The euro zone economy will grow 1.5 per cent this year and 2 per cent in 2006, with the biggest threat to growth coming from further appreciation of the euro, a network of 10 leading research institutes lead by the Economic and Social Research Institute said yesterday.

In its first report on the area's economy for the European Commission, the Euroframe network cut the forecasts it made last November when it saw growth at 2 per cent this year rising to 2.4 per cent next year.

In its latest report it predicted an inflation rate of 2 per cent this year easing to 1.8 per cent in 2006, and saw the European Central Bank hiking interest rates by 75 basis points over the two-year period.

"This faltering recovery will move the euro area back towards rates more in line with its estimated potential after almost a half-decade of underachievement," the institutes said.

"The most potent threat to euro-area growth prospects stem from the risk of a further appreciation of the euro and... global macroeconomic imbalances," they added.

Euroframe said the high oil price was "most likely not a threat to the euro-area recovery" because increased oil revenue would be recycled by oil producers, boosting the global economy and therefore helping the economies of Europe.

The report criticised the deal reached by European Union leaders last week, when they agreed to loosen the bloc's budget deficit rules set down in the Stability and Growth Pact.

Under the deal, EU states will be given more time to bring deficits back under the 3 per cent limit and can claim exemption for all sorts of public spending. "Some of us are worried that the agreement will be detrimental to budgetary discipline and will lead to higher government deficits," Euroframe said.

Euroframe is lead by the Economic and Social Research Iinstitute and made up of institutes from Austria, Britain, Denmark, Finland, France, Germany, Ireland, Italy and Poland. It predicted the three core euro-zone countries - Germany, France and Italy - would again exceed their 3 per cent limit. - (Reuters)