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The Eurozone, What to Expect in the Year Ahead

20/03/2013 11:32 GMT | Updated 19/05/2013 10:12 BST

The eurozone recession deepened in the final quarter of 2012, with GDP contracting by 0.9% year on year. Budgets for 2013 foresee further fiscal tightening, partly to make up for missed targets in 2012. We expect this to contribute to a second successive economic contraction in 2013, and we now expect a decline of 0.4% this year, following a contraction of 0.5% in 2012. Broadly, the economic pattern of 2012 will continue. Economies on Europe's periphery will remain weak, whereas core economies should show some resilience.

We expect the largest declines in output to be in Greece (-5%) and Portugal (-3%). Spain (-1.6%) and Italy (-1.2%), the large peripheral economies which were the source of most concern in 2012, will also have another tough year. Spain continues to suffer the effects of its burst construction and housing bubble which has wrought devastation to private-sector balance-sheets and to its savings banks.

However, the banks are being recapitalised with eurozone funds and Spain's recent export performance has been encouraging. Italy's outlook has been clouded by the February election which has failed to produce a government. A prolonged period of political instability is in prospect, offering little encouragment that Italy will undertake the politically sensitive structural reforms needed to restore the economy to growth. Until this happens, the sustainability of Italy's large public debt will remain in question, even though it is now running primary fiscal surpluses (2.5% of GDP in 2012).

A lot of attention will be focused on France, the region's second largest economy, which has been slow to take measures to consolidate fiscally and undertake structural reform. The 2013 budget envisages a large adjustment, with corrective measures worth €30billion, two-thirds of which will come from further tax rises (split equally between firms and households). Owing to the squeeze on corporate and household spending, we expect the French economy to stagnate for the second consecutive year.

Germany's economy, the region's largest, is more resilient than the rest of the euro zone although activity weakened steadily during 2012, notably in the large industrial sector. A moderate rebound in activity is underway in early 2013, with recent business surveys and new orders data pointing to an improvement in sentiment on the back of stronger non-EU export demand. But Germany faces challenging base effects in 2013 and for the year as a whole we forecast another year of modest expansion in 2013, of 0.7%.

Given the focus on fiscal consolidation, it has fallen to the European Central Bank to provide the lion's share of policy support. The ECB's signature contribution in the past year has been to take sovereign default risk off the table by introducing its OMT (Outright Monetary Transactions) programme, offering to buy the debt of stressed sovereigns in unlimited amounts provided they apply for EU / IMF support and adhere to conditionality. Official interest rates have been at 0.75% since a 25-basis-point cut in mid-2012, a level at which we expect them to remain throughout 2013. In itself, the decline in borrowing costs for sovereigns in the euro area has amounted to a loosening of monetary policy, and the ECB now seems minded to let the improvement in financial conditions support the economic turnaround. But even with record-low interest rates, monetary policy will remain too tight in peripheral countries to perform its normal macroeconomic stabilisation role of offsetting severe fiscal contraction. And where there is demand for credit in hard-hit member states, availability will remain highly restricted.

Conditions on funding markets for both sovereigns and banks have stabilised since the ECB announced its OMT programme in July. This stability has prevailed in the face of shocks such as allegations of corruption against senior members of the Spanish government and the Italian election results. The latest shock emanates from the terms of the Cyprus bail-out announced over the weekend, which 'bails in' depositors by imposing a levy on their deposits. The levy applies even to insured deposits of under €100,000, apparently because the Cypriot government sought to preserve the island's reputation as an international banking centre. The depositor "bail-in" structure may yet be changed, towards protecting small depositors and hitting large (predominantly foreign) depositors harder. Even so, the move has reawakened fears over the threat of a bank run from peripheral member states. So far market reaction has been fairly sanguine. But a precedent is being set which could trigger and an exodus of bank deposits in advance of any future rescue deals.