Since mid-2012, stress in financial markets has abated substantially due to fiscal and structural reforms at the Member State level. The entering into force of the European Stability Mechanism (ESM) and the ECB's announcement of outright monetary transactions (OMT) added up to financial stability, alongside with the decision by the European Council to create a Banking Union.

This was complemented by the completion of the negotiations on a program for Cyprus, and the agreement on lengthening loan maturities for Ireland and Portugal. But negative feedback loops between private-sector debt overhangs, bank funding problems and government financing constraints still exist and risk affecting economic prospects.

The unsustainable accumulation of debt in the private and public sector, combined with uncertainty over the macroeconomic situation and asset quality as well as adverse credit conditions, has triggered substantial balance-sheet adjustments in several Member States which are set to be weighing on economic prospects over the forecast horizon. Corporate debt levels have started to fall gradually since mid-2009, but weak economic activity and its negative impact on corporate profitability interrupted this decline in 2012.

Overall, companies' deleveraging efforts are reflected in the net lending position of the EU non-financial corporate sector since the final quarter of 2009. Moreover, the fall in loans to non-financial corporations in the euro area until February 2013 does not suggest an imminent reversal of this underlying trend.
A large number of corporations in vulnerable Member States, notably Italy, Portugal and Spain, are still burdened by substantial debt overhangs. Coupled with lower profitability and higher funding costs induced by financial fragmentation, high corporate debt levels are weighing on capital spending and growth, but continue to pose also a risk to banks' balance sheets.

Alongside the deleveraging of the corporate sector, private households started to increase their net lending, which had sunk to historically-low levels prior to the global financial crisis. However, household debt in the euro area, largely in the form of mortgage loans, has hardly changed since 2010 and has thus remained at elevated levels.

With the prevailing need for both the household and corporate sector to repair balance sheets on a large scale, while, at the same time, governments are reining in deficits and reducing unsustainable public debt levels, growth in domestic demand is expected to remain constrained in several Member States.

As a result of the expected further decline in borrowing of the total economy induced by necessary deleveraging net lending positions of the total EU and euro-area economy are forecast to widen over the forecast horizon. Given the substantial economy-wide need to reduce debt levels, balance-sheet adjustment is expected to weigh on domestic demand over the forecast horizon and the return to a self-sustained recovery is likely to be a time-consuming process.

Despite the decisive political achievements in terms of crisis-management and institutional reforms of the economic governance in the euro area, uncertainty remains elevated. However, financial markets appear to have become less sensitive to adverse policy news from vulnerable countries and the observed relative calmness during and after the program negotiations in Cyprus may lend support to the hypothesis that the available policy instruments for crisis management have proved effective so far.