While the timing of the re-emergence of the eurozone debt crisis remains unpredictable, the probable trajectory is more easily discerned.
First, continued weakness of the real economy will increase financial pressure on European countries. During 2013, European economies recorded positive growth, technically ending the recession. However, excluding Germany and France, the levels of economic activity remained low.
Ever-optimistic European governments and policy makers now proclaim a stabilisation or even a lower rate of decline as an indication of the success of their policies. The EU’s economic affairs commissioner, Olli Rehn, provided an interesting summary: “The current situation can be summarised like this: we have disappointing hard data from the end of last year, some more encouraging soft data in the recent past and growing investor confidence in the future.”
European forecasts of recovery are over-optimistic. The turnaround may prove fragile, given deteriorating conditions in emerging markets which have been major buyers of European exports. Increases in the value of the euro may also affect eurozone exports.
Second, banking sector problems will continue. European banks may have as much as €1trn (£840bn) in non-performing loans. Italian banks alone may have as much as €250bn of these.
The new round of asset reviews may reveal eurozone banks’ need for extra capital, but it is unclear where the money for recapitalisation is going to come from.
Increasingly, European governments are resorting to tricks to resolve the problems of their banking systems, including inadequate stress tests, overly optimistic growth and asset price forecasts, and some unusual accounting stratagems. For example, Spain is seeking to convert €51bn in deferred tax assets resulting from loan losses into core capital to meet minimum requirements. If successful, this would represent about 30 per cent of Spanish banks’ core capital.
Without some urgent and resolute action, bad debts and weak capital positions will lead to “zombie banks”, unable or unwilling to supply credit to the economy and so restricting any recovery.
Third, much-needed structural reform of labour markets and entitlements will be slow, reflecting weak economic activity and also the unpopularity of many such measures. In addition, the relative stability of the past 12 months has lulled governments into a false sense of security, reducing the urgency of pursuing economic restructuring.
Fourth, political tensions, both national and within the eurozone, are likely to increase.
As shown in Greece, Portugal, Spain and Italy, weak economic conditions have increased pressure on current governments, highlighting the political differences and fragility of ruling coalitions.
Many countries also have domestic issues that contribute to political instability. In Spain there is the bribery scandal involving the ruling Popular Party. In Italy, continued political volatility centred on a fragile coalition government and the legal difficulties of former prime minister Silvio Berlusconi remain.
Debate on crucial policy measures is being held hostage to these political dramas. Italy is living up to its former dictator Benito Mussolini’s observation: “Governing the Italians is not impossible, it is merely useless.”
Across the eurozone, Germany’s repeated rejection of any steps amounting to a mutualisation of debt or hidden transfer payments, as well a reluctance to increase German commitments (increasingly supported by northern European nations), will complicate crisis management. Little is expected to change under the new German government.
The slow, rancorous process of eurozone negotiation will not help. The French President, François Hollande, provided a candid diagnosis: “The problem with Europe is that there are others involved.”
Economic and political pressures will manifest themselves in a number of ways.
Weaker countries may require extensions of existing loans, additional assistance or debt writedowns.
Credit ratings are likely to be under further pressure. Italy’s current rating (BBB with a negative outlook)) is perilously close to non-investment grade. Stronger economies are not immune, facing ratings pressure from the financial burden of supporting their weaker EU partners, and from the general European and global economic weakness.
Problems within the banking system will continue to simmer, and without strong growth (which is looking unlikely) Europe’s debt problems may prove intractable.