% in 2007). The short-term inflation outlook remains benign, with price expectations well anchored, imported inflation still tame and unit labour costs progressing slowly. However, some upward risks to prices may materialise as the cycle matures.

Don't blame the euro

Euro-area trade growth slowed significantly in the first quarter to 0.3% compared with the previous quarter. The deceleration partly reflects a statistical correction after the exceptionally strong figures in the last quarter of 2006, but may also reflect a slight easing of world trade growth.

After a pause in 2005, the euro appreciated, in recent quarters, against the currencies of some of the euro-area's main export destinations. On average, the appreciation remains relatively modest, at about 4% in nominal terms since the beginning of 2006 and has been partly offset by favourable domestic cost developments. Furthermore, the experience with the previous period of appreciation, in the first half of this decade, shows that fluctuations in the real exchange rate (the exchange rate adjusted for the relative developments in costs and prices in the euro area and its main trading partners) have a relatively modest impact on the euro area's export performance: it is estimated that between 2001-06, exchange rate fluctuations curbed annual growth in euro-area exports by 0.6 pp, which is small relative to the 5% average annual growth in the exports over the period and should be seen against the 0.5 pp annual fillip in the second half of the 1990s when the euro depreciated. The fact that some euro area countries have performed much better than others sharing the same currency is further evidence that the exchange rate plays only a limited role in the export performance of the individual countries. The causes for a lacklustre trade performance of some members must, therefore, be found elsewhere and particularly in domestic wage and productivity developments. There is also evidence that the euro appreciation has taken only a modest toll on exporters' profits in recent years.

The report goes on to explore the link between fiscal policy and inflation. It shows that fiscal policy can have quite sizeable effects on domestic inflation. However, this will depend on the nature of the fiscal adjustment. Simulations show inflation spillovers from a fiscal expansion in one Member State to the rest of the euro area can be of a sizable magnitude and rather persistent in the case of expenditure shocks in large and open countries.

In its Focus Section, the report analyses EU financial integration and its role for euro-area adjustment. Financial integration creates more and better products and leads to higher growth in the EU. But it is also important for the smooth functioning of the euro-area through its stabilization role and a better allocation of resources in case of country-specific shocks. By lending and borrowing in the international financial markets, financial integration allows agents to hold a wider range of assets, which help consumers cushion themselves against shocks. This reduces consumption volatility over time. A number of financial market indicators confirm increasing financial integration in the EU as the euro acted as a catalyst for change. Portfolios have become more diversified to improve risk/reward structures, reducing home bias and leading to increased risk sharing. Euro-area countries have more to gain from financial integration than the rest of the EU and should move into the vanguard of efforts to create a truly and completely integrated financial market for the EU as a whole.