So all is looking well in the eurozone and any new bout of crisis has receded beyond the horizon. Or has it? In my view, there will be a renewed crisis. This time, though, it will run from the banks to the sovereigns in peripheral states. Eurozone banks are still inadequately deleveraged and capitalized, especially in the peripheral economies. They face substantial rising bad debts in the corporate and household sectors in 2014. At the same time, sovereign debt sustainability is set to worsen, GDP growth is (and will remain) zilch; fiscal and economic reform is nonexistent; and banks are vulnerable on their loan books to the corporate sector as much as on their massive holdings of domestic sovereign debt. And the eurozones banks, particularly in the periphery, face the tests of the European Central Banks asset quality review (AQR) and stress tests over the next year. This will provide transparency, but not the means of addressing the flaws it will uncover. In the meantime, as I argued in my last column, the architecture of budding European banking union is riddled with Gruyère holes and is under-resourced. The political ambition to keep all funding resolutions dependent on private sector bail-ins and national government resources is likely to make banks more vulnerable to runs on them. The nexus connecting excessive private and public debt in the eurozone is the banking system. Bank credit is still contracting; loan rates are still high in peripheral economies; and the breakdown in intra-eurozone credit and capital flows remains. There is an adverse feedback loop in which the eurozones banks are the weak link between still high private-sector (corporate and household) debt and rising sovereign debt.
Italys gross public debt ratio is now over 130% of GDP, more than twice the EUs Fiscal Compact target of 60% by 2030 and is still rising. And Italys banks are tied more closely to the sovereign than any others in Europe. A crisis focused on Italy and the nexus between the sovereign and weak banks would be tough to deal with. Italy thus remains the real flashpoint for a new round of the euro debt crisis in 2014.