After a hugely-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 its shaky banks and keep a lid on 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 two-year-old crisis that has seen three countries bailed out.
If the auctions go well and borrowing costs ease, then hopes may rise that the 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, may be working.
If rates are still high and show that investors remain nervous about lending to governments, then fears will rise 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 major players — eurozone governments, the European Union's executive Commission and the European Central Bank — must work together 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 euros ($94 billion) in bond redemptions and interest payments. Spain, which is expected to sell up to 25 billion euros ($33 billion) in new debt, starts a heavy period of auctions on Jan. 12, and Italy begins on Jan. 13.
Overall, Italy will have to borrow over 300 billion euros ($392 billion) in 2012.
Italy's auctions are "absolutely pivotal," said Jane Foley, an analyst at Rabobank International.
"If Italy manages to auction this debt successfully, then the debt crisis will take a step back from the cliff edge," Foley said. "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 euros ($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 euros ($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 euros in debt, but the crisis has pushed bond yields on the country's benchmark ten-year bonds to over 7 percent.
Italy's new government, led by economist Mario Monti, can probably pay rates that high for a while, analysts think. Italy paid much higher interest rates in the 1990s for several years; rates peaked at 14 percent in 1992 but fell gradually to around 4 percent by 1998 as the country shaped up its finances to join the euro at the beginning of 1999.
But the country is now hit by contagion after eurozone authorities allowed Greece to ask creditors to take less than they were owed. Italy also suffers from lagging growth, held back by burdensome red tape and bureaucracy while Spain has an unemployment rate of 22.8 percent — 48.9 percent for people under 25 — after the collapse of its real estate bubble.
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 increase the strain on governments trying to persuade voters to accept more cutbacks in spending, pensions and government wages while raising taxes.
It's also 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 euro ($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 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."
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