Re­form­ing south­ern Europe: What's next?

Financial Nigeria Magazine - - Contents -

The economies of the eu­ro­zone are grow­ing again, but po­lit­i­cal and eco­nomic risks per­sist. In the com­ing months, a se­ries of re­forms in three of the bloc's largest coun­tries – France, Italy and Spain – will test the sta­bil­ity of their gov­ern­ments and their com­mit­ment to keep­ing a bal­anced bud­get amid high lev­els of pub­lic debt.

The eu­ro­zone's largest Mediter­ranean mem­bers are head­ing to­ward choppy seas as 2019 ap­proaches. In Italy, plans to cut taxes and in­crease spend­ing will make fi­nan­cial mar­kets ner­vous about the sus­tain­abil­ity of the coun­try's debt, while in France, a con­tro­ver­sial pen­sion re­form pro­posal will once again prompt the French to take to the streets. Over the bor­der in Spain, the mi­nor­ity gov­ern­ment will push for a higher deficit but will strug­gle to get things done. As all three coun­tries con­sider del­i­cate eco­nomic mea­sures, the risk of blow­back from their own pop­u­laces, as well as from in­ter­na­tional in­vestors, will be high.

Italy: Un­der a Heavy Debt Bur­den

Italy's gov­ern­ing par­ties, the pop­ulist Five Star Move­ment and the right-wing League, are cur­rently work­ing on the coun­try's bud­get for 2019. The par­ties have an­nounced plans to cut taxes for house­holds and com­pa­nies, in­tro­duce a ba­sic in­come for the poor and lower the re­tire­ment age. Fi­nan­cial mar­kets, how­ever, fear that these mea­sures could cre­ate a higher deficit, thereby com­pli­cat­ing Italy's ef­forts to re­pay its mas­sive debt, which cur­rently stands at roughly 130 per­cent of gross do­mes­tic prod­uct. In late Au­gust, the first gov­ern­ment meet­ings to dis­cuss the bud­get cre­ated tur­bu­lence in the mar­kets, as Italy's bond yields rose and the gap be­tween Ital­ian and Ger­man bonds (which are con­sid­ered to be Europe's safest) widened.

Eager to hear the Ital­ian gov­ern­ment's plans, credit rat­ings agency Moody's post­poned its as­sess­ment of the coun­try, which was orig­i­nally due in early

Septem­ber, un­til late Oc­to­ber – the same month Stan­dard and Poor's will also re­lease its as­sess­ment of Italy’s eco­nomic prospects. Re­gard­less of the agen­cies' re­spec­tive de­ci­sions, Italy's rat­ings will re­main above the feared "junk" sta­tus (a qual­i­fi­ca­tion that would pre­vent many in­sti­tu­tions from pur­chas­ing Italy's debt), but any down­grade would prob­a­bly in­crease the coun­try's bor­row­ing costs.

Rome has promised that its new mea­sures will keep Italy's deficit (which is ex­pected to to­tal around 1.6 per­cent of GDP this year) be­low the Eu­ro­pean Union's ceil­ing of 3 per­cent of GDP in 2019. How­ever, the par­ties are strug­gling to draft mea­sures that will al­low them to hon­our their elec­toral prom­ises while si­mul­ta­ne­ously re­spect­ing EU rules. Italy does have some room to ma­noeu­ver, since Rome can in­crease its deficit with­out breach­ing the EU lim­its. But the mere change in di­rec­tion – from deficit re­duc­tion to deficit in­crease – could frighten mar­kets, es­pe­cially as the Ital­ian econ­omy is grow­ing too slowly to ap­pease fears about the sus­tain­abil­ity of its debt. Strong eco­nomic growth would make Italy's debt bur­den eas­ier to bear, but Italy is ex­pected to grow by just 1.2 per­cent next year – al­most half the aver­age growth rate for the eu­ro­zone. At the same time, the Eu­ro­pean Cen­tral Bank has vowed to end its bond-buy­ing quan­ti­ta­tive eas­ing pro­gram by the end of the year, which means it will no longer pur­chase Ital­ian debt, thereby re­mov­ing one of the fac­tors that has kept Rome's bor­row­ing costs low. Fluc­tu­a­tions in debt mar­kets also af­fect Ital­ian banks, which have pur­chased bil­lions of eu­ros in Ital­ian debt over the years, be­cause any sub­stan­tial drops in the value of Ital­ian bonds would harm the cap­i­tal buf­fers of the coun­try's main banks. Con­cerns about the fu­ture of Ital­ian debt could also make Ital­ian banks think twice be­fore pur­chas­ing more bonds from their coun­try, which would re­duce their role as a source of fi­nanc­ing for the gov­ern­ment.

And then there is Brus­sels. Italy must present its bud­get to the Eu­ro­pean Com­mis­sion by Oct. 15. Even if Italy main­tains its deficit within the Eu­ro­pean Union's pre­scribed mar­gins, the com­mis­sion could quib­ble with Italy's change of di­rec­tion and ask Rome to amend the bud­get. Be­cause any fight be­tween Italy and the com­mis­sion would take months to un­fold, such a sit­u­a­tion does not rep­re­sent an im­me­di­ate fi­nan­cial risk to the coun­try. Nev­er­the­less, a dis­pute would put Brus­sels in a quandary, as a softer ap­proach to Italy would raise ques­tions about the com­mis­sion's cred­i­bil­ity to en­force the rules, while a tougher ap­proach would risk fur­ther alien­at­ing the gov­ern­ment in Rome.

France: Rolling Out Con­tro­ver­sial Re­forms

Dur­ing his first year in of­fice, French Pres­i­dent Em­manuel Macron in­tro­duced re­forms in ar­eas such as the tax sys­tem, labour mar­ket and the state-owned rail op­er­a­tor. While unions and other groups have protested many of these mea­sures, the pres­i­dent suc­ceeded in pro­ceed­ing with his plans. Even so, Macron has not emerged en­tirely un­scathed, as re­cent sur­veys put his pop­u­lar­ity at around 30 per­cent.

On Sept. 24, the French gov­ern­ment pre­sented its bud­get plans for 2019, which in­clude about 6 bil­lion eu­ros ($7.1 bil­lion) in house­hold tax cuts and roughly 19 bil­lion eu­ros in cor­po­rate tax re­duc­tions. In slash­ing taxes, the gov­ern­ment hopes to im­prove its pop­u­lar­ity be­fore elec­tions for the Eu­ro­pean Par­lia­ment in May, when Macron's cen­trist Re­pub­lic on the Move party is ex­pected to fight a close bat­tle with the far-right Na­tional Rally (for­merly known as the Na­tional Front). French au­thor­i­ties plan to com­pen­sate for these re­duc­tions in state rev­enue by elim­i­nat­ing around 4,500 pub­lic sec­tor jobs, re­duc­ing bu­reau­cratic in­ef­fi­ciency and in­creas­ing taxes on fuel and cig­a­rettes. De­spite the mea­sures, the French gov­ern­ment ad­mit­ted that the coun­try's deficit will reach 2.8 per­cent of GDP in 2019, up from 2.6 per­cent this year.

The gov­ern­ment's most con­tro­ver­sial plan, how­ever, in­volves a re­form to sim­plify the pen­sion sys­tem and re­duce the ben­e­fits to some seg­ments of so­ci­ety, such as pub­lic work­ers. Be­cause the gov­ern­ment is cur­rently dis­cussing the plan with dif­fer­ent so­cial and eco­nomic sec­tors, it is not ex­pected to sub­mit a for­mal pro­posal un­til late 2018 or early 2019. Unions, lef­t­and right-wing po­lit­i­cal groups, stu­dents and other sec­tors will likely take to the streets to protest the plans, which will cre­ate tem­po­rary eco­nomic dis­rup­tions amid the pos­si­bil­ity of can­celled flights, blocked roads and sus­pended pub­lic ser­vices.

Paris could make some con­ces­sions to pro­test­ers, but the gov­ern­ment will still in­tro­duce most of its plans. Macron will ben­e­fit from his party's ma­jor­ity in the Na­tional Assem­bly, as it will not need to ne­go­ti­ate with the op­po­si­tion to pass the pen­sion re­form. At the same time, France's trade unions are di­vided, and while some will protest the gov­ern­ment's plans, oth­ers will seek to ne­go­ti­ate com­pro­mises with Paris. Con­sid­er­ing the com­plex­ity of the is­sue, the de­bate is likely to last long, sug­gest­ing the pen­sion re­forms will not be ap­proved un­til 2019.

If France suc­ceeds in over­haul­ing the pen­sion sys­tem, it would send a mes­sage to

do­mes­tic and for­eign in­vestors that the coun­try can be re­formed, which, in turn, could im­prove its busi­ness and eco­nomic cli­mate. A vic­tory for Macron would also en­cour­age the gov­ern­ment to con­tinue in­tro­duc­ing re­forms. But if the pres­i­dent fails to im­ple­ment a plan he fought so hard to in­tro­duce, it would se­verely erode his po­lit­i­cal cap­i­tal and re­duce the chances of any ad­di­tional re­forms. Be­cause the next French pres­i­den­tial elec­tion is not un­til 2022, Macron's po­si­tion is safe for now, but the up­com­ing elec­tions for the Eu­ro­pean Par­lia­ment will pro­vide a good barom­e­ter of the French pop­u­la­tion's sup­port for the gov­ern­ing party.

Spain: A Mi­nor­ity Gov­ern­ment's Strug­gles

To the south, Spain's So­cial­ist gov­ern­ment has promised to undo many of the aus­ter­ity mea­sures in­tro­duced by its con­ser­va­tive pre­de­ces­sor since it as­sumed power in June. Prime Min­is­ter Pe­dro Sanchez has vowed to in­crease spend­ing on ed­u­ca­tion, lower the value-added tax for some prod­ucts and im­prove fi­nan­cial as­sis­tance for low­in­come fam­i­lies. The gov­ern­ment in­tends to com­pen­sate for the spend­ing hikes in part by in­tro­duc­ing new taxes, in­clud­ing a levy on fi­nan­cial trans­ac­tions and a higher in­come tax for those earn­ing high salaries. Most no­tably, Sanchez wants to ap­prove a bud­get for 2019 that would in­crease spend­ing by around 6 bil­lion eu­ros, while he is also seek­ing ways to by­pass a law that re­quires the Span­ish state to main­tain a bal­anced bud­get.

In July, Madrid an­nounced that its 2019 deficit would amount to around 1.8 per­cent of GDP – 0.5 per­cent higher than the fig­ure the pre­vi­ous ad­min­is­tra­tion promised to the Eu­ro­pean Com­mis­sion. Ear­lier this month, Pierre Moscovici, the Eu­ro­pean com­mis­sioner for eco­nomic and fi­nan­cial af­fairs, said "Spain is not Italy" in not­ing that Madrid still wanted to play by EU rules. Still, Moscovici in­sisted that the Span­ish gov­ern­ment should con­tinue to fo­cus on fis­cal con­sol­i­da­tion mea­sures.

In the com­ing months, the main source of risk in Spain will be po­lit­i­cal. The So­cial­ist Party con­trols just 84 of the 350 seats in par­lia­ment, re­quir­ing it to gain the sup­port of other par­ties, in­clud­ing the left-wing Pode­mos, to pass leg­is­la­tion. At the same time, the main op­po­si­tion par­ties (the con­ser­va­tive Pop­u­lar Party and the cen­trist Ci­u­dadanos) will at­tempt to block as many gov­ern­ment ini­tia­tives as they can – a prospect that will se­verely com­pli­cate pol­i­cy­mak­ing. Sep­a­rately, fric­tions with the pro-in­de­pen­dence gov­ern­ment in Cat­alo­nia are likely to con­tinue, even if Madrid wishes to re­duce ten­sions and the rebel re­gion is un­likely to pur­sue any dras­tic uni­lat­eral ac­tion. This com­bi­na­tion of prob­lems could take its toll on the Span­ish gov­ern­ment, in­creas­ing the chances that Spaniards will go to early polls in 2019, a year ahead of sched­ule.

Un­rest in the Off­ing?

A decade af­ter the start of the in­ter­na­tional fi­nan­cial cri­sis, the main chal­lenge for coun­tries in South­ern Europe is to gen­er­ate enough eco­nomic growth to re­duce their debt bur­den, cre­ate jobs and keep so­cial un­rest within tol­er­a­ble mar­gins. For Italy and France, the prob­lem is that growth is mod­est at best, while un­em­ploy­ment is still rel­a­tively high in France and Italy and ex­tremely high in Spain. Ac­cord­ing to the Eu­ro­pean Com­mis­sion, growth will slow down in the three coun­tries over the next year, lead­ing to two main con­se­quences: One is that the ap­peal of ex­trem­ist par­ties will re­main alive. The other is that low growth could force gov­ern­ments to in­tro­duce aus­ter­ity mea­sures to keep their deficits un­der con­trol, which would, in turn, open the door for so­cial un­rest and po­lit­i­cal in­sta­bil­ity.

On the other side of the coin, ex­ter­nal fac­tors such as a po­ten­tial no-deal Brexit sce­nario, a deep­en­ing trade dis­pute be­tween the Eu­ro­pean Union and the United States, and fi­nan­cial fragility in some eu­ro­zone mem­bers (like Italy) will cre­ate risks for the re­gion be­tween late 2018 and early 2019. In sum, the eu­ro­zone's south­ern mem­bers might not be fac­ing quite the same eco­nomic, fi­nan­cial and po­lit­i­cal chal­lenges they were a decade ago, but the storm clouds re­main ever present on the hori­zon.

Strong eco­nomic growth would make Italy's debt bur­den eas­ier to bear, but Italy is ex­pected to grow by just 1.2 per­cent next year – al­most half the aver­age growth rate for the eu­ro­zone.

“Re­form­ing South­ern Europe: What's Next?” is re­pub­lished un­der con­tent con­fed­er­a­tion be­tween Fi­nan­cial Nige­ria and Strat­for.

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