LONDON The euro zone crisis is entering a new, treacherous phase for governments, which can only cross their fingers that slow-burn reforms will pay off before voters get fed up with austerity and high unemployment.
On the face of it, 2013 should be a much less traumatic year than 2012 for the 17-nation single-currency area.
Financial conditions have improved enormously since the European Central Bank promised to do whatever it takes to preserve the euro. Yields on the bonds of highly indebted peripheral countries have fallen sharply, bank funding strains have eased and stock markets have rallied.
Countries on the southern rim of the euro zone have made big strides in reducing their budget and trade deficits. They are no longer living way beyond their means. They have also introduced politically touchy structural reforms, notably to make their labour markets more flexible.
But demand is likely to remain weak, while unemployment, already at a record 11.8 percent, is forecast to rise further before it comes down. Recovery will be slow.
"They've taken the medicine, but they're not going to jump out of bed straight away," said Sebastian Barnes at the Organisation for Economic Cooperation and Development in Paris.
"The problem is bridging the gap over the next two or three years when you're putting in place the right policies but they're not quite bearing fruit. So it's a question of managing public expectations," Barnes, adviser to the rich-country forum's chief economist, added.
Berenberg Bank said all forward-looking indicators point to a resumption of growth this spring, which should further reduce the euro zone's aggregate fiscal deficit to below 2.5 percent of GDP in 2013. It stood around 3.4 percent last year, down from 4.1 percent in 2011.
What's more, Italy, Spain, Portugal, Ireland and Greece shrank their combined current account deficit to an estimated 1.5 percent of GDP in 2012 from 7 percent in 2008 and look set to balance their external accounts this year.
But Holger Schmieding, the bank's chief economist, said the single currency was not out of the woods yet.
"Despite impressive progress, serious risks remain. The euro zone needs growth in its major markets abroad and the political patience to stay the course at home," he said in a note.
A nagging worry is that the euro zone is making up for its economic mistakes through what Barnes calls "bad rebalancing".
So, while rising exports have played a role, the improvement in the periphery's current account has been achieved mainly by slashing imports.
And the reduction in relative wage costs needed to bring about 'internal devaluation' - the only devaluation available in the absence of exchange rate flexibility - has so far been engineered disproportionately through a rise in unemployment rather than wage moderation.
Ireland is a notable exception - as is Britain outside the euro zone - and Barnes said there were encouraging signs elsewhere, for example in Spain.
Italy, however, has barely touched its wage bargaining system. "The problem there is that wages have run ahead of productivity," he said.
LET'S GET STRUCTURAL
Gilles Moec, an economist with Deutsche Bank in London, also frets about Italy. Italy has its government deficit under control, but Moec sees signs of a growing 'employment overhang', linked to what he says is extremely slow financial rebalancing by the private sector since the onset of the crisis.
This is reflected in a rise in employee compensation in Italy as a percentage of corporate value-added to 57.7 percent from 52.5 percent in 2007.
By contrast, in Spain, where unemployment of 25 percent is more than twice as high as Italy's, the wage share dropped over the same period to 55.9 percent from 64.7 percent.
Rebalancing, in short, is far from complete. That is true for creditor countries, too. Germany's current account surplus is stuck at a stubbornly high 6 percent of GDP, reflecting weak investment and consumption.
Goldman Sachs has attempted to measure the progress being made in ironing out the imbalances by updating its estimates of the real exchange rate changes needed to bring countries' net debt positions - the result of accumulated annual current account deficits and surpluses - back into broad equilibrium.
In keeping with improvements in their current accounts, Greece, Portugal and Spain now require an inflation-adjusted depreciation that is about eight to 10 percentage points lower than two years ago, Goldman reckons.
Still, the remaining adjustment is huge - about 25-30 percent in the case of Spain and around 15-25 percent not only in Greece and Portugal but also in France, where employers and unions this month agreed on a package of labour reforms to restore competitiveness.
Germany, incidentally, requires a real appreciation of 15-25 percent.
Instead of higher unemployment and lower wages, structural reforms offer a less painful path to rebalancing, Goldman said.
Switching resources to exports from domestic sectors such as construction in Spain and public services in France would reduce the need for further real exchange rate depreciation.
"But adopting such reforms is not painless: the potential loss of political capital from vested groups standing to lose existing privileges can prevent politicians from implementing the necessary reforms. This remains true across most of the periphery, in France and Germany," wrote Goldman economist Lasse Holboell W. Nielsen.
Barnes with the OECD said all countries could do more, but the lack of reform in bigger economies, including France and Germany, was a particular concern.
The OECD's research suggests that, contrary to received wisdom, structural reforms can yield positive results within a year or two, notably by catalysing investment and jobs. In turn, that can have an impact on public perceptions.
"I don't think in any of these countries the reforms are sufficient for what they should be achieving in the long run," Barnes said. "But just getting reform on the agenda and getting people to recognise that the system needs to change, and is going to change, is very important."
(Editing by Will Waterman)