Europe will enjoy above potential GDP growth for two more years. This should be a good reason to boost reform momentum. Despite high expectations, the institutional breakthrough has been delayed to late 2018
Exogenous factors (i.e. US policy), but also endogenous (i.e. Brexit) call for a speed-up in European institutional reforms
Europe is likely to experience still above potential GDP growth for at least the next two years, at +2.1% in 2018 and +1.9% in 2019 respectively. The recovery, truly visible since 2017, has not yet sufficiently morphed into higher household purchasing power and significantly lower unemployment rate in a widespread manner across all Eurozone economies. In Italy for example, the unemployment rate reached 10.7% in May, the lowest since 2012, but remains around 4pp above the 2007 level.
Despite a speed-up in the national reform momentum since 2014, Italian GDP growth has lagged peers. Insufficient progress on the economic front has probably contributed to the rise of anti-establishment parties. This trend is visible across the Eurozone countries. Our simulations suggest that 38% of the seats of the next European Parliament could be held by “populist” parties against 30% in 2014. This suggests that both the European Parliament and the European Commission would be governed by a “grand-coalition” between traditional parties, but it also shows a high risk of polarization in the European political landscape. This could represent a significant obstacle to reform.
The 28-29 June European Summit was a step in the right direction, but the outcome remains below expectations
The Meseberg joint French-German statement on Europe on June 19th revealed the projects on which there is a consensus and willingness to progress on both sides. Its content has increased expectations in terms of reform speed in the Eurozone as the statement outlined several initiatives looking at strengthening and reforming topics such as security, migration, competitiveness, taxation, EMU integration, climate and innovation.
Despite this, the June Summit brought a consensus on controlling the migration flow into the EU (the most pressing issue for the German and Italian government), security and trade policies (reforming the WTO, notably the dispute settlement mechanism) while it disappointed on the economic reform.
Europe is indeed in a tough situation: the German coalition is weak, the Brexit-related deadlines approach fast with no major progress and increased political uncertainty, Italy is governed by an anti-establishment coalition and the US foreign policy goes for decreasing multilateralism and a lower role as a provider of world public goods (security, trade, protection of environment…). In the wake of the European elections, and the rise of populist forces, progress on the European reform agenda seems to have been delayed.
On the economic side, the revamp of the European Stability Mechanism, to be most probably called European Monetary Fund (EMF) is good news.
However, it will remain an inter-governmental tool (and not a European Institution) while a lot of details are still to be given in December.
The only concrete agreement was that the EMF provides a credit line (around EUR55bn to be confirmed) to the Single Resolution Mechanism (second pillar of the banking union and the last resort backstop for distressed banks) by the time it becomes fully operational in 2023.
Awaited details at the December Summit – which would be considered as positive – are: (i) greater responsibility for the development and monitoring of financial assistance programs, (ii) a debt restructuring option post debt sustainability analysis, and (iii) a more efficient usage of the precautionary lines.
European Parliament, share of total seats 2014 vs 2019
Next steps on European reforms: a clear roadmap for completing the Banking Union and agreement on setting a Eurozone budget for targeted investments as the next steps for the 14-15 December Summit
The European reform goes beyond France and Germany. To understand what can come next, we looked at the common denominator between the tandem France-Germany and the Group of 8 EU countries1 that have been vocal on the matter. We have found 4 main common objectives: (i) the transformation of the ESM into a European Monetary Fund, (ii) the finalization of the Banking Union, (iii) the reinforcement of the post 2020 Multiannual Financial Framework, and (iv) progress on the Capital Markets Union in order to foster cross border private risk sharing.
Completing the Banking Union means reinforcing the common backstop for the SRF (already announced in June) and implementing the European Deposit Insurance Scheme (EDIS), the third pillar. This last point is very much dependent on the risk reduction in the banking system and the legacy issues post crisis (i.e. remaining close to EUR300bn of non-performing loans in Italy for example). The November European Banking Authority (EBA) stress tests would comfort the banking risk reduction since the 2016 stress tests, in particular for Italy. Thus, we would expect an agreement on a concrete roadmap implementation in December.
We would also expect an agreement on a Eurozone Budget as part of the Multi-annual Financial Framework as announced by the Meseberg joint French-German statement. Resources would come from both national contributions, allocation of tax revenues and European resources (financial tax, digital tax). The Budget focus would be on investments targeting innovation, technology and human capital. Setting up a Eurozone unemployment reinsurance fund as part of the Eurozone budget would come as a second step, most probably in H2 2019, once the size of the Budget would have been decided (President Macron called for several points of GDP while President Merkel spoke about tens of billions).
Finally, more decisive progress on the Capital Market Union (CMU) would not be announced in our view before Brexit is finalized and that the EMF and the banking union are close to finalization (which we see as pre-conditions to the CMU) – which would take at least until end-2020 in our view.