• Revision. Fears that the German upswing could end after the VAT increase have dissipated. We are, therefore, raising our GDP forecast by half a percentage point. For 2007, we now expect growth of 2.1%, followed by 2% in 2008. The readings for the eurozone are then correspondingly higher (just over 2??%).
• Dip. The dampener in Q1 2007 growth was, however, unavoidable after the advance effects at the end of last year. Private consumption probably even posted a strong decline in Q1. But a dynamic construction sector taking advantage of the warmest winter on record, as well as a strong inventory build-up, should have ensured minimal growth in the first three months (pages 3-5).
• Upwards. From the second quarter on, however, the German economy should again grow at or even slightly above trend. Corporate sentiment is excellent (cf. chart below), unemployment is falling, incomes are rising, foreign demand remains robust, and the investment motor is running at full speed in light of record-high capacity utilization rates.
• ECB. Consequently, there is no reason for the European Central Bank to end its tightening cycle any time soon ??“ even if the EUR were to post further new highs.

Further topics:

• Weekly Comment: EMU ??“ Taking the broader view (page 2).
• Eurozone: Falling savings rate to support consumption (page 6).
• US: Decline in March core inflation leaves the Fed cold (page 9).
• Data outlook: European purchasing managers remain bullish; their US colleagues, in contrast, are much more reserved (p. 12).
• Market outlook: Sovereign bonds remain well supported; EUR catches its breath before renewed attacks on the all-time high (page 21).

EMU: TAKING THE BROADER VIEW

Over the last several weeks, we have explained in detail our positive view on the eurozone??™s economic outlook. In this issue of the Friday Notes, we are reaffirming this positive view, upgrading our growth forecast for Germany for this year and next.

In this piece, however, I want to discuss briefly two recent and seemingly unrelated developments that are not directly related to the current eurozone performance but that do have some bearing on Europe??™s longer-term prospects. The first one took place in Turkey, where the ruling AKP party announced last Tuesday its official candidate for this year??™s presidential elections. Rather that on Prime Minister Erdogan, the party??™s undisputed leader, the choice fell on Foreign Minister Gul. This is a very positive development. Erdogan had led the AKP to an overwhelming victory in the 2002 elections, laying the basis for five years of stable government. The victory had initially raised some concerns that the Islamic leanings of AKP might exacerbate tensions with the secular establishment in Turkey, and in an extreme case scenario even lead the army to try to push the AKP out of power. In any case, Turkey, which had just emerged from a major currency and banking crisis, enjoyed five years of high growth and successful economic reforms. A ballooning fiscal deficit and potentially unsustainable public debt have been brought down below the Maastricht criteria, inflation has been reduced to single digits, and big-ticket privatizations have boosted foreign investment in the country. At the same time, political reforms have allowed Turkey to finally begin formal accession talks with the European Union. Concerns about the AKP??™s Islamic leanings, however, have not been completely dispelled, and there were rising fears that the AKP might try to use the office of the Presidency to push a religious agenda against the country??™s longstanding secular tradition. As Erdogan is seen as closer to the religious soul of the party, his candidature would have exacerbated these concerns. Gul, instead, has from the beginning represented the more modern face of AKP; he played an important part in reassuring foreign investors in the initial phases of the AKP tenure, and has accumulated precious international experience by representing Turkey in the EU negotiations. Erdogan??™s decision to step aside in favor of Gul was very statesman-like, and greatly enhances the chances that Turkey will continue to enjoy political stability in the years ahead. While there is obviously great uncertainty as to whether or Turkey will ever have the possibility of becoming an EU member, we see an extremely high likelihood that Turkey??™s economy will continue to develop successfully. This should continue to provide attractive investment opportunities in both the fixed income and equity markets ??“ and our EEMEA specific publications provide a number of recommendations for interested readers. But it will also continue to provide attractive growth opportunities for European businesses. The debate on whether or not Turkey should be allowed to become an EU member has assumed extremely contentious tones, often focused on very sensitive issues of religion and cultural identity. Perhaps more important, even if less openly admitted, is the problem that Turkey would be a political and economic heavyweight, which would reshuffle the balance of power within the EU in a dramatic way. But whether Turkey comes in or stays outside, its growing economic weight cannot be avoided or ignored, and European businesses and politicians should focus on ways to benefit from it.

A second example of how Europe cannot afford to ignore the outside world comes from Italy, where the government has just launched a revamping of its immigration laws. The changes include some overdue positive steps, such as streamlining procedures for allowing the entry of qualified foreign workers to fill identified vacancies in the labor market, from child care to electronic engineering. It is not clear what impact the changes will have on the sensitive problem of illegal immigration, but the recognition of the fact that qualified immigration should be actively managed and encouraged rather than hindered is an important step forward. Qualified immigration can of course not be seen as simply a substitute for a more efficient education system strongly attuned to the needs of the market place, but it can play an extremely precious role in supporting economic growth and helping domestic companies to improve competitiveness.

Globalization will continue to put European economies under enormous pressure. The best response includes looking at the issue in a global way, and trying to take advantage of resources and opportunities wherever they can be identified. The surprising strength of the current upswing should not distract us from the need to pursue further economic reforms in the eurozone.