The euro-area economy will shrink in back-to-back years for thefirst time, driving unemployment higher as governments, consumersand companies curb spending, the European Commission said.

Gross domestic product in the 17-nation region will fall 0.3percent this year, compared with a November prediction of 0.1percent growth, the Brussels-based commission forecast today.Unemployment will climb to 12.2 percent, up from the previousestimate of 11.8 percent and 11.4 percent last year.

Economic and Monetary Affairs Commissioner Olli Rehn saidauthorities must press on with reforms to end the region's debtcrisis and help the recovery. While “hard data” has beendisappointing, there also has been more encouraging “soft data”that points to better times, he told reporters today.

A strengthening of the euro economy later this year may be ledby Germany, where investor confidence rose in February to a10-month high. The commission's weak outlook reflects governmentausterity measures and efforts by companies and consumers to reducedebt. The European Central Bank said today banks will next weekreturn 61.1 billion euros ($80.5 billion) of its second three-yearloan, a measure introduced to aid lending at the depths of thefinancial crisis.

“We clearly have a decoupling with different recovery trends,with Germany certainly recovering at a much faster pace,” saidMarco Valli, chief euro-area economist at UniCredit Global Researchin Milan. “We still have a lot of noise and volatility in themonthly data, but the bottom line is that the euro zone as a wholehas already turned.”

The commission cut its forecast for the German economy, Europe'slargest, to 0.5 percent growth this year, from 0.8 forecast inNovember, due to a drop in euro-area demand that damps export andinvestment.

In a sign that Europe's largest economy is anticipating bettertimes, the Ifo institute in Munich said its business climate indexclimbed to 107.4 from 104.3 in January. That's the biggest increasesince July 2010 and the fourth straight monthly gain. Earlier thisweek, the ZEW gauge of investor sentiment rose to the highest inalmost three years.

Separately today, the ECB said 356 financial institutions willrepay money on Feb. 27 from its second long-term loan. The 61.1billion-euro figure is about half the 122.5 billion euros forecastby economists. The ECB flooded markets with more than 1 trillioneuros in three-year loans a year ago and banks have the option ofrepaying after 12 months. They started returning the initial loanlast month.

“The second LTRO was used by a wider range of institutions withpoorer collateral and given the positive carry still on offer, itmakes sense for many of these institutions to hold on to thesefunds,” said Elsa Lignos, a currency strategist at Royal Bank ofCanada in London. “We wouldn't take this as a sign that financialtensions are returning.”

Budget Deadlines

The Stoxx 600 Index rose 1.1 percent as of 12:33 p.m. Londontime, bringing its advance for the year to 3 percent after a 14percent gain last year. The euro slipped 0.1 percent versus thedollar to $1.3172. It has strengthened 6 percent over the past sixmonths.

On the euro area, Marco Buti, head of the commission's economicsdepartment, said the labor market “is a serious concern.”

“This has grave social consequences and will, if unemploymentbecomes structurally entrenched, also weigh on growth perspectivesgoing forward,” he said.

The commission said domestic demand won't improve until 2014,when it should take over as the main driver of growth. Investmentis expected to be a drag on the economy this year, subtracting 0.3percent from GDP, before offering a 0.4 percent contribution in2014.

Seven euro-area economies are expected to contract in 2013, withthe Netherlands joining Italy, Spain, Portugal, Greece, Cyprus andSlovenia in the new forecast.

The EU's outlook for next year was more upbeat, with 2014forecasts of 1.4 percent growth and 12.1 percent unemployment inthe euro area. Across the 27-nation European Union, the commissionprojected 0.1 percent growth for 2013 and 1.6 percent growth in2014, after the bloc shrank 0.3 percent last year.

“Some signs of a turnaround are now discernible,” Buti said.“The present forecast projects a return to moderate growth in thecourse of this year, as confidence gradually recovers and theglobal economy becomes more supportive.”

Budget Shortfalls

Rehn urged nations to keep cutting budgets and overhauling theireconomies in the face of slowing growth. In a statement, he saidany shift away from fiscal consolidation would prolong thedownturn.

“The decisive policy action undertaken recently is paving theway for a return to recovery,” Rehn said. “We must stay the courseof reform and avoid any loss of momentum, which could undermine theturnaround in confidence that is under way, delaying the neededupswing in growth and job creation.”

Still, he said deadlines may be extended because of the poorshort-term economic outlook, giving deficit violators such as Spainand France room to avoid penalties or draconian cuts.

The EU is close to agreement on how to install the ECB as acommon bank supervisor for the euro area, as well as how it willapply new global standards on how much protective capital banksshould hold, Rehn said. These steps also will help set the stagefor improvement in future years, he said.

The euro area as a whole is expected to post a budget deficit of2.8 percent in 2013, according to the EU report. Spain is projectedto show a 10.2 percent deficit for 2012, falling to 6.7 percent in2013. The Spanish economy is projected to shrink 1.4 percent in2013, the same as in 2012, with unemployment rising to 26.9 percentin 2013.

France, where President Francois Hollande has tussled with EUcalls for more austerity, is projected to post a 4.6 percentdeficit in 2012 and a 3.7 percent gap in 2013, the commission said.Without any changes, France's deficit would rise to 3.9 percent in2014 and Spain's would rise to 7.2 percent, the commissionsaid.

Rehn said it's too soon to determine whether the commission willcall for France to take additional steps.

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.