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.
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 honor their electoral promises while simultaneously respecting EU rules. Italy does have some room to maneuver, 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, labor 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 French government's most controversial plan involves a reform to simplify the pension system and reduce the benefits to some segments of society, such as public workers.
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, left- and 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 canceled 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 low-income 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.