2011 and 2012 were both characterised by periods of calm and stress. Although 2013 should avoid the extremes of those years, swings in temperature are an integral part of the eurozone crisis.
Periods of stress should also help to resolve the crisis eventually by forcing reform, integration, and mutualisation.
Here are eight themes to watch in 2013 that point to another mixed year for the eurozone.
Economy likely to remain anemic through 2013
A gradual, shallow recovery is likely - a robust rebound is not. Current consensus economic forecasts for 2013 may be too pessimistic. A mild recovery beginning in the second quarter seems likely.
Financial stress has plummeted since August 2012, which should help confidence and be positive for growth.
Although fiscal austerity will be a drag on the economy, it should not have the same pronounced impact as last year.
The eurozone will continue to face headwinds to growth from fiscal consolidation, high private sector debt, and banking sector deleveraging. Just like Japan during its lost decades, the eurozone is likely to experience recurring periods of negative gross domestic product growth in the next few years.
The doctrine of fiscal austerity will weaken
There is evidence that the doctrine of fiscal austerity is weakening. The European Commission (EC) and European Central Bank (ECB) seem to be realising that an endless recession will undermine public support for the eurozone and, ultimately, make solving the crisis more difficult.
New politicians, particularly president Hollande of France, are not as willing to sacrifice economic growth in pursuit of fiscal sustainability. German leadership appears willing to slow the pace of fiscal consolidation to support the broader economy ahead of German elections in September.
Fiscal policy will still tighten in 2013, but the easing of fiscal austerity targets will avoid an additional round of midyear fiscal tightening as occurred in mid-2012.
There will be few rating downgrades
Sovereign rating downgrades were abundant in 2011 and 2012. The (unweighted) average eurozone sovereign rating declined from AA- in December 2010 to A+ in December 2011, and then to A in December 2012, based on ratings by the three major credit rating agencies.
Few sovereign rating downgrades are expected in 2013. The reasons are twofold. First, the action taken by the ECB and eurozone governments has, at least temporarily, stabilised the sovereign creditworthiness from a macro-financial perspective. The prospect of a “death spiral” of rising yields and falling GDP growth leading to liquidity crises is now unlikely.
Second, most sovereigns are currently fairly rated based on their fundamentals.
Social unrest will return
The major driver of social unrest in the eurozone is likely to be rising unemployment. Even though the region is expected to exit recession this year, growth is unlikely to be strong enough in the periphery to create jobs.
There are other potential causes of social unrest - labor market reforms that reduce protections for existing workers, pension and retirement reforms, higher taxes, and cuts to public services. All are necessary to solve the crisis long term yet all will also exacerbate social stress in the short term.
Greece will not be solved
The common perception that Greece is ‘solved’ is too sanguine. There is still much potential for the situation to deteriorate again in 2013. The high and rising unemployment rate, combined with the cuts to pensions and public sector employment passed in November, could lead to a resurgence of public protests in the spring and summer.
There will be at least one more IMF-EU rescue program
The most obvious candidate for an IMF-EU rescue program is Cyprus. Although it has a small economy, the market probably does not fully appreciate the nature of its problems - large insolvent banks, high government debt levels, and a collapsing economy. Cypriot banks need to be recapitalised, but lending the government the money to do so would push its debt/GDP limit to 160 per cent.
The second candidate is Spain. The country will be forced to request a contingent credit line from the European Stability Mechanism, thereby allowing the ECB to activate outright monetary transactions the ECB’s program to purchase government bonds of one to three year maturities subject to the requesting country meeting certain conditions.
The ECB will continue to ease monetary conditions
The ECB is likely to take action to prevent a contraction of its balance sheet, following significant expansion in the past year, as it will want to avoid a tightening of liquidity conditions across the eurozone. Several options are available, such as cutting the repo rate to 0.5 per cent or 0.25 per cent.
Others include reintroducing multi-year long-term refinancing operations which provide low-cost financing to eurozone banks, using the outright monetary transactions to reduce sovereign spreads, buying financials sector assets, such as covered bonds, to try and keep the market for these instruments open to periphery banks or moving the deposit rate into negative territory to encourage banks to lend and invest more.
The cycle of hope, disappointment, and crisis will continue
The eurozone crisis has been characterised by a cycle of hope, disappointment, and crisis since the region’s sovereign debt problems began. The market is currently in the hope phase. Disappointment and crisis are likely to return again at some point, even if they are less pronounced than in the past.
The crisis will not be solved without new institutions and greater integration. Changes to the eurozone’s structure are needed to minimise the collective action problem, transfer fiscal and financial risks from the national level to the eurozone level, and make the eurozone more like a federal state rather than a collection of individual states.
The problem with new institutions and integration, however, is that there will be winners and losers. The transfer of risk, resources, and decision-making powers will benefit some countries while hurting others. The politicians in the losing countries can only justify the changes when financial stress is high enough that the transfer leaves them better off on a net basis.
The link between market stress and progress toward institution building and greater integration is fundamental to the crisis itself. A lack of stress leads to procrastination, which leads to crisis, which later leads to progress on institutions and integration. Market stress is a symptom of the crisis but should also drive the solution to the crisis.
Although we will not see the ultimate solution in 2013, it should be a little bit closer by this time next year.
Ken Orchard is portfolio manager and analyst of European sovereigns at TRowe Price
