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UPDATE: EU Sees Gradual Economic Recovery In 2010, 2011

(Adds details from forecasts, comments from EU's Almunia.)

By Adam Cohen

Of DOW JONES NEWSWIRES

BRUSSELS -(Dow Jones)- The European Union economy will recovery gradually over the next two years, while unemployment and government budget deficits continue to climb, the European Commission said Tuesday.

The commission, the EU's executive arm, expects the bloc's economy to contract 4.1% this year before expanding 0.7% next year and 1.6% in 2011.

For the 16 countries that use the euro, the commission expects a 4% contraction this year, followed by 0.7% growth next year and a 1.5% expansion in 2011.

The commission's forecasts show how the region's economic prospects have improved steadily over the past six months. The commission in May predicted the EU and euro-zone economies would contract 0.1% in 2010. In September, it forecast that both economies would grow about 0.4% next year.

The EU recovery will be uneven, however, with some economies emerging from recession faster than others. The U.K. economy is expected to grow 0.9% next year and 1.9% in 2011, outpacing the euro-zone average. Ireland and Spain, by contrast, are expected to remain in recession next year before recovering in 2011.

The commission also expects average growth rates to retreat back toward 0% in the first half of 2010, before a second rebound in the second half of the year. This "soft patch" can be attributed to the withdrawal of stimulus measures in major economies and slack EU exports, the commission said. It warned that "the relative strength of the euro may restrain export growth somewhat more than predicted."

The commission said that, while financial markets generally are improving, the banking sector is still fragile and credit markets remain stagnant. It cautioned that EU financial companies could face "substantial" losses in the near future.

Even with these hiccups, the commission's latest forecasts confirm that EU countries should start unwinding their fiscal stimulus plans by 2011, at the latest, European Commissioner for Economic and Monetary Affairs Joaquin Almunia said.

"In 2011 we will be in a sustained recovery, even if this recovery is a gradual one," Almunia told a news conference. EU finance ministers last month agreed to start reducing support for their economies if a recovery is underway.

The commission said its outlook is still "highly uncertain," adding that " significant fiscal and monetary policy measures" are supporting the region's early moves toward recovery.

EU countries last December agreed to spend about EUR200 billion to support their economies. Combined with a sudden fall in tax revenue, this spending has caused a sharp deterioration in EU public finances.

The commission expects the total EU government deficit to be 7.5% of gross domestic product next year, roughly triple the level recorded in 2008. Next year, among the bloc's 27 member countries, only Bulgaria is expected to have a deficit below 3% of GDP, the EU-mandated limit.

"A protracted period of fiscal consolidation will have to follow at some stage to put public debt back on a sustainable footing," the commission said in its report. The commission expects states' support for the economic recovery to " fade away" in the course of next year.

Almunia said he won't be lenient with countries that have large budget deficits, warning that some governments will be ordered to start reducing their budget gaps faster than others. The commission is due to issue a set of recommendations Nov. 11, including harsh criticism for Greece, which is expected to have a budget deficit worth 12.7% of GDP this year.

Even though the EU and euro-zone economies are expected to recover over the next two years, unemployment will continue to rise, according to the commission. It expects the jobless rate to reach 10.9% in the euro zone in 2011, while stabilizing around 10.3% in the EU as a whole.

-By Adam Cohen, Dow Jones Newswires; +322 741 1486; adam.cohen@dowjones.com

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