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					Economic Research:
The Eurozone Enters An Uncertain
2013 As The New Recession Drags On
Credit Market Services:
Jean-Michel Six, Chief Economist EMEA, Paris (33) 1-4420-6705;
jean-michel_six@standardandpoors.com
Sophie Tahiri, Economist, Paris (33) 1-4420-6788; sophie_tahiri@standardandpoors.com


Table Of Contents

World Trade Is Likely To Recover Gradually As Emerging Economies Gain
Strength

Rising Prices, Despite Falling Wages, Are Depressing Consumer Demand

A Sustainable Recovery Requires Monetary Transmission To The Real
Economy

Our Economic Forecast: We've Trimmed Our Projections For Germany
And France In 2013

Related Criteria And Research




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Economic Research:
The Eurozone Enters An Uncertain 2013 As The
New Recession Drags On
A number of uncertainties continue to prevail over the economic outlook as Europe enters 2013. Standard & Poor's
believes that three key factors will determine the depth and length of what we have called the "new recession" that
started in the middle of 2012:

• The strength of the recovery in world trade and especially in emerging markets,
• The outlook for real incomes and especially retail price trends in the weakest economies of the eurozone, and
• The re-establishment of effective transmission of monetary policy to the real economy.

Standard & Poor's Ratings Services believes the eurozone will probably start to feel a recovery in international demand
for its products in the first part of 2013. However, sticky consumer prices on the periphery are dampening domestic
demand for now. We are keeping our forecast for economic growth in the eurozone (European Economic and
Monetary Union or EMU) nearly unchanged at 0% for 2013 and 1.0% in 2014 from our previous September forecast.
However, we believe the downside risks have diminished a bit, and now see a one-in-three chance of a recession
extending beyond 2014, versus 40% previously.

  Overview

  • The most recent international purchasing managers' data confirm our expectation that Europe's external trade
    conditions will become increasingly more supportive during the course of 2013.
  • As long as wages and prices show diverging degrees of flexibility in the eurozone, consumer demand will stay
    depressed and net competitiveness gains will remain small.
  • The European Central Bank's announcement of Outright Monetary Transactions has already calmed the
    sovereign bond markets, and could improve investor sentiment and kick-start activity on the interbank
    markets.
  • Our forecast for overall economic growth in the eurozone is virtually the same as in our September update: 0%
    in 2013 and 1.0% in 2014, but we see a slightly lower downside risk of a longer recession extending into 2014.




World Trade Is Likely To Recover Gradually As Emerging Economies Gain
Strength
The most recent November release of purchasing managers indices (PMIs) for the world's main economies points to a
gradual improvement from a very low level. Out of 26 economies in the initial release, 18 posted some improvement in
their indices. The average read was 48.3, which, like any reading below 50, still indicates contraction. The most
impressive improvement came from China, but Brazil and South Africa also reported solid gains. We are inclined to
view these signals as an encouraging confirmation of our expectation that Europe's international environment will
become increasingly more supportive in the course of 2013 and beyond. Accommodative monetary policies in most



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                      Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


emerging markets, made possible by the decline in consumer price inflation in the past six quarters, are stimulating
domestic demand in those economies.

Chart 1




This is not to say that the international outlook for 2013 is without risks. The unresolved "fiscal cliff" in the U.S. has
added volatility to the financial markets. And a number of potential developments could still derail the recovery in
emerging markets, such as a surge in oil prices on the back of rising geopolitical tensions in the Middle East. Yet
according our estimations, foreign demand for eurozone products should rise 5.3% in volume in 2013 (versus 3.2% in
2012 and 7.9% in 2011) and gain further momentum in 2014 (7.4%).



Rising Prices, Despite Falling Wages, Are Depressing Consumer Demand
A number of European economies, especially on the periphery, have attempted to improve their competitiveness since
2010 though increased wage flexibility. Elevated labor costs and low productivity have been putting a drag on exports.
The emphasis on wage flexibility, in other words on a higher correlation between wages and unemployment, and
economic cycles more generally, is even more relevant when countries cannot use exchange rate movements to close
their competitive gap--as in the eurozone. In that case, a decrease in labor costs is the equivalent of an "internal




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                     Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


devaluation." But successful internal devaluations require that labor costs and prices move in concert. Otherwise the
risk is that falling real wages depress domestic demand while sticky prices jeopardize potential competitive gains. This
is what appears to have taken place, to different degrees, in most eurozone economies, and especially on the
periphery.

Chart 2




Wage trends since the beginning of the crisis fall into two periods. Between March 2009 and March 2010, during the
Great Recession, nominal wages continued to increase but price inflation eased, resulting in an acceleration of real
wage growth. Ireland is a distinct exception: Prices and wages both declined in response to a much more rapid
downturn, though prices dropped faster than wages.




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                     Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


Chart 3




In the second period that started in March 2010, the rise in unemployment on the periphery was behind the sharp
deceleration in nominal wage growth, which turned negative in Portugal, Ireland, and Greece in the second quarter.
But while wage growth slowed, consumer price inflation accelerated. For instance, compensation per head in Italy
grew 2.3% in 2010, 1.2% in 2011, and 1.1% in 2012. Meanwhile, inflation averaged 1.6%, 2.9%, and 3.1%. In other
words, prices have shown much more rigidity than wages during this downturn.


What comes immediately to mind to explain this rigidity is the rise in indirect taxes, which feed into the overall
calculation of inflation. The European Commission's Statistical Office, Eurostat, publishes a retail price index
"assuming constant indirect taxes." What this computation reveals is that excluding tax hikes, inflation remained
stubbornly positive after 2009, especially in Italy. In the case of Greece, despite a severe recession, inflation turned
negative under that measure only recently (mid-2012).

What accounts for the persistently rising prices? A breakdown of the CPI index for each country reveals some similar
trends: Utility prices generally come out with the highest increases since 2010, followed by the costs of transportation,
education, and household services. In other words, those sectors that are least exposed to international competition
continued to post the largest increases.




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Wage flexibility accompanied by price rigidities results in depressed real incomes and in turn weaker domestic
demand on one hand, but limited competitive gains on the other. The effects of the wished-for internal devaluation are
stunted because prices remain rigid. In the longer term, structural reforms aimed at increasing competition in the
services sector are a way to reduce price stickiness. Meanwhile, the most recent trends of the past six months suggest
that headline inflation has been moderating in Portugal, Spain, and especially in Greece, indicating that the economic
downturn is finally starting to affect price trends. But this does not seem to be so much the case in Italy yet (see chart
4).

As long as wages and prices continue to show diverging degrees of flexibility, consumer demand will remain depressed
and net competiveness gains limited.

Chart 4




A Sustainable Recovery Requires Monetary Transmission To The Real
Economy
When an economy experiences a phase of fiscal adjustment, the typical policy mix includes restrictive fiscal policies
and accommodative monetary responses. What makes the current situation in the eurozone more intricate is that




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                      Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


while in theory the monetary policy stance of the European Central Bank (ECB) has unquestionably been
accommodative, transmission to the real economy has been limited: since 2008, the ECB's balance sheet has more
than doubled, but money supply growth has remained feeble. Liquidities injected into the financial system by the ECB,
especially via the Long-Term Refinancing Operations of December 2011 and January 2012--have remained within the
financial system. Loans to the private sector–-households and nonfinancial corporations--have been growing at
historically low rates.

Chart 5




Low credit demand could explain this situation. After all, when the economy overall is weak, so should the demand for
new loans. This is partly true in the current context. But a breakdown by member country reveals a more complex
picture, which the ECB itself has characterized as a "fragmented monetary union."

A fragmented monetary union has several features. First, the central bank policy rate (currently at 0.75%) shows up
unevenly in credit costs across the monetary union. Indeed, we find that interest rates on new loans with a maturity of
between three months and one year vary greatly in the EMU. In turn, a second and related feature is that credit
distribution varies considerably across countries within the union.




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Chart 6




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                     Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


Chart 7




One of the roots of this "fragmentation" is dysfunctional interbank markets. Since the middle of 2011 when the
sovereign crisis reached a new high, financial institutions have increasingly relied on the ECB itself rather than on
interbank lending to cover their needs. Direct flows of financing via the interbank markets have dwindled, implying
that "there is plenty of liquidity in some parts of the euro area and there are shortages in other parts," as ECB President
Mario Dragghi has recently said (see box). The breakdown in confidence among financial institutions has been
compounded by national regulators' concerns that institutions under their jurisdiction would take on excessive
cross-border exposure via their subsidiaries in the rest of the union. Cross-border lending has slowed dramatically
since the middle of 2011.

  Mario Dragghi On The Eurozone's Dysfunctional Markets

  "We still have very low nominal rates and negative real rates. We also have … dysfunctional markets--the
  interbank market is very dysfunctional, it is not working--and there is a certain amount of fragmentation in most
  of the other financial markets in the euro area. The issue is now whether another LTRO [Long-Term Refinancing
  Operation] would actually be effective. In this regard, I refer again to fragmentation: there is plenty of liquidity in
  some parts of the euro area and there are shortages in other parts."
  June 6, 2012, press conference with European Central Bank President Mario Dragghi.




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                     Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On



Chart 8




The fragmentation of the monetary union and the resulting decline in credit growth in some member states have
worsened the recession. In response, in September the ECB announced a new framework to boost the confidence of
investors in the long-term sustainability of the eurozone and reduce tensions on the sovereign debt markets. The
announcement of Outright Monetary Transactions, to be conducted in concert with the European Stability Mechanism
if a member country formally asked for assistance, has already had favorable effects: The 10-year yields on Spanish
declined 99 basis points (bps) and on Italian bonds by 97 bps between Sept. 5 and Dec. 6, although at the time of
writing no country had formally asked for assistance. Were this to occur, execution risks could materialize. But in our
opinion the very existence of this new framework could over the coming year brighten market sentiment and kick-start
interbank markets. More fluid credit flows across countries and sectors are an important precondition for a sustainable
recovery in the eurozone in the second part of 2013 and in the years to come.



Our Economic Forecast: We've Trimmed Our Projections For Germany And
France In 2013
We've updated our economic growth estimates for 2012 and our forecast for the coming two years. With three




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                      Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


quarters of hard economic data in for most countries, we now have a more reliable assessment for 2012, and believe
that the eurozone will average 0.6% growth in real GDP. Comparing our December and September estimates suggests
that growth may have been a bit stronger than we thought in Germany (0.8% against 0.6% in September). On the other
hand, data available so far suggest that the downturn was a bit less steep in Spain (-1.4% versus -1.8%) and especially
in The Netherlands (-0.4% against -1%). There are no changes to our September estimates for the other major
countries.

Looking at 2013 and 2014, our central forecast has not substantially changed from our September release. However,
we trimmed our 2013 growth projections for Germany (0.9% versus 1.2%) and France (0.1% versus 0.4%). In the case
of Germany, this is due to our lower expectations for corporate investment growth. For France, we see a slightly larger
negative carry-over from 2012 (-0.2%). Outside the eurozone, our projections for the U.K. (1% in 2013, and 1.7% in
2014) have not changed.

Our alternative projection assumes a longer recession into, rather than until, 2014. For 2013, GDP growth comes out at
-1.6% (versus -1.9% in September) and 0.8% in 2014 (1.3%). Given what we described above, we are inclined to attach
a slightly lower probability to this alternative, more pessimistic scenario: About one in three instead of 40% in
September. This is another way to say that in our opinion the downside risks have slightly diminished. The recovery in
emerging markets appears more tangible, and the ECB's recent actions have had a positive impact on sovereign debt
markets.

Table 1
Standard & Poor's European Economic Forecast
          Germany France Italy Spain Netherlands Belgium Eurozone U.K.                 Switzerland
                                             --Central forecast--

Real GDP (% change)
2010           4.0     1.7    1.8    (0.3)            1.7       2.4     2.0     1.8            3.0
2011           3.1     1.7    0.6     0.4             1.2       1.8     1.5     0.8            1.9
2012e          0.8     0.1   (2.4)   (1.4)          (0.4)      (0.2)   (0.6)   (0.3)           0.8
2013(f)        0.9     0.1   (0.7)   (1.3)            0.3       0.4    (0.1)    1.0            1.1
2014(f)        1.4     1.1    0.8     0.7             1.2       1.0     1.0     1.7            1.6

CPI inflation (%)
2010           1.2     1.7    1.6     2.0             0.9       2.3     1.6     3.3            0.6
2011           2.5     2.1    2.8     3.2             2.4       3.5     2.7     4.5            0.2
2012e          2.0     2.0    3.1     2.4             2.5       2.8     2.4     2.8           (0.7)
2013(f)        1.9     1.7    2.2     2.0             2.0       2.0     2.0     2.0            0.1
2014(f)        2.0     1.5    1.0     1.5             1.4       1.8     1.6     1.6            0.8

Unemployment rate (%)
2010           7.1     9.8    8.4    20.1             4.5       8.3    10.1     7.8            4.5
2011           6.0     9.7    8.4    21.7             5.3       7.2    10.2     8.0            4.0
2012e          5.5    10.5   10.7    25.5             6.3       7.3    11.6     8.2            4.2
2013(f)        5.3    10.7   12.0    26.0             7.0       7.9    12.1     8.4            4.5
2014(f)        5.2    10.2   11.8    25.5             6.0       7.5    11.7     8.2            4.3




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                      Economic Research: The Eurozone Enters An Uncertain 2013 As The New Recession Drags On


Table 1
Standard & Poor's European Economic Forecast (cont.)
                                  --Alternative scenario: Severe recession--

Real GDP (% change)
2012e        0.8       0.1    (2.4)   (1.4)         (0.4)      (0.2)      (0.6)      (0.3)    0.8
2013(f)     (0.8)     (1.3)   (2.1)   (2.6)         (1.0)      (1.2)      (1.6)      (0.5)   (0.7)
2014(f)      0.6       0.4     0.2     0.5            0.4       0.3            0.4    1.0     1.2




Related Criteria And Research
• The Eurozone's New Recession--Confirmed, Sept. 25, 2012




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