ANALYSIS: Calm before new storm or turning point in euro debt crisis?

By Andrew McCathie Jan 27, 2011, 16:29 GMT

Berlin - Europe's economy has begun the new year on a solid note amid signs that the tensions unleashed by the region's debt crisis were abating, a key indicator released Thursday showed.

While key economic sentiment indicators remain at high levels, signs have emerged of growing investor confidence that Europe's political leaders will agree to new measures to contain the crisis at their summit set down for next month.

But analysts are far from convinced that a turning point has been reached in the crisis, which first first sent shock waves across Europe more than 12 months ago.

Instead, analysts believe that the recent positive mood surrounding the 17-member eurozone could represent only a brittle calm before the outbreak of another round of financial turmoil in the region with resurgent inflation now threatening to accentuate the crisis.

'It is encouraging but it is not enough to signal the end of the crisis,' said Martin van Vliet, eurozone economist for the ING Bank.

On Thursday, the European Commission said its closely watched business and consumer survey for the eurozone nudged down from an upwardly revised 106.6 last month to 106.5 in January. But still remained near a more than three-year high.

'The level of the indicator is approaching the historical peak reached in spring 2007, suggesting that the recovery in industry will continue in the coming months,' the commission said releasing the survey.

Only a matter of weeks ago the threat of Portugal and possibly Spain being forced to tap the eurozone bailout fund, known as the European Financial Stability Facility (EFSF), was casting a dark shadow over the eurozone.

But underlying the change of the investor mood surrounding the eurozone, investors on Tuesday piled into the first bond issue by the EFSF. The 5-billion-euro (6.9-billion-dollar) bond issue was more than eight times oversubscribed.

Meanwhile, several of the eurozone's cash-strapped states have made progress in knocking their state finances into shape by cutting back high deficit levels.

Eurozone stocks have also moved up recently and the euro has steadily gained ground to hit a two-month high this week of more than 1.37 dollars amid forecasts it was edging towards the key 1.40- dollar-mark.

European leaders have also helped to steady investors' nerves by repeatedly confirming their commitment to the euro as they have done at critical moments in the upheaval, such as when both Greece and Ireland called for bailouts.

Now Europe's political establishment has launched a new drive to beef up the 440-billion-euro (602-billion-dollar) EFSF bailout fund and to address weaknesses in the eurozone structure.

But the debt crisis still appears far from being defeated with the International Monetary Fund (IMF) this week pointing to the risk of the financial turbulence threatening nations at the heart of the eurozone.

'In particular, continued market pressures could result in serious funding pressures for major banks and sovereigns, increasing the likelihood that problems spill over to core countries,' the IMF wrote in a report.

But then European political leaders do not have a lot of time to produce a blueprint to resolve the crisis.

Analysts say the cash-strapped members of the eurozone will face another major test in April, when a batch of bond redemptions are due.

Further complicating efforts to bring the crisis to an end is the sudden resurgence of inflationary pressures.

Annual German inflation climbed to a two-year high of 1.9 per cent this month amid higher energy and food costs, data released Thursday showed.

For the European Central Bank (ECB) the coming months could prove to be a particularly difficult balancing act.

'The question is: How long will the ECB continue to take the crisis states into consideration by leaving interest rates at a very low level?' said Commerzbank economist Christoph Weil. At 1 per cent, the ECB's refinancing rate currently stands at an historic low.

With energy and food costs climbing, the talk in European markets is that eurozone rates could rise by 50 basis points by the end of the year.

But any hike in borrowing costs would further hamper the efforts of the eurozone's cash-strapped states to cut high debt-and-deficit levels.

Moreover, rising inflation could hit consumer spending just when the weaker eurozone nations need stronger domestic demand to power economic growth to help them battle their way out of the crisis.