Elga Bartsch, economist at US investment bank Morgan Stanley, based in London, said in a recent commentary that in 2010, the European economy should transition towards a more sustainable, albeit still sub-par recovery.

This economic transition will be reflected by a shift in the engines of growth from a swing in the inventory cycle towards an ongoing recovery in domestic demand and net exports. The transition is unlikely to be smooth, though.  Hence, she says investors should brace themselves for potential setbacks in the course of the next few quarters.  The MS quarterly forecast profile suggests a gradual slowdown in growth momentum over the course of next year. 

"Until some domestic demand dynamics start to materialise, the European economy remains in what could be coined as the no man's land of the business cycle,"Bartsch says.

Monetary and fiscal policy decisions to move from triage treatment towards long-term rehabilitation: Exit strategies will likely be a focus for financial markets. With few exceptions (the UK, Spain, Ireland), MS don't expect any meaningful fiscal policy tightening next year.  Hence, the fiscal policy issue is mainly about preparing the budgets for 2011 and beyond.  These are likely to bring more meaningful tightening in order to ensure a return to fiscal sustainability over the medium term.  As such, they will be key in shaping medium-term growth expectations too.  Monetary policy, by contrast, will likely start exiting its current ultra-expansionary stance in late 2010. The anticipation of the new tightening cycle should cause higher bond yields, flatter yield curves and wider country spreads.

From an inventory-led bounce in industrial activity to a broader demand-based recovery:  As expected,  Bartsch says the European economy emerged from recession in mid-2009. The ignition was triggered by a turnaround in the inventory cycle, a normalisation in global trade flows and a policy-induced stabilisation of the financial system.  With the global economy clearly having turned the corner courtesy of buoyant growth in emerging markets, and with the euro's unrelenting ascent having been stopped for now, a revival in external demand is already coming through in the quarterly GDP reports. The key question for 2010, however, is whether the initial spark that ignited the engine will translate into a broader domestic demand recovery.  She says that until these domestic demand dynamics materialise, the European recovery remains vulnerable.  There is no mistaking the considerable headwinds still faced by both consumers and corporates.  After a steep decline in 2009, MS therefore looks for what probably is best described as a stabilisation in domestic demand. 

Investment spending still struggles with subdued capacity utilisation and, what companies argue, are tight financing conditions:Yet, rising business confidence and rebounding corporate profits should suffice to create a small rise in machinery and equipment investment - - consistent with repair and replacement and possibly some rationalisation projects - - in the course of the year.  Construction investment is a much more diverse story, driven by local property prices, public infrastructure projects and excess capacity issues.  Public construction investment aside, MS expects construction investment to lag behind capital goods investment next year.  For the year as a whole, investment spending will likely stagnate due to a negative statistical overhang from 2009.

Consumer spending is to be dampened by a rise in unemployment, modest gains in wages and an increase in inflation: Elga Bartsch says while in terms of their debt load, balance sheets and savings rate, European consumers are in better shape than their US and UK counterparts, the lower number of layoffs recorded in Europe since the start of the recession suggests that part of the labour market adjustment is still to come - - after all, activity shrank more sharply on this side of the Atlantic.  Thus far, tighter employment legislation, voluntary labour hoarding and government-sponsored short-shift programmes have prevented an adjustment in labour costs.  MS sees payrolls being trimmed further and expect the Eurozone unemployment rate to rise well into H2 2010.  Against the backdrop, and factoring in the expansionary fiscal policy measures taken by several governments, MS forecasts broadly stable consumer spending for 2010.  After what likely will be a marked contraction in 2009, a stabilisation can already be regarded as an achievement in itself,  Bartsch says.

After a marked growth rise in the divergence between countries in 2009, MS expects to see some renewed convergence in 2010: "We expect export-oriented countries with sizeable industrial sectors, such as Germany and Sweden, to outperform in terms of headline GDP growth.  However, the bigger bounce-back partially reflects that they were hit harder by the global trade slump than many of their counterparts," the economist says."We expect other countries such as Spain and Ireland, who were hit hard by the financial crisis, to continue to underperform as they work their way through the aftermath of a property price bubble, a construction boom and a saving-investment imbalance.  Both are making good progress though in rebalancing their economies and should be able to return to positive GDP growth in 2011."

MS expects the ECB, the BoE and the Riksbank to start raising rates gradually in H2: In total, MS expects the ECB and Sweden's Riksbank to hike by 50bp (0.5%) and the Bank of England (BoE) by 75bp by the end of next year.  In conjunction with raising rates, central banks will also begin to unwind their quantitative easing (QE) measures. This unwinding might at least partially precede the first interest rate hikes but will unlikely be completed before the start of the new interest rate tightening cycle.  Bartsch says the details of the unwinding of QE are largely determined by the QE strategy pursued during the crisis. The ECB and the Riksbank have resorted to passive QE via their various refi/repo operations. Hence, unwinding QE will affect the banking system directly and asset markets indirectly.  Meanwhile, the BoE pursued a strategy of active QE, where it purchased assets directly in the open market.  Unwinding these measures would thus likely affect markets more directly and banks more indirectly. 

At this stage, there has been little indication that unwinding of QE or rate hikes are imminent:The ECB signalled that it is no longer willing to offer one-year funding at a fixed rate of 1% - - instead opting for a tracker rate reflecting the average refi rate (the benchmarke rate, currently at 1%)  in 2010 - - and that it will phase out its one-year and its six-month LTROs (Long Term Financing Operation) next year.  The cornerstone of the ECB's QE, the fixed-rate tenders with full allotment (which allow the banking system to draw down unlimited funds from the ECB), will remain in place for as long as it takes though -  -at least until spring 2010.  Under this operational set-up, the overall liquidity entirely depends on the bids submitted by banks - - unless, of course, the ECB takes additional action (e.g., reverse tenders).  Where the EONIA overnight rate and the EURIBOR money market rates trade relative to the ECB refi rate therefore depends on these bids too. Hence, in addition to the two factors that would normally drive EONIA - - the ECB's decision on the refi rate and/or the deposit rate and the ECB's liquidity provision (notably the decision to drain liquidity from the system via conducting reverse tenders or by issuing debt certificates) - -  there is a third risk factor: banks' bidding behaviour.  Thus far, overbidding by the banking system caused excess reserves to swell and pushed market rates well below the policy/benchmark rate.  But this bidding behaviour could change, potentially causing the market rate to jump higher.

The unwinding of QE will likely have marked effects on money markets, bond markets and country spreads: Elga Bartsch says the heavy use of the ECB's refi facilities allowed banks to become big buyers of bonds. Since the start of the crisis, Eurozone banks have added about €330 billion to their holdings - - effectively indirect QE via the banks. These purchases have likely helped to lower benchmark bond yields. But the main beneficiary probably was the Eurozone periphery. Less generous liquidity provision next year is likely to have repercussions on the Eurozone government bond markets.  After intra-EMU (European Monetary Union) spreads were characterised by a high degree of co-movement during the crisis, reflecting systemic concerns, Bartsch says that country-specific factors are likely to play a bigger role again in 2010. The start of another ECB tightening cycle should also contribute to wider spreads across the board, as it has done historically.  Eligibility for the ECB's collateral pool, which is scheduled to revert back to A- at the end of 2010, could become another country-specific concern for investors.

IMF on Europe 2010

Interview with Marek Belka, director of the Fund's European Department:

IMF Survey online:2009 has been a tough year for Europe. What will 2010 be like?

Belka: The crisis that hit Europe in late 2008 was unprecedented. All we can say for certain about the near future is that 2010 is not going to be anything like 2009.

We are now in the middle of a recovery but it is not very robust, although clearly the situation is improving. I find it interesting that the markets are much more upbeat about Europe’s near-term prospect than we are. Here at the IMF, we look at the structure of the recovery, and we see both the forces that will drive the recovery and the forces that may hold it back. So it’s going to be an interesting year, with much riding on the choice of economic policies.

The year 2010 will be dominated by the challenge of how to strike a balance between continuing to support the economy and gradually phasing out unconventional measures. Here, I’m thinking about unconventional financial and monetary measures rather than fiscal stimulus.

In Europe, the banking sector is not yet in as good shape as we would like it to be. However, now is the time to switch from extraordinary, meltdown-preventing measures (like blanket guarantees) to institution-specific measures. We know the problems are concentrated in a limited number of institutions, so policymakers should concentrate on them. National authorities need to ensure that banks keep capital up to deal with the loan losses ahead and be in a position to extend credit. Weak banks should be required to raise capital and restructure or face resolution.

IMF Survey online:When will the situation improve for the many people who have lost their jobs?

Belka: Unemployment, as we all know, is a lagging indicator. The turnaround in the labor market will only happen after business activity has recovered. In the most general terms, this means we can probably expect the labor market to start improving late in 2010 and into 2011.

That said, the situation is very different in different countries, and I don’t simply mean between western and eastern Europe. When you look at advanced Europe, the unemployment rate has barely moved in countries such as Germany and the Netherlands whereas in other parts of Europe, including Spain, Ireland, and a number of countries in emerging Europe, unemployment has spiked.

So the situation is very uneven, partly because of the policy response to the crisis, partly due to the structure of the economy. For the hardest hit countries, the situation will stabilize but the improvement will be gradual during 2010 and beyond. In those countries that didn’t experience a marked increase in unemployment, we will probably see a marginal increase.

IMF Survey online:What is your advice to policymakers as they start unwinding the policies that were put in place to fight the crisis?

Belka: Keep the overall supporting stance of policies for the time being because we’re not sure how robust this recovery is. As and when the situation permits, 2011 is the year to start fiscal consolidation, and here we fully support the approach of the European Commission. Some countries, of course, have to act faster. Greece, Ireland, and Spain for instance can’t afford to wait, but most of them are already doing what is necessary. Several countries in the east—Serbia, Ukraine, Romania, and Hungary—have already started the process of consolidation.

As far as the financial sector is concerned, I have already mentioned it is time to switch from systemwide measures to institution-specific measures.

When it comes to monetary policy, the European Central Bank (ECB) is being cautious, as always. It is not signaling any withdrawal from monetary easing anytime soon, and that is as it should be. But we should expect some withdrawal of unconventional monetary measures when the economy allows for it.

"It may seem as if regulation is a burden. But if it helps avoid a crisis, then it’s a burden worth taking on."

All these policies are pinned down by very low inflation. There is no sign of a pickup of inflation even close to the 2 percent that is described by the ECB as price stability. We believe inflation will stay close to 1 percent in the near future, not least because inflation expectations are well anchored.

So, to sum up, our advice is: Support economic activity for now. Plan for a careful exit. And finally, deal with impaired financial institutions more forcefully than is being done now.

IMF Survey online:Countries in emerging Europe have weathered the crisis very differently, ranging from your native country, Poland, which escaped recession altogether, to Ukraine and the three Baltic countries, Romania, and Hungary, which suffered deep downturns. What factors determined whether countries ended up in one camp or the other?

Belka: I would name four factors: structural features of the economy, the quality of macroeconomic policies, the quality of institutions, and the exchange rate regime.

In a crisis, it’s good to be a relatively big economy with a diversified production base. Poland comes to mind. It not only has a relatively big domestic market but also a diversified export industry. In fact, Poland’s economy alone constitutes 40 percent of the region. If you add two other countries that have remained relatively stable - - the Czech Republic and Slovakia - - you have 65 percent of the region’s GDP. So looking at how Poland has weathered the crisis may give you a better picture of how emerging Europe has handled the crisis rather than looking at, say, Latvia.

Those countries that had unsustainable fiscal policies, such as Hungary or Romania, fell into crisis first. And those that had managed their policies well, including Poland but even more so the Czech Republic, remained relatively stable. And even though the crisis delivered a pretty severe blow, we have seen a clear rebound quite early in the crisis and no sign of destabilization in the banking sector in these two countries.

The quality of institutions played a role. One of the key institutions is financial sector supervision. Those countries that had strong supervisory regimes in place, such as the Czech Republic, managed to avoid excessive currency mismatches. Low interest rates also played a part because there was no incentive to engage in carry trade. The same was true, but to a lesser degree, of Poland.

Fixed exchange rate regimes have been a pillar of economic stability for the three Baltic states and Bulgaria. But they also encouraged excessive capital inflows. And now, with the crisis, these fixed regimes have radically limited the policy options for these four countries. That said, the exchange rate regime is only one factor. Some of the hardest hit countries, including Ukraine, Hungary, and Romania had floating, rather than fixed rates. So I’m far from saying the most important factor in the crisis is the exchange rate regime. The other three factors I have mentioned probably played a bigger role.

IMF Survey online: There have also been big differences within advanced Europe, with countries such as Ireland, Britain, and Greece struggling to regain their footing, while other advanced countries are already growing again. Again, what policy lessons can we draw from their experience?

Belka: Well, the first blow from the crisis came from the trade channel and it did not discriminate against individual countries. On the contrary, we saw a situation in which Germany’s GDP fell more than that of other countries that we sometimes think of as poor performers. So the numbers do not really reflect the complexity of the situation. Germany’s economy is at the crossroads of the global economy and that’s why it suffered first when trade imploded. This was a hard blow, but in Germany’s case, it is temporary.

You also have two other categories of countries. First, countries with homemade imbalances—mainly real estate and asset price bubbles. When the crisis hit, these bubbles suddenly burst and the economies were hit not only by declining trade but also by sinking housing markets. Ireland and Spain are two good examples.

As it happens, both these countries started with relatively low levels of public debt, so they were able to react to the crisis by using the fiscal space that they had accumulated in good times. Now, of course, both countries have been forced to start fiscal consolidation. In a monetary union, depreciating your economy out of the crisis is not an option. So countries must rebuild their competitiveness through factory price adjustment, which often means, unfortunately, cutting wages. This is currently going in many countries.

The third category of countries includes Greece as the most prominent example. The country had a difficult fiscal situation leading up to the crisis but was not hit so badly in terms of growth. Whereas Germany experienced a decline in GDP of almost 5 percent in 2009, Greece’s corresponding number was just under 1.5 percent, making the country seem initially like an oasis of stability.

Well, needless to say, these numbers don’t tell the entire story. Greece now has to undertake a very painful fiscal adjustment, but it’s not really because of the crisis. The crisis just brought problems to the fore which had been accumulating for decades. We may see similar problems show up in other parts of Europe.

IMF Survey online:When it comes to regulating the financial sector, how do you strike the right balance between making sure another crisis doesn’t happen anytime soon and not stifling competition?

Belka: This is a frequent call that we hear: do the right thing but not yet! We don’t want to micromanage what needs to happen in the financial sector, and the markets play an important role. But basically, banks need to increase their capital base, and they should probably do it sooner rather than later because capital is cheap right now. The future may be less benign for them.

"Keep the overall supporting stance of policies for the time being because we’re not sure how robust this recovery is."

We are in a situation where the banks are using the unprecedented monetary easing that has taken place as a massive subsidy provided to them by society. But let’s be clear: It’s the taxpayer who is rebuilding the financial system. Current high profitability will not last forever.

I am often asked whether new regulation will strangle the banks and slow down the growth of the global economy. My answer is that almost all crises bring about a permanent drop in wealth which is never regained: the output is lost forever. Economies may be able to return to their pre-crisis growth path, but it’s been very rare that an economy has made up for the loss of wealth not created during a crisis.

Now, if good regulation and tough supervision can prevent or at least soften the impact of crises, isn’t it, on balance, better for our long-term standard of living? Avoiding crises is probably the best way to stimulate the long-term growth rate. So, yes, it may seem as if regulation is a burden. But if it helps avoid a crisis, then it’s a burden worth taking on. Having said this, we are not advocating a “regulate everything” approach. The new regulatory framework should precisely address the vulnerabilities that have become evident in the crisis.

IMF Survey online:Now that the panic is behind us, what main lessons do you take away from this crisis?

Belka: Good policies begin in good times. Unfortunately, good times are usually seen as something to enjoy while they last, not only by politicians, but also by the people who elect them. And then the crisis hits and makes us realize good times don’t go on forever.

Therefore, good times are also times to make provisions for a rainy day. Making provisions is not only about accumulating reserves. It is also about building institutions that are able to resist the onslaught of a crisis, including in the financial sector.

We have drawn many lessons from the crisis when it comes to the shortcomings and imperfections of the financial markets. It is only legitimate to use the situation to bolster the regulatory framework and supervision. I worry that some lessons may not be learned. Policymakers were so effective in preventing a real catastrophe that some people may now simply forget what really happened.