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The European economy appears to nally be

emerging out of the long tunnel of stagnation. The eu-

rozones real GDP, after contracting for six consecu-
tive quarters from the OctoberDecember quarter in
2011, rose on a quarter-on-quarter basis in the April
June quarter last year, and went on to post positive
growth for three consecutive quarters until the Octo-
berDecember quarter, albeit at more modest levels
around an annualized rate of 1%.
Looking back, Europe has been focusing on scal
reconstruction during the sovereign debt crisis, which
started with revelations of Greeces window dressing
of its scal decit in October 2009, and it has been
facing deationary pressure associated with the cri-
sis. If the European economy is truly recovering, Eu-
rope will join the United States and Japan in driving
the global economy, which is denitely very good
news for the global economy.
Our conclusion, however, is that it could be too
early to adopt that optimistic view. This is because,
given a lack of demand, deationary pressure is in
fact increasing. As a result, non-performing loans at
nancial institutions continues to rise, and the risk of
a nancial system crisis occurring has not been re-
duced at all.
The chart shows trends in the GDP gap ratio in
the eurozone, and outstanding non-performing loans
and the non-performing loan ratio in the ve most
heavily indebted countries (Portugal, Italy, Ireland,
Greece, and Spain) from 2009. The rst thing that at-
tracts attention is that the GDP gap ratio shrank from
2009, hit a peak of 0.764% in 2011, and then wors-
ened to 2.749% in 2013, roughly the same as the
level in 2009 in the immediate wake of the Lehman cri-
sis. In fact, although real GDP rose in the OctoberDe-
cember quarter last year on a quarter-on-quarter basis,
the rise reected an increase in foreign demand, and
the contribution of domestic demand declined. As the
effects of scal stimulus after the Lehman crisis de-
clined, scal policy changed to scal tightening with
the emergence of the sovereign debt crisis. However,
private-sector demand has not recovered sufciently to
offset the effect of deationary pressure. This is shown
by the high unemployment rate of the eurozone, which
remains at a record level of 12%.
The second point is that non-performing loans
have increased dramatically. Outstanding non-per-
forming loans in the heavily indebted countries are es-
timated to have doubled from around 390 billion euros
in 2009 to approximately 780 billion euros in 2012. The
non-performing loan ratio is estimated to have risen
from 6.4% in 2009 to 14.1% (for countries excluding
Italy). The non-performing loan ratio is far higher than
the peak seen in Japan, 8.9% in 2002, during its own
nancial crisis, and suggests a heavy burden on the -
nancial institution management in Europe.
History tells us that a sovereign debt crisis will
transform into a nancial system crisis, which ulti-
mately will transform into a burden on taxpayers. Eu-
rope is standing at the gateway to a nancial system
crisis. In the event nancial institutions begin to col-
lapse in a chain reaction, the entire economy will in-
evitably enter a deationary spiral. The European
Union is not just standing idly by, and responding to
the risk described above, it is striving to rapidly de-
velop a single resolution mechanism for bank failures.
However, with non-performing loans of 370 billion
euros, for which no reserves have been set aside in the
ve most heavily indebted countries, it is reasonable
to question whether a planned single resolution fund
of 55 billion euros is adequate.
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European Economic Outlook: No Room for Optimism
Government bond yields in the heavily indebted
countries, after surging to dangerously high levels,
have stabilized thanks chiey to ECB President Mario
Draghis announcement of an unlimited government
bond-buying program in September 2012. The debt
crisis appears to have eased. Monetary policy may
control the market, but its effects on improvements in
the real economy are limited. Since Europe has chosen
to strengthen scal discipline, it will logically have to
pay the price in the real economy. Europe may thus
have to be prepared for deation for some time to
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