The forecast came as Greece — Europe's most indebted country — said that it was on course to have its worst recession ever in 2011.
Ernst & Young also said unemployment in the euro zone was unlikely to fall below 10 percent until 2015.
The prospect of a mild recession in the euro zone in the first half of 2012 is now looking increasingly likely according to Ernst & Young’s Eurozone Winter Forecast (EEF).
Despite the reforms announced on December 9, the details on how the agreement will be enforced remain unclear ensuring that volatility is likely to remain high in the near future, dampening growth prospects for the next six months at least.
However, assuming that the December agreement is implemented, the forecast predicts weak growth in the euro zone should resume by the end of 2012. The forecast suggests a mere 0.1 percent GDP improvement in 2012, rising to 1.5 percent — 2 percent in 2013-15.
Marie Diron, senior economic adviser to the Ernst & Young euro zone Forecast, says: “The reforms agreed at the summit on 9 December were a step in the right direction and the response seems to have been mildly positive. Yet investors remain very concerned about the commitment and ability of euro zone governments to implement reforms quickly. Although this slow down is not currently comparable to the one experienced in 2008 there are still major worries regarding bank liquidity issues and unemployment for 2012.”
Mark Otty, Ernst & Young Area managing partner for Europe, Middle East, India and Africa, says: “The uncertainties hanging over the euro zone can only continue to dampen the enthusiasm for European companies to make long term investment and recruitment decisions. Fundamentally, the real challenge for Europe and the ‘advanced economies’ is growth and whether mature economies can find ways to grow above their historical trend to pay off their debt and learn to live within their means going forward.”
The EEF welcomes the recent decisions by the European Central Bank (ECB) to reverse its premature interest rate rises of earlier in 2011.
It is likely that further easing will be required accompanied by more measures to supply liquidity to banks. In addition, ongoing doubts about the ability of some countries to implement necessary reforms will mean that the ECB will need to keep buying government bonds.
Many commentators including the EEF believe that a strong commitment by governments about fiscal reforms could allow the ECB to step up its bond purchase program. Although government bond yields in the euro zone have come down recently they remain high and very unpredictable.
Since reforms to the fiscal and economic structures take time, the ECB could well play a key role in the near term in ensuring that bond yields do not reach or stay at unsustainable levels.
As Diron explains, “With bond markets very volatile, weak growth prospects and high borrowing requirements in 2012, the ECB is likely to have to consider acting as a lender of last resort if even deeper problems – perhaps even a split in the euro zone — are to be avoided.”
Unemployment has been rising fast in some euro zone countries since 2008 particularly in the periphery, but the EEF believes there is a strong possibility of a worsening situation spreading to some of the core. Given the outlook, the jobless total will remain high for a lengthy period — EEF do not expect the unemployment rate in the euro zone to fall below 10 percent until 2015.
Diron says: “Changes to the euro zone labor markets to enhance their flexibility and reduce labor costs would help to ensure that the euro zone comes out of this crisis on a stronger basis.”
Banking sector liquidity is another major concern across the euro zone.
Bank lending in the euro zone remains tight, as banks restructure their balance sheets and reduce exposure to riskier sectors and countries.
The ECB lending survey for Q4 2011 showed that lending standards tightened again, with surveys for individual countries suggesting tighter conditions throughout the euro zone.
Among the key factors accounting for this are reduced access to capital markets and banks’ worsening perceptions of the general economic outlook.
These lending figures suggest an increasingly adverse impact on business investment and companies’ capacity to raise production heading into 2012.
Diron said: “The ECB has extended its loans to banks for up to three years and widened the range of collateral that banks can use to obtain liquidity from the central bank. All these measures are aimed at easing the current very difficult funding situation for banks, enabling them to play their essential role as provider of loans to the economy.”
Several factors should ensure that inflation slows in 2012.
Firstly, oil prices are off their peak and are now forecast to fall by about 10 percent in 2012.
Secondly, base effects will become favorable.
And thirdly, there will be a reduction in the headline inflation rate at the beginning of 2012 as the effects of the VAT increases at the start of 2011 drop out. EEF expects inflation to average 1.8 percent in 2012, down from 2.6 percent in 2011, with similar rates seen in 2013-14.
Diron added: “The latest developments in Greece, Italy and Spain and the European agreement lowers the risk of a break-up of the euro zone. This risk remains however, especially since in 2012 very large amounts of sovereign debt require refinancing which could cause tensions.”
The costs of a break-up of the Eurozone would undoubtedly be very high and have a long-lasting impact on the whole of Europe and the world economy.
As a result, EEF believes that the authorities in the leading countries will strive to hold the single currency together. It seems likely that the cost of the ECB acting as a lender of last resort would be less than the medium-term costs of a break-up.
Although near-term prospects for the euro zone remain gloomy steps are being made towards a brighter future. The situation in Italy, Spain and Greece remains extremely worrying but if early progress on reforms is made this could give authorities in other countries the mandate needed to proceed with similar tough reforms. In turn this would give a major psychological boost to European markets.
Inflation is also likely to decrease in the next year. Ireland has set a good example as to how a country can reform and trade its way to recovery.
Diron said: “Despite the bleak outlook for the short-term and continuing downside risks, we still expect on balance the Eurozone to stabilize in 2012, with an end to the crises in Italy and Greece enhancing medium-term growth prospects and a return to greater financial stability. In addition, the ongoing stimulus from the emerging markets, which are expected to drive world growth in the coming years and overtake the developed countries as a share of world GDP as early as 2014, will help lift euro zone growth back to around two percent in 2014-15, with improving prospects thereafter.”
