Assessments

The Eurozone's Upcoming Financial Problems

Adriano Bosoni
Senior Europe Analyst, Stratfor
7 MINS READAug 26, 2020 | 15:13 GMT
A close-up of a five-euro banknote.

A close-up of a five-euro banknote.

(Bartkowski/Shutterstock.com)
Highlights

Escalating soverign debt and fiscal deficit levels in eurozone countries due to the COVID-19 crisis will increase the probability of financial and banking crises in the years ahead, as well as surges in social unrest and higher taxes for both large corporations and big earners. Furlough schemes, subsidies and other forms of welfare spending across the eurozone are mitigating the economic fallout from the pandemic by keeping money in people's pockets and helping sustain domestic consumption at a time of deep recessions. But these schemes are financed through sovereign debt, loans from EU institutions and deepening fiscal deficits -- all of which are unsustainable....

Escalating sovereign debt and fiscal deficit levels in eurozone countries due to the COVID-19 crisis will increase the probability of financial and banking crises in the years ahead, as well as surges in social unrest and higher taxes for both large corporations and big earners. Furlough schemes, subsidies and other forms of welfare spending across the eurozone are mitigating the economic fallout from the pandemic by keeping money in people's pockets and helping sustain domestic consumption at a time of deep recessions. But these schemes are financed through sovereign debt, loans from EU institutions and deepening fiscal deficits — all of which are unsustainable.

  • By the end of 2020, seven of the 19 members of the eurozone (Belgium, Greece, Spain, France, Italy, Cyprus and Portugal) will have debt-to-GDP ratios above 100 percent, up from only three in 2019 (Greece, Italy and Portugal). 
  • According to Eurostat projections, those heavily-indebted countries will return to growth in 2021, but their GDP expansions will not be enough to fully compensate for the contractions of 2020. 
  • 18 of the 19 members of the eurozone will have fiscal deficits above 5 percent of GDP in 2020, exceeding the 3 percent limit established by EU rules (which have been temporarily suspended). 

Southern European countries such as Italy, Spain, Portugal and Greece will face the highest risk of entering sovereign debt crises due to their combination of massive public debt levels and high fiscal deficits. Such a crisis would occur if the borrowing costs for these countries increase to the point that they become unsustainable, if financial markets perceive the European Central Bank (ECB) as unlikely to come to their rescue, and/or if credit rating agencies downgrade these governments' creditworthiness. In the coming months, Southern European countries will have access to cheap loans from the European Union's permanent bailout fund, as well as conventional loans from the European Recovery Fund. These loans will be given to countries under favorable conditions, such as long maturities and low interest rates, but will only add to their debt. Italy and Spain, in particular, have the riskiest combination of high debt and deep deficits, which will raise concerns about the sustainability of their sovereign debt:

  • Italy's debt is expected to reach roughly 160 percent of GDP by the end of 2020, from around 130 percent at the start of the year. Its deficit is expected to exceed 11 percent of GDP by late 2020, from roughly 1 percent at the start of the year. 
  • Spain's debt is expected to reach around 115 percent of GDP by the end of the year, from around 95 percent at the start of 2020. Its deficit is projected to exceed 10 percent of GDP by the end of the year, from around 3 percent in early 2020. 
  • Italy's credit rating is also only one notch above so-called "junk" status, meaning a downgrade would bar some investors from purchasing Italian debt. 
  • The ECB is artificially holding down interest rates through quantitative easing, which creates demand for government bonds, such as those from Italy, that would not otherwise exist.

Contracting economic activity is leading to an increase in personal and business bankruptcies across the European Union — a trend that will continue well into 2021, especially in the tourism sector. The lockdown measures that EU governments introduced in the second quarter led to thousands of companies shutting down, especially in the tourism and hospitality sectors, but also in sectors such as retail. With countries across Europe reintroducing social distancing measures and trying to limit people's mobility to keep infections under control, economic activity will remain below pre-crisis levels for at least another year, leading to higher unemployment as hundreds of thousands of companies continue to collapse or default on their debt. 

  • The total number of companies that are active in Spain fell by around 6 percent between February and June, as almost 90,000 companies have disappeared. 
  • According to the Italian business association Confesercenti, around 90,000 companies in Italy's tourism and services sector are in danger of permanently shuttering their doors.
  • According to the German Hotel and Restaurant Association, around 60 percent of companies in the country's hotel and restaurant industry are also at risk of closure.

The combination of rising unemployment and contracting economic activity will raise the risk of households and individuals defaulting on their bank loans, which could also lead to banking crises across the currency area. Such crises would test whether the European Union is willing to use its newly established "bail-in" rules to keep banks active (in which creditors and depositors must take losses), or whether it will stick with traditional bailouts (in which national states use taxpayers' money to rescue banks in trouble). Both options are problematic: While "bail-ins" would involve the politically costly decision of forcing savers and creditors to lose money, bailouts force governments to use public funds to rescue private banks, often by asking EU institutions for money in exchange for unpopular austerity measures. 

  • Most banks in the eurozone have reduced their exposure to non-performing loans as a percentage of total loans over the past decade. But the rate remains high in Greece (35 percent) and Cyprus (18 percent), followed by Italy (6.7 percent) and Portugal (6.1 percent). 
  • According to the European Central Bank, Spanish and Italian banks' domestic sovereign bond holdings rose by 16 percent and 15 percent, respectively, in the first half of 2020.
  • In the case of a banking crisis, the European Union believes creditors and depositors should take losses instead of using taxpayers' money to fund bailouts (as was the case during the banking crises of the early 2010s). But this new approach remains controversial, with Italy and other EU governments speaking out against it.  

The progressive removal of subsidies and furlough schemes will also increase the probability of social unrest and political instability, especially in Southern Europe. Some of the measures that eurozone governments introduced during the peak of the COVID-19 outbreak in the second quarter, such as furlough schemes, are meant to be temporary. These measures have kept social unrest within tolerable limits and have somewhat masked the pandemic's full impact on the labor market. Governments, especially in Southern Europe, will try to extend these measures as long as they can, but this will prove unsustainable due to their already high deficit levels. When these measures start to be lifted, the political backlash could weaken already fragile governments in countries such as Italy and Spain, as well as spur protests in France and other countries with unpopular governments.

Escalating debt and fiscal deficit levels in eurozone countries due to COVID-19 will raise the risk of financial and banking crises, as well as social unrest and higher taxes.

To increase state revenue and reduce their fiscal deficits, some governments will consider tax hikes on large corporations and high earners, which will further damage their countries' business environment. Despite their high deficits, eurozone governments are unlikely to lift all the welfare measures they introduced in recent months for fear of weakening consumption and increasing social unrest. As a result, Southern European countries and potentially others will look at taxation, especially for large companies and wealthy households, as a way to increase state revenue. This will probably result in higher operating costs, especially for multinationals, as well as stronger fiscal pressure on top earners. 

  • Italy and France introduced new taxes on large digital companies earlier this year, and Spain is in the process of approving one as well. 
  • In July, Spanish Prime Minister Pedro Sanchez said the country's tax system should be reformed so that large companies and people who are in the highest income tax bracket pay higher taxes. 
  • The Green Party in the Netherlands, which is currently in the opposition, has also proposed a special tax on companies with revenues of more than 750 million euros ($886 million) who relocate to lower tax jurisdictions. 

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