Nov. 3 (Bloomberg) -- The euro-area economy will return to growth next year, the European Commission said, raising its forecasts even as budget deficits and unemployment swell to the highest levels since at least 1995.

The economy of the 16 countries sharing the euro will expand 0.7 percent in 2010 and 1.5 percent in 2011, after contracting 4 percent this year, the Brussels-based commission, the European Union’s executive, said today in its semi-annual economic forecasts. It previously forecast a 0.1 percent contraction in 2010. The region’s average deficit will widen to 6.9 percent of economic output next year and unemployment will reach 10.9 percent in 2011, the most since at least 1995.

European companies from STMicroelectronics NV to Pernod Ricard SA cited signs of recovery as they reported earnings in the past month, suggesting that record-low interest rates and emergency stimulus measures are feeding into the broader economy. At the same time, the European Central Bank is warning that it is time for governments to start shoring up budgets or face the risk of higher rates when the stimulus is removed.

Governments should start reining in budget deficits in 2011, by which time the recovery should be “sustained,” EU Monetary Affairs Commissioner Joaquin Almunia told a news conference in Brussels after issuing the forecasts.

‘Gradual Recovery’

“In 2011, I think everybody should start the consolidation,” he said “Major challenges persist for the near term; we are optimistic but we see in 2010 and 2011 only a gradual recovery.”

The euro, which has strengthened 10 percent against the dollar in the past six months, traded at $1.4659 at 3:26 p.m. in London, down 0.8 percent from yesterday.

The global economy is emerging from the worst recession in six decades, led by China, where data showed yesterday that the manufacturing industry expanded at the fastest pace in 18 months in October. Factory orders in the U.S., the world’s largest economy, rose in September for the fifth time in six months, the Commerce Department in Washington said today. Manufacturing in Europe grew for the first time in more than a year last month.

Global stocks have soared on indications of recovery. The MSCI World Index has risen almost 60 percent since March.

The commission’s growth forecasts are more optimistic than predictions from the International Monetary Fund on Oct. 1 that the region will grow 0.3 percent next year after a 4.2 percent contraction in 2009. The IMF forecast an unemployment rate of 11.7 percent for next year.

European Exports

“It’s still far from certain that we’ve got a sustainable recovery,” said Howard Archer, chief European economist at IHS Global Insight in London. “Global economic activity could suffer a relapse and particularly in the euro zone with the euro at $1.50 any relapse in global activity, together with the strong euro, could really hit European exports.”

Euro-area economies are recovering at different speeds, with Germany and France returning to quarterly growth in the three months through June, while Spain, Greece and Ireland are set to post full-year contractions in 2010, according to the commission’s forecasts.

Those three countries are also projected to have some of the highest budget deficits and unemployment rates in the region, posing further risks to the recovery. Deficits next year will amount to 14.7 percent of gross domestic product in Ireland, 10.1 percent of GDP in Spain, 8.2 percent in France and 5 percent in Germany, the region’s largest economy, the commission said.

Deficit Limit

All euro-area nations will breach the EU’s deficit limit of 3 percent of GDP in 2010 and 2011, according to today’s forecasts.

“The combination of sustained large deficits, lower potential growth and unfavorable demographic trends is a source of major concern,” Almunia said.

As some fiscal and monetary stimulus measures start to be withdrawn next year, rising unemployment will also stretch deficits, as joblessness is projected to rise to 10.7 percent next year and 10.9 percent in 2011. Metro AG, Germany’s largest retailer, said today that quarterly profit plunged 61 percent as rising joblessness eroded consumer spending across Europe. The company forecast no improvement for the rest of the year.

While unemployment has more than doubled in two years in Spain, countries including Germany and the Netherlands have held down job losses with government incentives.

‘Flip Side’

“These schemes are softening the pain,” said Martin van Vliet, senior economist at ING Bank in Amsterdam. “The flip side is that the odds of a jobless recovery in the euro zone are much higher than in the U.S.”

Inflation next year will remain below the 2 percent ceiling set by the ECB, the commission said, with annual price declines projected in Ireland in 2009 and 2010. The euro-area inflation rate will be 0.3 percent this year, rising to 1.1 percent next year and 1.5 percent in 2011, it said. The Frankfurt-based ECB expects annual price growth to average about 0.4 percent this year and 1.2 percent in 2010.

The ECB, which holds its next rate-setting meeting in two days, is expected to keep its benchmark rate at a record low of 1 percent until the third quarter of next year, according to the median forecast of economists in a Bloomberg survey.

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.net

Last Updated: November 3, 2009 10:34 EST