One year into the sovereign debt crisis, we have reached a new stage. What was unthinkable one year ago, namely Greece requiring new financial assistance and having to restructure its sovereign debt, is now unavoidable according to Ernst & Young’s Summer Eurozone Forecast (EEF).
Assuming that governments and the ECB come to an agreement on a range of measures to take Greece through the next couple of years, Eurozone GDP is forecast to increase by only 2% this year and by 1.6% in 2012. It is in the interest of all to strike an agreement. The only alternative involves a disorderly restructuring that would plunge the whole Eurozone back into recession.
Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast comments, “Our forecast for 2011 has been revised upwards because of the positive signs that we saw in the first quarter of the year. However, there is still much uncertainty about the impact of Greek debt restructuring on the financial sector and its implications for the Eurozone economy as a whole. We could easily tip into a disorderly scenario where Eurozone GDP would fall significantly.”
Mark Otty, Ernst & Young Area Managing Partner for Europe, Middle East, India and Africa, says, “The business environment across the Eurozone will be challenging for some time with slow economic growth and an uncertain investment environment providing little incentive for organizations to help deal with the critical issue of rising unemployment particularly in the periphery. Unemployment is forecast to remain above 13 million until 2015, compared with 11.5 million at the beginning of 2008.”
Short-term relief for Greece
An additional bailout package from the European Union and International Monetary Fund will only offer short-term relief for Greece. Marie explains, “Despite dealing with the liquidity issue and giving the Greek government time to improve its fiscal accounts and make progress in structural reforms, a bailout will not provide a long-term solution.”
EEF expects Greek government debt to rise to close to 170% of GDP, with interest payments amounting to more than 20% of government revenues. Moreover, the difficulties in implementing the conditions of the previous bailout packages do not bode well for the government’s ability to implement these plans.
There will also be wider implications beyond Greece, as Marie says, “Once bailout renegotiations are re-opened for Greece, the EU and IMF will also need further discussion with Ireland and Portugal, thereby undermining any remaining credibility in the conditions attached to their packages.”
The risks of debt restructuring
In combination with the additional bail out, EEF believe a modest and orderly debt restructuring while no panacea, would offer some relief to the Greek government while trying to avoid uncertainty and chaos in the Eurozone financial and banking sectors.
However, such a limited restructuring will only have a moderate impact on the overall debt burden, and could fail in its primary objective to restore investors’ confidence. A wider, more disorderly restructuring process which would then ensue would increase the risk of contagion to other countries.
Contagion would spread first to other peripheral countries, and in particular Ireland and Portugal, that face similar - albeit somewhat less severe – debt challenges. Contagion could also spread to core countries via the banking sector as it owns significant amounts of peripheral sovereign debt.
The stress tests to be published in July are likely to shed further light on the health of the banking sector although, like last year, the credibility of the stress tests has been undermined by what are perceived to be too favourable assumptions. Marie says, “Any impact from a disorderly restructuring would have a further knock on effect on the Eurozone economy as a whole, via more restricted credit from the banks and negative confidence effects on businesses and households.”
Opportunities in two speed Europe
While overall Eurozone growth will be weak and faces significant downside risks, some countries are expected to grow robustly in the next few years. In the ‘core’ Eurozone countries including Germany, France and the Netherlands, GDP is forecast to rise by 2.2% per year on average in 2011 – 2015, a growth rate slightly higher than in the decade before the crisis. EEF forecast growth in 2011 of 3.5% in Germany, 4.1% in Finland and 2.2% in the Netherlands for instance. By contrast, in the periphery of Portugal, Ireland, Greece and Spain, GDP is forecast to rise by only 1.2% in the next five years, not even half the pace of the decade before the crisis.
As Marie explains, “This strong growth has created significant opportunities for companies that are looking to tap rising purchasing power in the core countries. Companies with strong balance sheets could also see opportunities in the periphery where production costs are likely to fall. This is particularly the case for Ireland, where labor costs have already fallen.”
Eurozone prospects are also mixed at the sectoral level. Business services is among the sectors with the brightest outlook, with the Eurozone benefiting from a skilled workforce and established expertise in this area. The manufacturing sector is also expected to recover more quickly than the economy as a whole, benefiting from robust external demand for the Eurozone’s goods, in particular from emerging markets.
Difficult choices ahead on inflation and interest rates
The European Central Bank (ECB) continues to face difficult choices as it struggles to deal with relatively high inflation, prospects of low growth and the contrasts between a robust core and a shrinking periphery. So far, it has put more emphasis on high inflation and the robust core, and has signalled that further increases in interest rates are likely in the second half of 2011.
Marie comments, “This tightening is premature, adding to the challenges for the peripheral economies, especially as further monetary tightening will exert upward pressure on the euro. The downside risks to the Eurozone outlook are such that the ECB risks having to reverse its tightening, which would have a damaging impact on its credibility. Finally, we think it is unlikely that the current elevated inflation rate will feed into wages or prices more generally. Instead, we forecast Eurozone inflation to fall back below 2% at the beginning of next year.”
About the Ernst & Young Eurozone Forecast
The forecasts and analyses presented in the EY Eurozone Forecast are based on the European Central Bank’s model of the Eurozone economy. This model embeds state-of-the-art economic theory and techniques and is used by the ECB to produce its quarterly forecasts of the euro area.
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http://www.ey.com/GL/en/Newsroom/News-releases/Eurozone-Summer-2011---Press-release
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