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On the slide: euro zone set to fall back into recession, Ernst&Young latest eurozone forecast report says.

The elixir of economic growth is needed to find a lasting solution to the debt crisis. Certainly, the extreme weakness of European growth prospects will do nothing to encourage investment in the euro zone economy - quite the opposite, in fact.

The paradox is that the fiscal compact will impose increased austerity on national governments and reduce their ability to stimulate growth in their countries. Having a balanced lifestyle may be essential to a long and healthy life, but no one would argue that dieting is the happiest of experiences.

Our winter 2011 forecast expects business investment to be on hold in 2012. This is severely disappointing given that large companies are holding very large cash balances.

It would seem that many boards will again succumb to the temptations of buying back shares or holding cash reserves rather than investing in growth - either through investing locally in Europe or in rapid-growth markets elsewhere. Aversion to risk is now very strong in corporate boardrooms.

Forced reforms

The package of measures agreed by euro zone leaders at the October 26 summit to tackle the worsening debt crisis brought only short-lived respite to financial markets. As a result, the October agreement was quickly followed by another deal, signed on December 9, that institutes stricter fiscal rules.

Additional funding, via the European Stablisation Mechanism, whose start has been brought forward to June 2012 and via loans to the International Monetary Fund, have also been agreed upon and will help prevent an escalation of tensions similar to what we saw in November 2011.


The response to the December 9 deal was mildly positive. Investors remain very concerned about the commitment and ability of governments to implement reforms quickly. In particular, it will be very hard for Greece to implement the latest deep spending cuts and proposed increase in privatisation revenues - from an already ambitious 50 billion euro to 65 billion euro - at a time when the economy is still contracting sharply and consumer spending is very weak.

And in Italy, there remain major obstacles to the scale of economic reforms required to win back investor confidence. Meanwhile, the new centre-right government in Spain has promised more austerity, but will face challenges when the economy is barely growing.

In addition, the bank recapitalisation proposed at the end of October will weigh on growth in the euro zone overall, with lending coming under further pressure if banks try to meet the targets set by shrinking their balance sheets. In particular, it is difficult to see how some banks will be able to comply with the new capital requirements, given the current depressed economic conditions and difficulties in raising new capital from financial markets at a reasonable cost.

A number of countries face a much slower period of growth in the years ahead, plus much higher interest payments, than previously expected. If debt interest payment rates remain significantly higher than GDP growth, as now seems possible, the debt and deficit problems facing Italy, Spain and other peripheral countries are likely to worsen steadily.

Since reforms to the fiscal and economic structures take time, the European Central Bank (ECB) may play a key role in ensuring over the near term that bond yields do not reach or stay at unsustainable levels. Calls for the ECB to act as a lender of last resort to solvent but illiquid governments have multiplied, to buy enough time for members' structural reforms to take effect and for euro zone institutional changes to be implemented.

In addition to the probable need for short-term underpinning from the ECB, the deep problems facing the eurozone and the prospect of several more years of sluggish growth, underline the need for faster reforms in many countries, if monetary union is to survive in its current form.

The key problem facing the peripheral countries - Greece in particular, but also Italy, Spain and Portugal - has been a loss of competitiveness over the years since adopting the euro. With their narrow industrial bases and labour costs relatively high compared with non-EU countries, these countries have seen their share of world trade fall steadily, in turn increasing reliance upon financial market inflows.

As the latter have dried up in recent years, so the underlying weakness of these economies has become increasingly exposed. A key reform that these countries need to embrace is greater labour market flexibility and changes to restrictive working practices, which, over time, would encourage greater industrial diversification and labour mobility. The impressive turnaround in competitiveness seen in Ireland is an example of what can be achieved.

Beside changes to the labour market structures, reform of public finances is needed in the southern peripherals. Public sector cut-backs, improved efficiency of tax systems and changes to retirement ages and pension entitlements are key areas that need to be addressed to bring down deficits and to put public finances in these countries on a sustainable long-term footing.

Possible break-up scenarios

The latest European agreement lowers the risk of a break-up of the euro zone. This risk remains however, especially since in 2012 very large amounts of sovereign debt need to be refinanced, which may cause tensions. The costs of a break-up of the euro zone would undoubtedly be very high and have a long-lasting impact on the whole of Europe and the world economy. As a result, we think that the authorities in the leading countries will strive to hold the single currency zone together.

It seems likely that the cost of the ECB acting as lender of last resort would be less than the mediumterm costs of a break-up. For instance, if the ECB were to intervene in bond markets of solvent but illiquid governments for the next two years, by buying perhaps about one trillion euro of bonds, this would still be equal to only about 10 per cent of euro zone GDP, proportionately less than the quantitative easing seen in the UK and the US, which have amounted to 14 per cent and 17 per cent of GDP, respectively, since 2009.

With about one trillion euro of government debt from Italy, Spain, Greece, Ireland and Portugal needing to be refinanced over the next three years, such purchases would go a long way to ease tensions in sovereign markets.

And although some remain opposed to this type of action, fearing moral hazard and possible inflationary consequences, the main threat at present comes from deflation, if the euro zone slides back into deep recession - especially as governments are now not able to try to spend their way out of recession as they did in 2009.

A split could take place in a number of ways. First, and most likely, is that some peripheral countries, such as Greece, could decide to opt out of the single currency, as the burden of fiscal austerity could become politically unbearable.

This would have heavy costs for Europe. If only a few countries exit, with, in particular Italy and Spain still inside the single currency, the impact would be manageable. The costs would obviously be heavy for Greece, which would face hefty devaluation, of perhaps some 50 per cent in its re-introduced drachma, sharply higher inflation and several years of deep recession, corporate defaults and exclusion from international capital markets.

A second possibility is a move to a "core" euro zone, which would centre around the Franco-German axis and include the northern countries such as the Netherlands, Belgium, Finland, Austria, Slovakia and a number of others. This scenario would exclude the larger southern European economies of Italy and Spain, meaning that the split would trigger massive upheaval in financial markets, with deep falls in asset prices.

The sharp depreciations of the new currencies would trigger large losses to companies operating in these countries. Overall, in this scenario the euro zone and probably the world economy would be plunged back into a deep recession, probably more severe than what was experienced in 2008/09.

A third possibility is that Germany decides to with-draw from the euro, unhappy with the increasing fiscal burden that it may have to shoulder in the coming years in bailing out profligate southern partners. This is a highly unlikely scenario, given that it would imply a sharp appreciation of the new German currency which would threaten the country's large export sector.

One major unknown risk in these scenarios is the impact on electorates in both member countries and prospective members. If the euro zone does split in some form, leading to even greater costs in the near term, will politicians have a strong enough mandate to try to rebuild the currency union with the closer fiscal union that this will entail?

There is already a disconnect in many countries between politicians driving the move for closer ties within the euro zone and electorates who are rarely consulted on such matters. Failure to win electoral support for moves towards deeper European integration could have serious political implications.

Growth forecast

Although we assume that the euro zone remains intact, the debt crisis, volatile financial markets and a weaker than previously expected US economy mean that our growth forecasts for the euro zone have been lowered sharply. Having slowed to just 0.2 per cent in Q2 2011, euro zone growth remained in positive territory in Q3, also at 0.2 per cent, but is now expected to post declines in Q4 2011 and Q1 2012.

This would deliver over-all 2011 growth of about 1.6 per cent, with a slowdown to just 0.1 per cent predicted for 2012. The latter figure is sharply down from our fore-cast of 1.3 per cent, three months ago. And with the uncertainty over the Greek debt situation now likely to drag on for some months, the risks for 2012 are probably on the downside, although monetary easing by the ECB - via lower interest rates and continued additions of liquidity - and the continued buoyancy of emerging markets should offer some respite to this gloomy picture.

The latest data reinforces expectations of a return to mild recession after the very weak growth in Q2 and Q3 2011. The euro zone manufacturing Purchasing Managers' Index (PMI) fell throughout Q3 and in November was down to 46.4, its lowest since mid-2009. The service sector PMI is also pointing to contraction moving into Q4. On an individual country basis, survey data from Germany continue to weaken and the jobless total rose in October for the first time in nearly two years.

And amid mounting concerns about its banking sector exposure to Greece and a possible credit rating down-grade, the news from France is equally gloomy, with October unemployment at its highest level in nearly 11 years and the PMI surveys below the 50 level.

Despite the generalised slowdown throughout the euro zone, divergence in member countries' growth rates is set to remain as the core continues to outperform the peripherals. Germany is forecast to grow by just under one per cent in 2012, down from 3.1 per cent in 2011. But Italian GDP is now forecast to fall 0.8 per cent in 2012 and Greek GDP is seen plunging by six per cent.
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Author:Ernst; Young
Publication:The Sofia Echo (Sofia, Bulgaria)
Geographic Code:4EUGR
Date:Dec 23, 2011
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