The euro area economy remains deep in recession but the European Union’s policy response is helping, and most recent surveys point to more encouraging short-term economic prospects, the European Commission (EC) said on June 29.

In its quarterly report on the euro area, the EC said that the EU "strong and co-ordinated" policy  response was providing tangible support to economic activity.

Consumer and business sentiment indicators and financial markets had started showing tentative signs of improvement, the report said.

Most financial markets were showing encouraging signs of stabilisation "although conditions remain fragile," the EC said.

Spreads on money and bond markets had narrowed on the back of improved economic sentiment and lower risk aversion.

Financing conditions in the euro area had also improved as the cost of bank loans, equity capital and market debt had all declined.

However, money and credit growth had slowed further in recent months, mainly reflecting very weak economic activity but also some supply constraints.

Euro area GDP dropped by 2.5 per cent in the first quarter of 2009, according to a statement by EU statistics service Eurostat on June 3. This had been driven mostly by an inventory adjustment and a continued sharp fall in investment.

On the positive side, the fall in private consumption had been contained by the deceleration of consumer price inflation and comparatively supportive developments in nominal disposable income.

"While hard data have so far remained depressed, survey data have begun to show a pick up in confidence in most euro area countries," the EC said.

World trade growth had also shown signs of improvement but remained depressed.

The substantial banking support measures implemented by EU member states since autumn 2008 had helped to avert financial meltdown, according to the EC.

The measures, mainly in the form of recapitalisation, debt guarantees and asset reliefs had had a positive impact on banks’ capital and access to wholesale funding.

"Developments in price indicators of financial distress suggest that the functioning of interbank markets has improved significantly," the EC said. However, the convergence process towards more normal conditions had been only partial and the situation remained fragile.

In particular, further significant asset write-downs are still to be expected, as confirmed by a recent study by the European Central Bank, according to the EC report.

Budgetary policy was "significantly supporting" economic activity in the euro area. At the same time, pressure on public finances was increasing.

From a low in 2007, the euro area average debt ratio was projected to increase by 18 percentage points to reach 84 per cent of GDP in 2010 and would rise further in the years beyond because of high government deficits.