After a turbulent 2011, the 17 countries that use the euro will be quickly confronted in the new year with major hurdles to solving their government debt crisis, just as the eurozone economy is expected to sink back into recession.
With government finances under pressure as growth wanes, the eurozone will find it even more difficult to shore up shaky banks and reduce the high borrowing costs that threaten Italy and Spain with financial ruin.
As early as the second full week of January, bond auctions in which Italy and Spain need to borrow big chunks of cash will start showing whether the eurozone is finally getting a grip on the 2-year-old crisis that has seen Greece, Ireland and Portugal bailed out.
If the auctions go well and borrowing costs ease, the crisis will ease, lending support for the EU strategy of getting governments to embark on often-savage austerity measures to reduce deficits, along with massive support for the banking system from the European Central Bank.
High rates, on the other hand, would feed fears of a government debt default that could cripple banks, sink the economy and, in the extreme case, destroy the 17-member currency union.
Key events early in the New Year:
- Italy and Spain will seek to borrow heavily in the first quarter at affordable interest costs, starting the second week in January.
- The slowing eurozone economy may slip into or already be in recession, lowering tax revenue and increasing government budget deficits.
- Bailed-out Greece must agree with creditors on a debt writedown that will cut the value of their holdings by 50 percent in an effort to start putting the bankrupt country back on its feet.
The task is for the major players - eurozone governments, the European Union's executive Commission and the European Central Bank - to convince financial markets that troubled governments can pay their heavy debts and therefore deserve to borrow at affordable interest costs.
Default fears have driven up bond market interest rates and made it more and more expensive for indebted governments to borrow to pay off maturing bonds. That vicious cycle forced Greece, Ireland and Portugal to seek bailout loans from the other eurozone governments and the International Monetary Fund.
A key stress point will be whether Italy can continue to raise money in the markets at affordable rates.
In the first quarter, it has to step up its borrowing to pay off €72 billion ($94 billion) in bond redemptions and interest payments. Spain, which is expected to sell up to €25 billion ($33 billion) in new debt, starts a heavy period of auctions on Jan. 12, and Italy begins on Jan. 13.
Overall, Italy has more than €300 billion ($392 billion) in debt maturing in 2012.
"If Italy manages to auction this debt successfully, then the debt crisis will take a step back from the cliff edge," said analyst Jane Foley at Rabobank. "If it doesn't, it could go over the cliff edge. At the end of the day, whatever the nuances and hours of discussion that have gone on about the sovereign debt crisis, it boils down to whether a sovereign can sell its debt in the open market."
If Italy fails to borrow at affordable rates, the options are few and unattractive. The eurozone's €500 billion ($653 billion) in bailout funds - already partly committed to earlier bailouts - would struggle to cover Italy's financing needs, even if additional help can be found from the IMF. A bigger solution - commonly guaranteed eurobonds - faces German resistance and would take time to implement.
The European Central Bank could use its power to buy large amounts of Italian and Spanish bonds with newly created money - but has so far refused, out of concern that a central bank bailout would remove the incentive for governments to control their spending.
Instead, the bank has focused on pushing credit to banks so they can keep lending to support the economy.
Still, its limited bond purchases have provided essential support to Spain and Italy by helping hold down borrowing costs. And its latest massive infusion of €489 billion ($639 billion) in cheap, long term loans may help troubled governments borrow, as stronger banks may use some of the money to buy higher-yielding government bonds.
Italy pays an average of about 4.2 percent on its existing stock of €1.9 trillion in debt, but the crisis has pushed bond yields on the country's benchmark ten-year bonds to over 7 percent.
Bond auctions Wednesday and Thursday showed the government of new Prime Minister Mario Monti had made some progress in convincing lenders, as yields on 10-year bonds fell to 6.98 percent. Though that's painfully high, it's down from last month's equivalent 7.56 percent, which was the highest rate Italy has had to pay since the euro was launched in 1999. Yields fell further on shorter term debt.
Monti's big challenge will be to push Italian legislators to make far-ranging reforms to improve the country's growth performance and keep spending under control.
"We absolutely don't consider the market turbulence to be over," he said Thursday.
Italy and Spain's battle will be even harder if the debt troubles pull the whole eurozone into a recession. Economists at Ernst & Young foresee a mild recession in the first part of the year and only 0.1 percent growth for the year as a whole, with unemployment at 10 percent for several years.
That will make it harder for governments to persuade voters to accept more cutbacks in spending, pensions and government wages while raising taxes.
It's not clear how long voters in Greece, which will have its fourth straight year of recession next year, will tolerate continuous austerity. Yet the cutbacks are the price of getting the bailout loans that have kept Greece from default.
Meanwhile Greece is striving to get creditors to agree to write down some debt and avoid larger losses in case of a default that is not agreed ahead of time. A €14.4 billion ($18.8 billion) chunk of debt comes due in March.
Guntram Wolff, deputy director of the Bruegel think tank in Brussels, said that governments may get past the early hurdles - only to confront a souring mood among voters in the second half of the year over continuing cutbacks and sacrifices. New governments in Spain and Italy, currently enjoying political honeymoons, will be pressed to show progress. Greece, with a transitional government and elections expected in April, has seen repeated protests and strikes.
"There will be a point in the summer when people have seen a lot of action from government and no improvement in their living conditions and they will ask, do we have this euro to live with austerity and high unemployment," he said.
Wolff thinks that the determination of political elites to keep the euro together will win out: "I think it's going to survive."