"Events over the past two weeks in Europe have been extraordinary. The latest escalation in the sovereign debt crisis has led us to reassess our economic forecasts.
We believe that the outlook for the eurozone economy is now significantly more negative and that politicians have missed their opportunity to prevent a European credit crunch.
Following yesterday's events in Italy, the banking system in Europe is now likely to experience a serious shock from the fall-out of the country's bond market collapse. We expect debt-rating agencies to downgrade Italian debt significantly in the coming months. The downgrades combined with the falling value of Italian government debt will increase pressure on non-Italian banks to reduce their exposure, which could exacerbate the situation in the Italian bond market.
Many eurozone banks are already on life support - unable to raise funds in capital markets and heavily reliant on liquidity from the European Central Bank. However, this will not be enough to stop banks from deleveraging, and reducing lending to the real economy. As a result, we are now forecasting a serious recession in the eurozone in 2012, which is also likely to result in recessions in the wider European region, including the UK.
The downward spiral came after an initial note of optimism. First there was hope that Europe had finally grasped the urgency of the crisis, but the 27 October accord was overshadowed by Greek Prime Minister George Papandreou calling for a referendum on the Greek package. Since then, Papandreou has won a vote of confidence, but lost the support of his people. He announced his resignation to make way for a coalition government.
Yesterday, Italy's Prime Minister Silvio Berlusconi was forced to resign after losing his majority in a crucial vote to pass next year's budget. So two eurozone leaders have resigned in less than a week, following the same fate of the other peripheral European leaders: Ireland's Brian Cowen, Portugal's José Sócrates, and Spain's José Luis Rodríguez Zapatero.
The fall-out in financial markets has been troubling. European bourses are down between 2 and 4%, with shares in banks being hit particularly hard. Alarmingly, the yield on the 10-year Italian government bond rose above 7.4% and, in the process, triggered an increase in the risk margin charged by clearing house LCH Clearnet - effectively raising the cost of trading the bonds. As of yesterday, the yield on the Italian 10-year government bond had risen some 130bps since the start of the month, representing a capital loss of just over 9%.
By our estimation, Italy will need to raise some €275 billion in 2012 to repay maturing debt, meet interest payments and pay for public services. The amount represents a huge 17% of its existing outstanding debt, which given the current negative momentum will be a near impossible task."
Azad Zangana, European Economist at Schroders
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