Already downbeat, the outlook for the Eurozone has deteriorated a little further since our Winter report. Challenges facing businesses, consumers and governments have persisted into 2012, price pressures have taken longer to ease than earlier anticipated, and risks to stability have become more serious. Overall Eurozone GDP is now forecast to fall 0.5%, with few countries likely to escape falling output in 2012. For several countries, at least two more years of painful adjustment are likely.

2012 will be a very challenging year for the Eurozone, with large amounts of public and private sector debt to be refinanced, tight credit conditions, further fiscal austerity and job losses. As a result, we forecast a mild contraction in economic activity, with further steep declines in peripheral countries only partly offset by the more resilient core countries. These economic conditions will test policy-makers’ commitment and ability to preserve the Eurozone in its current form.

Assuming that policy-makers act decisively to resolve the current crisis by delivering an orderly restructuring in Greece and putting a credible firewall around Spain and Italy, growth should return in 2013. After a fall of 0.5% this year, we expect Eurozone GDP to grow by about 1% in 2013 before picking up to some 2% a year in 2015–16. This implies that the recovery will be slower than after any recession since the early 1970s.

The main constraints to growth this year will stem from fiscal consolidation, which we estimate will amount to more than 1% of GDP, and from credit constraints. Indeed, Eurozone banks are facing very difficult financing conditions, at a time when they need to achieve higher capital ratios. Tighter credit availability will dampen both investment and consumption. Indeed, there is a risk that credit constraints and fiscal austerity are more severe and protracted than we currently envisage; in this scenario, the Eurozone would experience a deeper recession.

On the positive side, economic activity should benefit from lower inflation, helping to sustain households’ real incomes. Also, businesses generally have large amounts of cash on their balance sheets. Assuming that confidence is restored during the year thanks to significant action from policy-makers, these cash surpluses are likely to be spent on investment and recruitment from 2013 onward.

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