MARKETS CONTINUE TO rise across the world as investors increasingly feel that the eurozone will avoid the worst. So convinced are markets about this positive outcome that they have withstood the actual news out of Europe, which has been mixed, at best. Since investors are not entirely irrational, what they are really saying is that some pretty unpleasant scenarios have already been priced in and that the eurozone should be able to absorb the potential shocks. The question Asian investors need to resolve is whether this view of how the eurozone crisis will play out is realistic and what impact the eurozone will have on Asia.

• First, it is virtually certain that the eurozone will be in recession this year. The International Monetary Fund and the World Bank have just revised their growth forecasts for the eurozone down sharply, with both now expecting its economy to contract in 2012 and recover very weakly in 2013. The last quarter of 2011 was a tough one for the eurozone, with even Germany probably suffering a contraction in its economy. With the global economy losing momentum, fiscal austerity biting harder and European banks cutting back lending to rebuild their capital adequacy, there is simply no reason to expect things to get better. This must therefore mean that unemployment will rise further and wages stagnate, dealing a substantial body blow to the average man;
• Second, the current policy mix is simply not working. Greece has been slashing its fiscal spending with greater and greater vigour, but its budget deficit keeps missing the targets set by creditors — reduced fiscal spending is undermining economic growth and reducing tax revenues. Greek savers are losing confidence and pulling money out of Greek banks, which are in dire condition. The economy is set to contract again this year, meaning that Greek citizens will have nothing to gain from all the blows they have taken to their well being. And all this pain for a policy that will, at best, bring Greece’s debt-to-GDP ratio down to a still-unsustainable 120%. Bond markets also seem to be saying that Portugal is heading towards a Greekstyle crisis;
• Third, the futility of the current strategy is evident in the predicaments of larger and systemically more significant countries. For example, even with recent falls in bond yields, the interest rates Italy is paying are not sustainable in the long term;
• Fourth, the eurozone’s financial and economic problems are now spilling over into some of its neighbouring economies such as Hungary. Other large emerging European economies such as Turkey are also beginning to falter; and
• Finally, it is simply not realistic to say that all these difficulties will occur with no political backlash. Political elites in Europe will soon confront a much more impatient electorate which would, among other things, be more willing to vote for extremist parties. The European elite will fear a repeat of the fascism that emerged in the 1930s and take fright.

• There will have to be a restructuring of Greek debt in some form. The only question is whether it will be orderly or disorderly. Given what is at stake, there will probably be a negotiated restructuring between creditors and debtors, with the restructuring accompanied by measures to bail out the banks that will go bust when that happens and to ring-fence other vulnerable economies such as Portugal, Spain, Ireland and Italy; 
• What is not certain is whether these measures will be sufficiently powerful to be effective: the record of the eurozone in the past 18 months suggests that they will not. Thus, it is likely that economic and financial stresses will spread to Portugal and other vulnerable countries;
• In this context, the European Central Bank will have little choice but to abandon its relatively cautious approach to monetary easing. The ECB will probably have to adopt some form of quantitative easing to prevent deflation. This will push the euro down against the other major currencies, improving export competitiveness and giving some breathing room to the ailing regional economy; and
• Politically, it is impossible to see this happen without Germany and the northern European countries insisting on a more comprehensive economic restructuring, to ensure that the distressed economies do not get a free ride. These countries will have to improve their competitiveness by undertaking reforms in the labour and product markets, with the ultimate aim of reducing unit labour costs across these weaker eurozone economies. In the longer term, this economic restructuring will be powerfully positive for Europe, but in the short term, it could cause more pain as businesses restructure.

• The eurozone accounts for about 20% of global output. Recession will hit eurozone import demand, with this effect being compounded by the likely euro depreciation. Trade-dependent Asian economies such as Singapore, Hong Kong, Malaysia, Taiwan and South Korea will take a major hit, as will China;
• As the global economy slows in response to the eurozone’s difficulties, commodity prices will tend to fall. So, even economies that are supposed to be domestically driven might suffer slower demand growth if their consumer spending depends materially on commodity prices boosting household incomes;
• Asia will also have to manage some financial challenges. Not only are European banks prominent in financing Asian trade, they also play a major role in project finance in Asia. It is not clear that Asian banks will be able to step into the breach and substitute for the European banks that will be cutting back. Beyond the impact of European banks, Asian asset markets are likely to see considerable capital outflows as global investors cut risk. Recent experience suggests that markets such as India and Indonesia are the ones that are most vulnerable to outflows;
• Europe is also a major source of foreign investment and tourists, both of which will decline in Asia; and 
• As the political mood in Europe darkens, the temptation to resort to protectionism will grow. Initially, China may be the main target, but it will not be long before other Asian exporters are also fingered.