Biggest Economic Risk to Europe Lies in the Politics
Posted by hkarner - 13. Oktober 2016
Source: The Wall Street Journal By SIMON NIXON
Some policy makers say the potential for another shock to the eurozone is alarmingly high, Simon Nixon writes.
It’s the politics, stupid. That was the consensus view on Europe among policy makers and finance chiefs at the International Monetary Fund’s annual meetings in Washington last week. The baseline outlook for the eurozone economy is a continued modest recovery. The IMF itself is forecasting growth this year of around 1.7%, falling unemployment, increased bank lending and a gradual pickup in inflation next year. The U.K.
may have, in the eyes of many economists, engaged in an act of economic self-harm by voting to leave the European Union, but few expect much direct economic contagion to the continent.
It is the political contagion that they worry about: the risk that other countries may act in ways that appear contrary to their rational economic self-interest.
Indeed, some policy makers fear that the eurozone may be just one shock away from disaster—and that the risk of another shock is alarmingly high.
There are plenty of candidates. Italy tops many people’s list, with opinion polls suggesting voters are evenly split over whether to back Prime Minister Matteo Renzi’s constitutional overhauls in a December referendum.
The markets are increasingly betting that Mr. Renzi will remain prime minister even if he loses the vote, avoiding the need for new elections that might bring the populist, euroskeptic 5 Star Movement to power. But Mr. Renzi may struggle to cling on if he loses by a wide margin. Even if he does, he may not be able to do much, raising fresh doubts about Italy’s long-term growth and making it harder for banks to raise capital. That could reignite concerns over Italy’s financial stability and the sustainability of its government debt.
Portugal’s difficulties were also much-discussed in Washington. The country has a debt-to-gross domestic product ratio above 130% and a government that is widely perceived to have unwound its predecessor’s economic overhauls. Its fortunes now hinge on Canadian rating agency DBRS, which will examine next week’s draft budget before deciding whether to maintain Lisbon’s investment-grade credit rating. That in turn will determine whether the European Central Bank can continue to buy Portuguese government bonds.
Even if Lisbon passes this test, its next hurdle is to persuade investors to invest up to €20 billion ($22 billion) in the Portuguese banking system, starting with the sale of €1 billion of subordinated debt in state-owned Caixa Geral de Depositos. Failure could jeopardize the government’s efforts to sell Novo Banco, the bank salvaged from the collapsed Banco Espírito Santo, and the efforts of Millennium BCP to raise capital. A banking crisis could force Lisbon to seek a new bailout, inevitably raising questions about whether government bondholders should face losses.
Meanwhile, Greece remains an ever-present source of risk. Eurozone finance ministers agreed this week to disburse the next €2.8-billion tranche of its current bailout. But Athens is likely to run out of money again next year. Furthermore, the next bailout installment will hinge on a full program review and will need to be sanctioned by a vote in the German Bundestag.
That would set the stage for another showdown between Germany and the IMF, which has so far refused to participate in the bailout until Greece gets substantial debt relief, which Berlin continues to resist. German Finance Minister Wolfgang Schäuble has already twice persuaded the Bundestag to back bailouts with promises of imminent IMF involvement. It is hard to see how he could do so a third time, raising the prospect of a new crisis just ahead of German national elections next fall.
Any of these scenarios could trigger a vicious spiral in the eurozone. Policymakers fear that in the current febrile environment—and with elections looming in France, Germany and the Netherlands—the eurozone’s capacity to find collective political responses to shocks has been reduced.
At the same time, the European Central Bank’s ability to ride to the eurozone’s rescue has also been weakened amid fears that its monetary policy may be doing more harm than good: ECB officials in Washington acknowledged the harmful side effects of negative interest rates and flat yield curves on bank business models as lending margins are compressed.
The longer this persists, the greater the risk that some lenders will reduce the availability or raise the cost of loans and that some banks will find it even harder to raise capital. Meanwhile, ultraloose monetary policy has political side effects, not least in Germany, where some fear it is helping fuel support for the euroskeptic AfD party.
Of course, a vicious spiral can also become a virtuous circle, if the eurozone can navigate the political rapids ahead over the next year.
Confidence would improve, which would make it easier for banks to raise capital. This would allow them to speed up their efforts to deal with bad debts, giving businesses more confidence to invest and creating an easier economic climate in which governments can deliver necessary structural reforms.
But even such a positive political shock would come with medium-term risks. After all, Germany is already close to full employment and wages are rising, raising the prospect that eurozone inflation could return to its target sooner than expected and bring an earlier-than-expected end to the ECB’s quantitative-easing program. That would remove vital support for the bonds of some of eurozone’s most highly indebted sovereigns. A politically rational eurozone would be thinking of ways to mitigate this risk now.