WSJ:Euro Zone Rode the Shock Waves in 2013

29/12/2013

The euro zone in 2013 proved remarkably resilient to a series of shocks in Cyprus, Greece, Italy and Portugal.

For the euro zone, the real story of 2013 has been what didn't happen rather than what did. Confronted by a series of shocks that in previous years might have reignited concerns over the survival of the currency bloc, the euro has proved remarkably resilient.

The decision to force uninsured depositors in the two biggest banks in Cyprus to take losses didn't lead to bank runs across the periphery as many had feared. Unemployment remained painfully high in much of Southern Europe, yet there was little evidence of the social unrest that the doomsayers had predicted. There were political crises in Italy, Greece and Portugal. But on each occasion, the outcome was a stable government committed to reforms designed to make the economy more productive and competitive.

Instead, as fear of an implosion receded, the economy recovered. The gross domestic product of the euro area is likely to have expanded by 0.5% in the second half of 2013; Portugal came out of recession in the second quarter, Spain in the third quarter; Italy stopped contracting in the fourth quarter and Greece is expected to return to growth in 2014 for the first time in seven years; Ireland defied most forecasts by growing 1.5% in the third quarter alone.

Spain, Portugal and Greece eliminated vast current-account deficits, reducing their reliance on foreign borrowing—and not just by slashing imports; Iberian exports in particular have surged, aided by structural reforms that have boosted competitiveness. Budget deficits have been cut: Greece's 19% fiscal adjustment is a remarkable achievement that should allow the country to deliver a primary surplus before interest costs in 2013.

Against this more benign economic backdrop, bond yields have fallen back to 2010 levels as foreign investors have returned to crisis-country debt markets. Ireland was able to exit its bailout program and Portugal hopes to do so next year. The European Central Bank's balance sheet, which ballooned during the crisis as funding markets closed, has shrunk as banks have been able to repay emergency loans; financial fragmentation across the euro zone has eased as borrowing costs in the periphery have finally started to come down.

All this progress has been enough to persuade some brave souls to call the end of the euro crisis. "All relevant economic and financial indicators indeed suggest the systemic crisis is over," declared Holger Schmieding, chief economist of Berenberg Bank in a research note last week.

True, not everyone is ready to go so far, but most forecasters expect the euro zone to continue to muddle through in 2014, albeit with lackluster growth in the region of 1%. The European Commission predicts growth next year of 1.1%.

Of course, even bullish Mr. Schmieding acknowledges that big risks remain. The current calm largely reflects the ECB's June 2012 promise to do "whatever it takes" to preserve the euro and the launch of its Outright Monetary Transactions government bond-buying facility. But the legality of the OMT is being challenged in the German Constitutional Court with a verdict expected early in 2014. A negative outcome could undermine confidence in the euro zone's crisis-fighting ability, sending peripheral country borrowing costs soaring again.

At the same time, government debt levels remain precariously high, leaving economies vulnerable to external shocks, including from China or as a result of the U.S. Federal Reserve's decision to dial back its bond buying. Some economists fear the euro zone is at risk of "turning Japanese" and argue that much looser monetary policy is needed in the form of the ECB engaging in some money-printing of its own to prevent a slide into outright deflation.

Nor can further political instability be ruled out. The economy may be recovering, but it won't feel like it for many citizens. It is likely to take years for Southern European economies to rebalance away from non-tradeable sectors such as construction and government services toward new export-oriented tradeable sectors. As a result, unemployment is likely to come down only slowly, exacerbating social tensions.

Meanwhile two of the euro zone's largest economies—France and Italy—have made the least progress in terms of improving their competitiveness and productivity through the crisis, reflected in very weak growth outlooks. It is an open question whether Paris or Rome has the will to undertake essential reforms—or face down the inevitable resistance from vested interests.

But while these risks are real, one shouldn't rule out the possibility of upside surprises too. After all, eurozone stock markets soared in 2013, which suggests that real money investors at least are anticipating a substantial recovery in corporate earnings over the next two years at odds with the gloomier macro forecasts.

What would transform the economic outlook—and help ease deflation fears—would be an upturn in business investment and German domestic demand. On both counts, there are reasons for optimism. Corporate investment has been exceptionally weak for five years, suggesting clear potential for a powerful snap back as confidence returns. At the same time, there are signs that ultralow borrowing costs are finally tempting Germans to start spending: German domestic demand rose by a surprise 0.7% in the third quarter and was the biggest contributor to growth.

Much depends on the ability of the banking system to make credit available. Recent surveys suggest credit conditions may finally be easing, helped by a surge in interest from foreign investors in Southern European distressed bank assets. In the past fortnight, a Venezuelan bank agreed to pay €1 billion ($1.37 billion) to buy Spanish state-owned lender NCG Banco SA following a hotly contested auction and U.S. hedge fund Cerberus paid €950 million to buy a portfolio of nonperforming loans from Italy's Unicredit SpA.

Efforts by banks and regulators to strengthen capital ratios before the ECB takes over responsibility for bank supervision at the end of 2014 should also help build confidence.

Indeed, it is even possible 2014 will see a reversal of the vicious spiral of recent years with higher growth, falling unemployment and stabilizing house prices leading to increased demand for—and supply of—credit. After all, this is exactly what seems to have happened in the U.K. and Ireland in the second half of 2013—and no one saw that coming either.

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