March 24th, 2016

Euro crisis: time for a rerun?

by Michael Wohlgemuth After Greece obtained its third bailout last summer, […]

After Greece obtained its third bailout last summer, Europe turned its attention to other crises. But it would be naive to conclude that the sovereign debt crisis is over. The Greek drama is still far from a happy ending; in Portugal and Spain, fragile left-wing governments may want to abandon austerity and roll back reforms; France has declared a state of economic emergency; Italy’s competitiveness keeps declining; the European Central Bank’s interventions are getting diminishing returns at increasing risk; and Germany has switched from complacency to angst mode.

In February, the European Commission published its latest economic projections for 2016-2017. Pierre Moscovici, the European Union’s commissioner for economic affairs, noted that the economy “is successfully weathering new challenges” due to the beneficial effects of “cheap oil, the euro rate and low interest rates.” Nevertheless, he mentioned “crosswinds” that could stall the positive trend: the slowdown in China, volatile oil prices, geopolitical tensions and “policy uncertainties inside Europe.” On this last point, Mr. Moscovici was curt. He mentioned neither the migration crisis nor the United Kingdom’s possible departure from the EU as major economic risks.

Misplaced confidence

Even more strangely, the full report cites extra government spending in response to terrorist threats and the refugee crisis as “positive surprises from public consumption.” In the econometric models that underlie the EU forecasts, these outlays count as “demand-driven” stimuli to the economy.

This confidence seems misplaced. It is clear that most of the refugees who have made it to Germany and Sweden, let alone those stranded in Greece and Italy, will not be integrated into local labor markets and creating added value anytime soon. Meanwhile, a side effect of uncoordinated refugee flows across Europe has been the reinstatement of border controls in several countries. If borders within the Schengen area are closed, the economic costs will be significant. A French think tank estimates the costs of freight and travel delays, along with reduced tourism, will amount to 110 billion euros over the next 10 years.

The European Commission forecasts the euro area economy will expand at a rate of 1.7 percent this year and 1.9 percent in 2017 – slightly slower than the EU as a whole and barely half the rate of the world economy, which is projected to grow by 3.3 percent and 3.5 percent, respectively. Europe’s growth engines will be Poland, where gross domestic product is seen expanding by 3.5 percent in 2016 and 2017, along with Spain, the UK and the Netherlands, which are all expected to grow faster than 2 percent. Germany is seen below the EU average at 1.8 percent in both years.

Greece is expected to do better than previously expected this year, posting a contraction of only 0.7 percent. The country should rebound in 2017 with solid GDP growth of 2.7 percent, its best performance in a decade, according to the EU forecasts.

Greek deadlock

However, “policy uncertainties” abound in Greece. Brussels expects Athens to run budget deficits this year and next. The country’s debt-to-GDP ratio is expected to peak this year at 185 percent before declining to 182 percent in 2017. Capital controls remain in place to prevent bank runs and capital flight. Border controls have proved less effective, as thousands of refugees continue to brave the Aegean Sea to land on Greek islands.

Meanwhile, Greece and its public creditors remain at odds over an assessment of bailout measures needed to unlock new financial aid. There is still no agreement on extremely unpopular pension cuts that have yet to win approval from lawmakers. Athens wants to conclude the review swiftly to start talks on debt relief. This is also what the International Monetary Fund (IMF) wants, because it sees no other way the country’s finances can be put on a sustainable basis. But the IMF is not convinced the Greeks have done enough to curb spending, and has delayed any decision on whether to participate in a third bailout until the second quarter.

The IMF’s continued involvement was a key argument for the German government to win approval of the Greek bailout package. Berlin believes that if EU institutions alone represent Greece’s creditors, they will be too lenient. On the other hand, there is great reluctance in the German government to take the IMF’s advice and grant Athens substantial debt relief, since any “haircut” would seriously affect German taxpayers.

In short, a lot could still go wrong in Greece. The Syriza government is fragile and under intense financial and political pressure. “Grexit” could still be a possibility in the near future, as a top IMF official recently warned.

Austerity fatigue

Other crosswinds are likely to build up in the southern members of the eurozone. While the European Commission expects strong growth from Spain, it also mentions “downside risks” stemming from the country’s inability to form a government since the inconclusive December 2015 elections. Despite coming first with close to 29 percent of the vote, acting Prime Minister Mariano Rajoy’s conservative Popular Party (PP) lacks coalition partners.

Socialist (PSOE) leader Pedro Sanchez has been in talks with the left-wing populist Podemos movement and smaller communist and secessionist parties on a possible government. While many issues divide these parties, they are united on ending austerity and pro-market reforms – precisely what Brussels believes is needed to keep Spain from becoming a problem child in the eurozone.

Portugal is similar to Spain in key respects. Its conservative reform government lost its majority in October 2015 and, after weeks of uncertainty, was succeeded by a minority socialist cabinet. The new government holds power thanks to support from the anti-euro Communist Party and the radical Left Bloc, both of which reject any more austerity. The terms of the country’s 78 billion euro bailout require it to present draft budgets to the European Commission. Following an extended tug-of-war, Portugal received conditional approval for this year’s budget, with Commissioner Moscovici warning that Portugal was at risk of non-compliance with EU fiscal rules and would require careful monitoring.

French emergency

Left-wing governments in France and Italy never wholeheartedly subscribed to austerity and pro-market reforms, to say the least. In contrast to their counterparts in Greece, Spain and Portugal, incumbent cabinets in Paris and Rome look set to survive until the next elections (May 2017 in France, May 2018 in Italy.) Since these countries are the second and third largest economies in the eurozone, however, even smaller political risks carry much more weight.

The European Commission expects growth in France and Italy to lag behind the euro area average in 2016 and 2017. France is projected to violate the EU budget deficit limit of 3 percent of GDP in both years, as it has done continuously since 2008. Despite Mr. Moscovici’s warning that the Commission will not accept further non-compliance with deficit reduction, French President Francois Hollande recently declared a “state of economic emergency” and announced a 2 billion euro spending program. Faced with 26 percent youth unemployment, Paris now wants to subsidize hiring young or unemployed people and to create more than 500,000 vocational training positions.

Testy Italians

Commissioner Moscovici has also been tested by the Italians. After recent rants by the Italian prime minister against pettifogging bureaucrats in Brussels and Berlin, Mr. Moscovici said he expected “serenity, patience and capacity for dialogue” from the authorities in Rome.

In January, Italy reached an agreement with the EU on the bad loans plaguing its banks. Non-performing loans had grown from 125 billion euros in 2012 to 201 billion euros in 2015 (only Greek banks had a higher share of non-performing loans). The deal was the first official test of the eurozone’s new rules for bank resolutions and bail-ins, making it a precedent-setter.

Italian banks will be allowed to package their bad loans into securities and then sell them off to private investors. The Italian state will facilitate this by guaranteeing the senior tranches of these securitizations. This clearly suggests there are risks involved that few market participants would be willing to bear. While the plan tries to work within EU rules on state aid, it does not really meet the banking union principle that investors and not taxpayers should bear the burden.

But Italy has more to worry about. After many years of recession, real GDP per capita is still lower than in 1999. Labor productivity continues to decline, without being offset by any reduction in labor costs. Taxes and regulations keep firms from growing. This all suggests Prime Minister Matteo Renzi’s government needs to move swiftly ahead with economic and institutional reforms.

QE ineffective

Over the past few years, the European Central Bank has become a key factor in the calculations of market players and politicians alike. An initially reluctant and now fully committed lender of last resort, the ECB is arguably more powerful than national governments in preventing a breakdown of the eurozone.

However, for reasons explained in other GIS reports, quantitative easing (QE) has had little effect on real investment. Most of the cheap new money is being used by banks to roll over bad loans or to fuel new asset price bubbles in stocks, bonds and real estate. Massive buying of government bonds has reduced governments’ incentives to reform. In buying time, the ECB has also helped delay needed restructuring of banks, businesses and the political system.

Brexit specter

Prime Minister David Cameron will hold a referendum on the UK’s continued membership in the EU on June 23. Polls suggest that there is a 49 percent chance that “Brexit” (a decision to leave the EU) would be the result.

Even though Britain does not belong to the euro area, the departure of the EU’s second-largest economy and its main financial hub would send shockwaves through financial markets and the political establishment. The economic consequences, both for the UK and the rest of the EU, are hard to predict because they would hinge on the shape of a post-Brexit settlement. Certainly, there would be years of legal, political and economic wrangling over future EU-UK relationships. A British pullout could also boost populist sentiment in other member states, further splintering the EU.

German angst

Germany remains the eurozone’s anchor. The three tailwinds mentioned in the European Commission’s winter 2016 forecast – cheap oil, the weak euro and low interest rates – have all helped the German economy to grow slightly faster than the eurozone average while keeping unemployment at the lowest level in the EU.

There is little reason to expect that the German economy will suddenly weaken. However, exporters’ confidence has faltered as growth in China and emerging markets slows, while trade within the Schengen area has lost momentum and could decline if a potential “Brexit” hampers sales to the UK. Meanwhile, the mood of German consumers has switched from complacency to angst in reaction to the arrival of more than one million refugees over the past year.

Chancellor Angela Merkel’s image as a crisis manager has suffered considerably, and confidence in the workability of the recent EU-Turkish agreement on the migration crisis is low. In this political climate, it cannot be taken for granted that German voters and politicians will support further bailouts of governments or banks if the euro crisis reignites.

Banking risks

The collapse of the eurozone may not be imminent, but it would be naive to suggest that the sovereign debt crisis is over.

The turmoil on stock markets in the first two months of this year is one gauge of increasing risk. Who could have imagined that Deutsche Bank would need to publicly reassure creditors that it can meet its obligations and pay coupons – sending its shares down 40 percent at one point in mid-February?

Germany’s flagship bank may have specific legal issues, but the picture across the euro area is not much different. As of March 21, the Euro Stoxx Index of European bank shares had fallen 15 percent this year and was 33 percent below its April 2015 peak. If this market sentiment reflects not just lower expectations of bank earnings, but also declining confidence in their ability to survive, it would be an alarming sign.

After all, most banks today are more solidly capitalized than they were before the onset of the euro crisis. The ECB’s strong engagement in quantitative easing, banking supervision and bank resolution should justify at least as much confidence as the recent “stress-tests” of euro area banks. But instead, it appears that all this monetary easing and regulatory tightening has not restored sustained trust in banks. Similarly, the many changes in eurozone governance have not instilled confidence in fiscal discipline or the governments’ ability to promote competitive reforms.

Toxic combination

In the worst-case scenario, a toxic combination of one or more of the following events could set off a banking crisis, followed by a eurozone-wide sovereign debt crisis:

* Greece reforms stall, prompting the IMF to withdraw its support for a bailout. With no debt relief, the Greek government calls new elections and “temporary Grexit” returns to the agenda. (We know now that last summer, not only Germany but other eurozone officials, including then Greek Finance Minister Yanis Varoufakis, flirted with this sort of “Plan B.”)

* Spain and Portugal roll back pro-market reforms, sending public debt, unemployment and economic growth back to acute crisis levels. Both countries could follow the Greek pattern of unstable minority governments prone to inconclusive snap elections, as creditors grow increasingly restless.

* Italy and France fail in domestically unpopular efforts to boost global competitiveness while keeping their bloated welfare states untouched. In terms of the eurozone’s survival, both countries are “too big to fail.” Once they switch from creditors to debtors, the EU’s bailout funds break down and there can no longer be a single currency for both the “Club Med” and the fiscally prudent northern countries.

* Brexit would wreak economic havoc on both sides of the English Channel and mark the biggest political setback for the EU since its founding. Populist and secessionist movements would be strengthened in member states, while the whole EU integration project could be called into question in many parts of Europe.

Each of these negative scenarios could be worsened by increased geopolitical tensions with Russia or in the Middle East, not to mention the possible fallout from the presidential elections in the United States.

Little faith

Very little of this would happen in the best-case scenario, which assumes a mild recovery in the eurozone and the EU economy as a whole. This is basically what the European Commission presents in its winter 2016 forecast. If one puts trust in the latest macroeconomic data and extrapolates from recent trends, the worst days for the European economy may indeed be over.

The question is whether we can invoke economists’ favorite assumption – ceteris paribus, that all other things will stay unchanged. That seems rash. The migrant crisis has just as much potential to trigger a general crisis within the EU as the looming banking crisis. Both are eroding trust in pan-European institutions and solutions. In each case, Brussels is working hard to show that it can deliver better results than member states could do on their own. But the faith of national governments and citizens in the European project has reached a low ebb not seen in decades.

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