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. J u n e 2 0 1 4 1 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 come. 2 J u n e 2 0 1 4