By Daniel Hunter

Despite a year of turmoil in the Eurozone the currency union will enter 2013 with a brighter outlook than 12 months ago. However, despite the early indications of improved stability there are many significant obstacles to overcome before any kind of recovery can take place according to the winter Ernst & Young Eurozone Forecast (EEF).

The forecast predicts that Eurozone GDP will shrink by 0.2% in 2013 but there will be a modest pickup from 2014 to 2016 of 1.3% a year. Similar growth rates are expected for the remainder of the decade. The North-South divide will remain for the foreseeable future with growth in some southern countries not predicted until 2015 at the earliest.

Although the forecast has lowered its assumption of a Greek exit from 15% to 5% no significant growth will return until the remaining doubts over the Euro are removed. EEF believes that more needs to be done by the ECB and governments to extinguish remaining concerns. There are however, encouraging signs that the policy mix is shifting from a sole focus on austerity towards measures designed to foster growth.

“The markets seem much more convinced than they did in the early summer that the Eurozone will survive," Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast commented.

"However, growth performance within the Eurozone is set to remain divided, with the core countries expected to continue to out-perform the troubled peripherals, with the latter struggling to grow at all over the next few years.”

This will be a tough operating environment for both business and political leaders. Businesses need to plan for a European “lost decade” as growth will remain muted and unemployment will continue to rise throughout 2013, peaking at close to 20 million. The peak in unemployment is expected to be both higher and slower to unwind in the peripheral economies with the unemployment rate expected to reach over 28% in Greece, 26% in Spain and almost 17% in Portugal.

Mark Gregory, Ernst & Young’s chief economist in the UK, comments, “UK business leaders need to plan for a future that is unlike the past and recognise that the low growth environment is the new normal.

“Companies must review their business plans against criteria that reflects the new economic reality. We are not going to go back to the economy of 2005, growth is not going to be achieved by focusing on domestic markets alone. Identifying opportunities to break into high growth economies, transforming the business model and gaining market share by targeted inorganic growth are the strategic priorities.”

As a policy framework to ensure the Eurozone’s survival remains a work in progress, business and consumer confidence have not improved in the way financial markets did in the initial weeks following Draghi’s July speech pledging that the ECB will do ‘what it takes’ to preserve the Eurozone. In fact, both measures of confidence have fallen fairly consistently for the past 12-18 months.

Until confidence improves companies will remain in “wait and see” mode and hold back on capital spending, recruitment and M&A activity. As a result, EEF forecasts a decline of 1.2% in fixed investment in 2013 following an expected 3.6% drop in 2012. As further policy steps are taken during 2013 to ensure the Eurozone’s survival business confidence should gradually improve and EEF expects investment growth of 2.3% in 2014.

EEF predicts that business investment is likely to fall further as credit conditions will remain tight for the foreseeable future. The latest bank lending surveys show a tightening of credit standards which will particularly impact small and medium-sized enterprises (SMEs). An easing of credit conditions is unlikely to occur until the Eurozone economy starts growing again which EEF predicts will be in Q2 2013.

In the near term, the peripheral economies are expected to continue undershooting official forecasts, leading to further overshoots in fiscal deficits and public debts in coming years. EEF forecasts continued recessions in 2013 in Greece, Portugal, Italy and Spain, with falling domestic demand, but positive GDP growth, in Ireland.

Although the short-term outlook for the peripheral economies remains challenging, glimmers of medium-term hope have started to appear. There has been significant progress in restructuring of peripheral economies. In particular, countries like Ireland and Spain have achieved large increases in productivity.

This has helped reverse negative competitiveness trends and has been reflected in strong exports growth. However, the adjustment in competitiveness is far from complete. In the short term these changes have led to a significant squeeze on households’ incomes, which in turn, deepen and prolong the domestic recessions in these countries.

“Strong exports have contributed to reduce current account deficits that were very large at the start of the crisis and a symptom of the imbalances within these economies," Marie added.

"This has in turn eased financing issues as foreign capital inflows dried up. However, the benefits from this will not be felt in the immediate future.”

A further boost to exports could be provided by a cut in interest rates however, recent ECB announcements suggest that neither this policy or further quantitative easing are being taken into consideration at the moment. EEF predicts that the ECB will keep interest rates on hold until 2017, as with risks to the forecasts skewed to the downside deflation is more of a risk than inflation. Inflation should halve from 2.5% in 2012 to 1.3% in 2015.

Marie concludes “Although there are some positive indicators for the Eurozone this is just the beginning of the road. Further steps to complete frameworks for both a banking and fiscal union, the introduction of some form of Eurobond and the full implementation of the Growth Pact should help to begin to restore confidence although they are unlikely to alter prospects for demand and growth in the short term.”

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