2017 Annual Forecast: Europe

Dec 27, 2016 | 13:41 GMT

In 2017, the eurozone crisis could enter a new, more dangerous stage.

For Europe, political and economic risk is nothing new. For years, nationalism, populism, conflicting strategic interests, low economic growth and high unemployment have driven EU members apart. The eurozone has seen a variety of threats to its existence over the past decade, connected to issues such as high levels of debt, fragile banking sectors and growing Euroskepticism. But so far it has managed to survive them. In 2017, however, the eurozone crisis could enter a new, more dangerous stage as risk reaches its largest political and economic players. As it does, it will threaten the future of the bloc in more profound ways than before.

The coming risk will be most pronounced in Italy, France and Germany. Nationalist forces have been building steam for years and will show their strength in general elections in Germany and France – and potentially Italy, if its government resigns before the legislature's term ends in mid-2018. And even if they fail to win some or all of these elections, the nationalists' popularity will nonetheless influence the decisions of their countries' leaders, furthering the political fragmentation of the European Union, increasing the demands for a return of sovereignty to national governments, and leading to more unilateral actions by member states. Uncertainty about political events in these core countries will also increase financial risk, especially in the banking sector.

And as it deals with these issues from within, the European Union will also have to deal with new issues from without – namely, the new global order that began the minute Donald Trump was elected. Questions over the reliability of NATO's security umbrella, not to mention recent terrorist attacks, will create opportunities for EU members to work together on security and defense. But growing Euroskepticism and domestic political considerations will prevent them from implementing economic and financial reform. Countries in Eastern Europe, meanwhile, will focus on regional and bilateral cooperation to try to show a united front against Russia.

Questions About the Future

What happens in France, Germany and Italy – the eurozone's three biggest economies – in 2017 will influence one another and indeed the entire currency union. The elections in France and Germany will test the Franco-German alliance, upon which the European Union was founded, and the economic duress in Italy will test the stability of the eurozone. Political tension will again develop between Northern and Southern Europe, which hold different views on the future of the eurozone.

France will be preoccupied with its elections for the first few months of 2017. During this time, the outgoing government will not introduce any significant reforms. The same cannot be said for the new government, regardless of who wins. Though most of the presidential candidates have similar stances on security issues – most, for example, support tough measures to fight terrorism and limit immigration – they differ markedly on economic issues. Voters will have to decide whether they want programs that will deregulate and liberalize the French economy or if they want added protectionism.

The presidential election, held in two rounds and scheduled for April and May, will show that a significant number of voters support anti-globalization and nationalist positions, as will the legislative elections. This will affect France's moves even if the moderates win. The next government is likely, therefore, to be skeptical about free trade and focus on security and defense – and support plans to enhance both at the EU level. The president can be expected to introduce measures to limit immigration. The president will also push Brussels to redesign the Schengen agreement and to improve the European Union's border controls. Paris will criticize the European Commission, even going so far as to demand that it scale back its responsibilities.

If moderates win, they will petition the eurozone to repatriate some powers to its constituent members (something that will clash with Germany's demands for a more apolitical administration of the common currency). The new government will probably also push for better relations with Russia. If the far-right National Front wins, the French government will probably introduce measures to limit the free movement of goods, people, services and capital throughout France. It can also be expected to announce plans for a referendum on France's EU membership. 

And therein lies the problem for the European Union: The bloc has been breaking apart for several years, but without France – a founding member whose alliance with Germany was the basis for its very formation – its dissolution is likely irreversible. In the ensuing crisis, the union would fragment into smaller regional groups. Questions about the future of the eurozone would trigger a run on Southern Europe's banks and precipitate the collapse of the currency area.

Ahead of its own general election in September or October, Germany will try to keep the European Union united. But it will be difficult for Berlin to do so. The members of the ruling coalition, composed of center-right and center-left parties, will try to distinguish themselves from one another before the vote, during which the government in Berlin will avoid making any significant decisions on EU issues. Conflicting national interests among EU members will also make consensus on EU reform difficult to find. (One of the few areas where Germany and its EU peers can find some degree of understanding, however, is defense and security.)

Significant EU reforms on financial or economic areas should not be expected. Germany and its northern neighbors will be even more at odds than usual with the south over the management of the eurozone, given the political pressures endemic to election seasons. The government in Berlin will remain skeptical about issues such as granting debt relief to Greece or allowing eurozone members to miss the European Union's deficit targets. Germany is also likely to conflict with the European Central Bank (ECB), especially if the economic case for quantitative easing continues to weaken. Germany and its northern neighbors will advocate the program's termination, though the ECB, in light of continued economic weakness in the periphery, may resist any effort to that end.

Security and immigration will feature prominently in the German electoral campaign. The right-wing opposition, and even some members of Chancellor Angela Merkel's coalition, will push for tougher immigration legislation and for granting more resources to security forces. The general election will show that German voters are willing to support smaller parties on the left and on the right. This will probably lead to a more divided parliament and to difficult coalition talks. While the nationalists may perform well enough to get some members into the legislature, they will be excluded from coalition negotiations.

What could force Germany to take a more decisive role in the European Union, however, would be a victory by the Euroskeptic forces in France or Italy. If that happens, Berlin would try to preserve the bloc and reach an understanding with the rebel governments to introduce internal reform. But the government in Berlin would also hedge its bets by making plans with its regional allies in the event the European Union and eurozone do, in fact, disintegrate.

As for Italy, political uncertainty, fragile banks, low economic growth and high debt levels will once again raise questions about the future of the eurozone's third-largest country – and about the currency union as a whole. Italy's caretaker government will be weak, and early elections are possible. No matter who is in charge, the Italian government will push for flexibility on EU fiscal targets and demand solidarity from its EU partners to deal with the immigration crisis. The government in Rome will also be ready to act unilaterally and criticize the European Union to achieve its goals.

If Italy holds early elections, the fear of a victory by anti-establishment forces would hurt Italian banks, raise borrowing costs and generate pressure on the euro. A victory of the Euroskeptics would put Italy on a collision course with the European Union. The first reaction by Germany and EU institutions would be to accommodate the new government in Rome and try to prevent it from putting membership in the eurozone to a vote. In the long run, however, that kind of referendum will be difficult to avoid. In 2017, therefore, Italy will be one of the greatest risks to the currency area.

The Netherlands, one of the eurozone's wealthiest countries and an important player in Northern Europe, will hold a general election in March. As in other eurozone countries, Euroskeptic and anti-immigration forces there will have a prominent role, showing that discontent with the status quo is strong. Even in the likely case the Euroskeptics fail to access power, their influence will force the Dutch government to become more and more critical of the European Union, resisting plans to deepen Continental integration and siding with other Northern European countries in their criticism of events in the south. If events in France and Italy bring about the collapse of the eurozone, the Netherlands would react by continuing to work with Germany and other Northern European countries.

Elsewhere, in the European periphery, the minority government of Spain will be forced to negotiate with the opposition on legislation, leading to a complex decision-making process and to pressures to reverse some of the reforms that were introduced during the height of the economic crisis. Catalonia will continue to push for its independence as its government challenges Madrid in some instances, ignores it entirely in others, and negotiates with it when necessary. Even if negotiations to ease frictions between Madrid and Catalonia take place, the central government will not authorize a legal referendum on independence, and Catalonia will not abandon its plans of holding it. Tensions will remain high in 2017, but Catalonia will not unilaterally declare independence this year.

In Greece, the government will continue pushing its creditors for additional measures of debt relief, but because of the German elections there will be little progress on the issue. With debt relief temporarily off the table, Athens will demand lower fiscal surplus targets and will reject additional spending cuts. Relations between Athens and its creditors will be tense, but there should be room for compromise. The resignation of the Greek government is possible, albeit improbable, considering that the emergence of opposition forces in the country makes the outcome of early elections highly uncertain – and the government has no guarantee of retaining power.

An Eventual Understanding on the Brexit

In 2017, the debate in the United Kingdom will not be whether the Brexit should happen but how it should happen. The British government will be divided on how to approach the negotiations with the European Union, and the Parliament will demand a greater say in the process. The issue will create a constant threat of early elections, but even if such elections do come to pass, they would only delay the Brexit, not derail it. The government and the Parliament will eventually reach an understanding, however, and the United Kingdom will formally announce its intentions to leave the European Union.

Once the negotiations begin, the United Kingdom will push for a comprehensive trade agreement to include as many goods and services as possible – one that would also give the country more autonomy on immigration. This would involve either signing a free trade agreement with the European Union or agreeing on Britain's membership in Europe's customs union, an area where member states share a common external tariff. A transitional agreement to buy London more time to negotiate a permanent settlement will probably also be part of the discussion. London and the European Union will also negotiate the terms of the United Kingdom's withdrawal, including its EU budget commitments and the status of British citizens in the European Union and the status of EU citizens in the United Kingdom. Given the magnitude of these issues, not to mention the magnitude of the elections in France and Germany, several of the most important decisions will be delayed until at least 2018.

Many Divisions, Some Exploited

Countries of Central and Eastern Europe will circle the wagons to protect themselves from what they see as potential Russian aggression – and from the uncertainty surrounding U.S. foreign policy. Leading the charge will be Poland, which will try to enhance political, economic and military cooperation with its neighbors. It will also support the government in Ukraine politically and financially and will lobby Western EU members to keep a hard stance on Moscow by advocating the continuation of sanctions, increasing military spending, supporting Ukraine, etc. – a position the Baltic states and Sweden are likely to support. Unsure though Warsaw may be about the Trump administration, the government will still try to maintain good ties with the White House as it continues to defend a permanent NATO presence in the region. Countries in the region may even pledge to spend more on defense.

Not all countries will react the same way to this new geopolitical environment, of course. Hungary or Slovakia, for example, do not have the same sense of urgency as Poland when it comes to Russia, so their participation in pre-emptive measures could be more restrained.

Moscow's attempts to exploit divisions within the European Union will strain German-Russian relations. Germany will try to keep sanctions against Russia in place but will face resistance from some EU members, which would rather lift sanctions to improve their relations with Moscow. Germany will also defend cooperation on defense and security as a way to deal with uncertainty about NATO and Russia. The German government will continue to support Ukraine politically and financially, but not militarily.

In the meantime, Russia will exploit divisions within the European Union by supporting Euroskeptic political parties across the Continent and by seeking to cooperate with the friendlier governments in the bloc. Some countries, including Italy, France and Austria, will advocate improved relations with Russia, giving Moscow a better chance to break the sanctions bloc in the union. Some level of sanctions easing from the European Union is likely by the end of the year.

Stopping Migration at Its Source

There is only so much EU member states can do to stem the flow of migrants in 2017. In the Central Mediterranean route, Brussels will try to halt migrants from leaving Africa by cooperating with their countries of origin and by working with the primary transit states. But the difficulty in actually severing African migration routes and the absence of any viable government in Libya will limit the European Union's ability to halt the flow of peoples through the Central Mediterranean.

In the Eastern Mediterranean route, the European Union will keep its line of communication with Turkey open, its political differences with Ankara notwithstanding. European elections and internal divisions, however, will prevent the bloc from giving in to many of Turkey's demands, particularly the one that grants visa liberalization for Turkish citizens. A short window of opportunity on the issue will open in the first months of the year, but if no progress is made before Europe's electoral cycle begins in March in the Netherlands, the issue will be postponed for the rest of the year. Progress on less controversial issues such as trade and funds will be somewhat easier to make.

Aware of how unreliable their outside partners are, EU members will try to shield themselves as much as possible. They will continue to toughen their national migration laws, and to increase deportations, to discourage migrants from coming in the first place. The option of introducing border controls within the EU will also be on the table as a way to sever migration routes. This will continue to be a source of debate – one waged between the countries of arrival (such as Italy and Greece) and the countries of destination (Northern Europe) – over Brussels' failure to develop a coherent migration policy.

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