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We expect the euro area to remain in recession in 2013 (-0.7%) and 2014 (-0.4%). The contraction will be deeper in the periphery countries than the core/ soft-core countries, but even the members of the latter group will at least flirt with recession. While there are differences in the weighting of the sources of economic weakness, in most cases it is a combination of private sector deleveraging, austerity measures and tight financing conditions producing an undershooting of the already-low growth potential. In addition, the ongoing risk of a euro area break-up - which has been substantially reduced by the ECB's OMT programme announcement - will undermine economic activity in the periphery countries. As we expect that Greece will leave the euro with a probability of 60% within the next 12 to 18 months, probably in early 2014, our economic forecast for the euro area from 2014 onwards excludes Greece. While we expect Grexit to happen (maybe followed by an exit by Cyprus) we do not foresee a broad break-up of the Euro area, because we expect governments and the ECB to put in place measures to contain its contagion (see EMU Crisis Outlook, page 11).
Area-wide debt reduction only through Grexit and debt restructurings
In early 2013 weaker economic data than currently projected by governments are likely to raise doubts on government fiscal targets and we expect that most countries will fail to meet the requirements currently set by the Excessive Deficit Procedure (EDP). With a stronger focus on structural rather than headline deficits, the EDP targets probably will be amended and therefore we do not expect additional large rounds of austerity for 2013, maybe with the exception of Spain where even reaching the structural deficit target is questionable. However, with the exception of Germany, there seems to be little room for fiscal easing in 2013 and we do not expect that already planned fiscal tightening will be withdrawn. In our view, a crucial factor is that policy makers are unlikely to change their assessment that more fiscal tightening is necessary. Therefore additional gradual austerity measures are in the pipeline for 2014 and beyond. In this environment, we expect a reduction of the area wide deficit-to-GDP ratio from 3.3% in 2012 to 2.9% in 2013 and 2.4% in 2014. This would be substantially smaller than the pace of deficit reduction in the previous two years, when the deficit-to-GDP ratio fell by 2.9 points. We forecast a further increase of the area wide debt-to-GDP from 94.5% in 2012 to 97.5% 2013. If Greece stayed in the euro area in 2014 and without sovereign debt restructurings in Portugal, the debt-to GDP ratio would reach 100% in 2014. From 2015 onwards some debt restructuring in Spain, Italy and Ireland (mainly in form of maturity extension and a reduction of coupons by around 150 basis points) will probably help to lead to a reduction in the euro area 2015 deficit-to-GDP ratio to 1.5% and a decline in the debt ratio from 95.7% of GDP in 2014 to 95.0% in 2015 down to 91.4% in 2017.
Limited use of the OMT in 2013
With future sovereign debt restructurings, in most cases probably coming together with bank restructuring (Slovenia and Cyprus might see only the latter) spreads of public and private sector funding costs will remain large between periphery and core countries. While the ECB's OMT programme will likely keep sovereign bond spreads in a range of up to 300bp relative to Bunds, we doubt that the ECB will use it to force a narrowing of spreads below 100bp. In our view, there is no chance that the ECB will use the OMT programme for a country that is not under an ESM/EFSF programme. Therefore, we expect that, after facing increasing market pressure, first Spain, and then Italy, will ask for ESM programmes in the form of an Enhanced Conditions Credit Line (ECCL). As market participants will probably not be keen to "fight the ECB" at the beginning of the programme, the OMT purchases should be relatively small in 2013. With only Spain and Italy qualifying for the OMT in 2013, maybe joined by Ireland at the end of the year, we expect total OMT purchases in a range between €100bn and €200bn, maybe even lower. This suggests that with a likely use of the repayment option of the 3Y LTROs - which we expect to be around €200bn - the ECB's balance sheet of currently €3.03trn (32% of GDP) is likely to move sideways in 2013.
The initial positive effects on government bond markets from the activation of the OMT in early 2013 are likely to prevent an escalation of the liquidity squeeze among banks at least in 1H 2013, despite some disappointment of market participants in respect of the speed of the implementation of the single supervision mechanism (SSM) and the strength of the banking union. While the ECB will remain ready to step in with an easing of collateral rules and additional multi-year (probably for 3 years) LTROs to prevent liquidity shortages in the banking sector, it probably will take until early 2014 (when Grexit is likely to happen) for the ECB to engage in further rounds of LTROs.
Further ECB rate cuts to come
We expect the ECB to cut interest rates further, as it is likely to become more obvious to the General Council that inflation will undershoot the inflation target of "close, but below to 2%" in the medium term. We expect a 25bp cut of the refi rate in 1Q 2013, followed by a second refi rate cut, which will be probably come in combination with a cut of the deposit rate by 25bp (to -0.25%) in mid 2013. With more possibilities for the banks to reduce excess liquidity (option to repay 3Y LTRO funding) the ECB probably will use the negative deposit rate to increase the pressure on banks to "use" the available liquidity. In addition, following the successful example of Denmark, the ECB might use a negative deposit rate to reduce upside pressure on the currency. The alternative to limiting upside pressure on the currency would be a Fed-like verbal intervention, by committing to keep interest rates low for a prolonged period of time. Such a policy does not look very likely for the ECB, in our view, because it would take away its ability to react quickly to a surprising increase of inflation risks. However, in a likely backdrop of low growth and low inflation, we see no interest rate hikes until 2016/17.
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