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Deepening debt crisis points to new recession

The debt crisis in the euro-zone has escalated rapidly over recent months and could now come to a head sooner than we had previously anticipated. This is likely to have severe near- to medium-term economic consequences and we now expect the euro-zone to fall back into recession next year.

The resolve of the core economies to provide continued support in the form of further bail-outs has weakened markedly. There are now major doubts over whether even the second Greek rescue package will see the light of day, let alone further possible packages for Portugal and Ireland and any help that Italy and Spain may come to need.

The upshot is that the once unthinkable prospect of major debt restructurings - i.e. defaults - in the euro-zone now looks virtually inevitable.

Germany and other core economies are reportedly taking action to protect their banks against such an outcome. Meanwhile, the ECB's purchases of Italian and Spanish government bonds have helped to reduce private sector exposure to those markets. Still, even a Greek default seems likely to prompt major financial disruption and the effects if Spain or Italy were to default would be much greater.

And default might not be the end of it. To address both their fiscal difficulties and their deep-seated economic problems, the peripheral economies would need both to default and to leave the single currency. Meanwhile, some countries like the Netherlands have talked openly about expulsion from the euro as a sanction for fiscal indiscipline. Either way, the chances that Greece, and maybe others, will leave the euro in the not-too-distant future appear to be climbing.

Judging the economic implications of all of this is not straightforward, but the near- to medium-term effects are likely to be negative. Indeed, our view that the consensus forecast of 1.5% growth in eurozone GDP next year is way too optimistic has already been supported by the recent marked weakening in activity indicators like the PMIs, which now point to falling output.

With the debt crisis set to escalate and the global outlook deteriorating, growth prospects look likely to weaken further. We have therefore revised down our forecast for euro-zone GDP growth in 2012 from +0.5% to -0.5% and have pencilled in a further contraction of 1% in 2013 (previously zero). The market implications of these changes will be discussed in separate notes.

Source (Capital Economics)

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