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Containers wait in the harbour of Hamburg, Germany.

Philipp Guelland/Philipp Guelland/AP

After defying gravity for much of last year, the German economy has finally succumbed to Europe's deepening financial and economic woes, highlighting the euro zone's dire straits.

The strongest economy in the troubled euro zone shrank in the fourth quarter by an estimated quarter of a percentage point and is likely to slip further in the early months of a difficult 2012, analysts warn.

Germany still grew by a reasonably robust 3 per cent for the full year, the government's Federal Statistics Office reported. But if the negative fourth quarter is followed by further contraction in the first three months of this year, Germany would join a growing band of euro zone countries that have slipped back into recession.

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After receiving revised figures, the European Union's statisticians reduced third-quarter growth for the 17-country bloc to a mere 0.1 per cent, from an earlier estimate of 0.2 per cent. The steady decline underscores the urgency for the region to resolve its widening sovereign debt crisis and develop a strategy for economic recovery.

The euro zone economy as a whole will be mired in at least a modest slump through the course of 2012, although Germany will manage to post weak growth of 0.4 per cent, ING economists forecast.

"Germany does not need an end to the sovereign debt crisis to resume positive growth, but it does at least need clarification how the Greek situation will be dealt with in a lasting fashion," said Timo Klein, a senior economist with IHS Global Insight in Frankfurt.

Greece, where the crisis began, is in the midst of contentious negotiations with key creditors to get them to accept a 50-per-cent haircut on their bond holdings, amounting to 15 cents on the euro in cash and another 35 cents in new 30-year debt. The so-called voluntary restructuring is a condition for the next phase of its bailout from its euro zone partners and the International Monetary Fund, without which Athens will be unable to meet a bond repayment of €14.5-billion ($18.8-billion) due March 20.

As long as Greece's future in the monetary union "is not decided one way or another … persisting uncertainty will restrain German growth," Mr. Klein said.

In the meantime, though, recently improved data, including an unexpected export bounce in November and stronger leading indicators last month "have bolstered hopes that the economic trough may be very shallow and perhaps already occurring right now," with a possible rebound as early as April, Mr. Klein added.

Despite the uncertain backdrop and deteriorating economic conditions, the European Central Bank is expected to leave its benchmark rate unchanged at 1 per cent when officials gather Thursday for their first policy meeting of the year. The lack of action comes after two consecutive interest-rate cuts and a series of aggressive measures to shore up liquidity in the battered financial sector.

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Further rate cuts are possible in the months ahead. But ECB president Mario Draghi "is likely once again to dampen expectations that the ECB will take more aggressive action to address the debt crisis by significantly ramping up its purchases of peripheral sovereign debt," Jonathan Loynes, chief European economist with Capital Economics, said in a research note.

Yet that is precisely what the central bank must do to help restore shaken market confidence, safeguard the euro and keep the monetary union from coming apart at the seams, most analysts argue.

The latest broadside on this front was fired Wednesday by a senior debt monitor.

"The ECB, clearly, does need to be more actively engaged," David Riley, head of global sovereign ratings at Fitch Ratings, told a conference in Frankfurt. The central bank "has plenty of scope to expand its balance sheet without unleashing inflation in the euro zone."

The failure of the euro "would be cataclysmic," he said. "The euro is a reserve currency. What would that do in terms of financial and political stability?"

Fitch is not forecasting such a dire outcome, but warns that Italy cannot be allowed to collapse. "It is hard to believe the euro will survive if Italy does not make it through," Mr. Riley said.

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Although the markets have heard this before, European stocks and the euro took a beating in response.

Mr. Riley stressed that the ECB cannot solve the crisis on its own, warning that European leaders have to come up with a plan for a "credible firewall" to halt the contagion.

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