Sovereign debt concerns overshadow eurozone recovery – Ernst & Young

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.

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.

Eurozone GDP is forecast to increase by only two per cent this year and by 1.6 per cent in 2012, according to Ernst & Young’s Summer Eurozone Forecast, published recently.

The report points out, however, that these growth figures are dependent on the eurozone and the European Central Bank coming to an agreement on a range of measures to help Greece over the next couple of years.

“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,” Ernst & Young says.

Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast says: “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 organisations 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.”

Diron says the additional bailout package from the European Union and International Monetary Fund will only offer short-term relief for Greece.

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, she insists.

The forecast says it expects Greek government debt to rise to close to 170 per cent of GDP, with interest payments amounting to more than 20 per cent 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.

In combination with the additional bailout the report says a modest and orderly debt restructuring would offer 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.

The report says contagion would spread first to other peripheral countries, and in particular Ireland and Portugal, that face similar – albeit less severe – debt challenges. Contagion could also spread to core countries via the banking sector as it owns significant amounts of peripheral sovereign debt.

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 cent per year on average between 2011 and 2015, a growth rate slightly higher than in the decade before the crisis.

Ernst & Young forecasts growth in 2011 of 3.5 per cent in Germany, 4.1 per cent in Finland, 2.7 per cent in Malta and 2.2 per cent in the Netherlands.

By contrast, in Portugal, Ireland, Greece and Spain, GDP is forecast to rise by only 1.2 per cent in the next five years, not even half the pace of the decade before the crisis.

“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 labour costs have already fallen,” Diron says.

Eurozone prospects are also mixed at the sectoral level. Business services are 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.

The European Central Bank 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, the report highlights.

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.

“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 European Central Bank risks having to reverse its tightening, which would damage 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 two per cent at the beginning of next year,” Diron says.


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