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In November 2009, Greece ignited the eurozone debt crisis when the incoming socialist government revealed the previous conservative regime had lied about government finances to the extent that the true budget deficit was 13% of GDP, not 4%. Athens’ debt load was reassessed to be about 115% of output, nearly twice the eurozone limit of 60%. And amid the ensuing turmoil on global financial markets, speculation mounted Greece would leave the euro.
After the world’s largest default in 2011, three bailouts, eight years of austerity, and political and social upheaval that led to the election in 2015 of Europe’s only left-wing government, Greece’s economy has since shrunk by a 1930s-depression-like 26% while government debt has swelled to the default height of 177% of GDP. Athens is still negotiating from crisis to crisis; the latest squabble over propping up Greece erupted in December.
But investors largely ignored the arguments over how to set Greece on a sustainable footing. They have been mostly sanguine about Greece since mid-2015 when the country was forced to accept its third bailout or risk being tossed out of the euro. This nonchalance was similar to the approach investors took to most threats to the eurozone last year, even if there was an initial shock sell-off. In November, they shrugged off the failed referendum in Italy on changes to the senate that cost Matteo Renzi his job as prime minister. They proved just as blasé in July when UK voters unexpectedly opted to leave the EU.
Perhaps investors will be less complacent in 2017 because threats loom that could turn into existential ones for the eurozone. Among these potential market-moving crises, Italy’s banks are fragile to the point of default, perhaps more so that political uncertainty has intensified. Elections are due to take place this year in France, Germany and the Netherlands that could place anti-euro populists in powerful positions. The biggest menace would be victory for the National Front’s eurosceptic Marine Le Pen in the French presidential election because she wants France to quit the euro. The eurozone’s current-account imbalances, the true source of the eurozone debt crisis (Greece’s lies about its finance was just the trigger), are worsening and aggravating politics. The euro area’s economy is souring politics because it is as sluggish as ever, while government debt is at record and worrying levels. Investors need to be aware that any one of these issues could morph into a crisis that would gyrate global financial markets, perhaps suddenly.
The list of threats to the eurozone is not exhaustive and each of these dangers might be diffused in numerous ways. If European policymakers have shown one talent over the eight-year crisis, it’s for finding stop-gap solutions that placate investors. Some of the threats are long shots. Polling, for instance, shows Le Pen losing to the conservative candidate and former prime minister François Fillon in the second round of voting. But Fillon and other mainstream candidates are fighting the populists by adopting populist positions that are often contrary to sound policy. The five problems listed here pose conundrums for policymakers because they loop into each other in various ways. A solution for one often exacerbates at least one of the other menaces. This year could be the one when dithering and errors catch up with European policymakers and expose the most likely fate of the eurozone; a breakup of some description.   
Conundrum after conundrum
The latest Greek saga entails deciding whether or not Athens has conducted enough budget fixing to warrant some debt relief, as per the conditions tied to the 2015 bailout. But complication is layered upon complication. Creditor nations (such as Finland, Germany and the Netherlands) need to be tough with ‘spendthrift’ Greece to appease their voters, which means they rule out the massive default that Greece inevitably faces. That bars IMF participation because the body essentially can only help if Athens’ finances are on a sustainable footing, taken to mean that Greece’s debt-to-GDP ratio falls to below 120% or thereabouts. But creditor nations want the IMF to participate in the bailout to maintain parliamentary support at home. At the same time, the EU struggles to present a plan sufficiently credible for investors, acceptable to other euro-using countries and not too painful for Greeks. This challenge explains why an agreement reached on December 5 collapsed eight days later after Greek Prime Minister Alexis Tsipras announced spending increases without notifying EU authorities. The impasse could lead to a snap election in 2017 and more instability. The danger for investors is that some unforseen event triggers the massive default that appears to be Greece’s inevitable fate.
Nearby in Italy, new Prime Minister Paolo Gentiloni heads an emergency government, the country’s 64th since World War II, and is under pressure to call an election that the Beppe Grillo-led Five Star Movement is well positioned to win with a guaranteed majority – such is Italy’s new voting system, which gives the leading party 54% of seats in the lower Chamber of Deputies.
Gentiloni’s other challenge is Italy’s banks that, despite some recent bailouts, project this conundrum. Problem loans extend to about 20% of bank lending and some of Italy’s 400-odd banks are tottering to the point of needing state aid. But EU rules demand that bank debt holders suffer losses before a government can rescue a bank, as will happen to as yet-to-be determined extent with the December-sanctioned rescue of Banca Monte dei Paschi di Siena, the world’s oldest bank that has needed two other rescues since 2008. Gentiloni cannot allow banks to fail because retail customers own about half of Italian bank subordinated debt and many Italians don’t even know they hold such dangerous assets; people think their money is in term deposits. Something could give before too long that would have repercussions for investors well beyond Italy, financially and politically.
Populist march
Among those most excited by Donald Trump’s victory in the US presidential election were the eurosceptic populists in founding and core EU countries who are benefiting from the bitterness of life under the euro and the rebellion against immigration. In Italy last year, where three of the four major political parties want to quit the euro, the insurgent Five Star Movement won mayoralties in Rome and Turin and defeated Renzi’s referendum. The right-wing Alternative for Germany party led by Frauke Petry gained seats in five more state parliaments, meaning the anti-euro party now sits in 10 of 16 state assemblies. In Austria, nominees from the two mainstream parties failed to make it past the first round of voting in the presidential elections. But such evidence of the collapse of the political centre across Europe failed to dismay investors.
That won’t happen forever. A Le Pen victory in the French presidential elections would destroy the eurozone and, probably, the EU as she is promising a referendum on French membership. While the polls show the euro-quitter won’t win, polls can change or be wrong. Even if Le Pen were to fail to become president, her National Front could do well enough in parliamentary elections due in June to prove a menace anyway.
In the Netherlands, Geert Wilders’ populist Party for Freedom is also promising a referendum on EU membership. As the eurosceptic party is leading the polls, it could become the largest party in parliament after the March elections. While investors may draw comfort from Merkel’s ‘favourite’ status to win a fourth term as chancellor in Germany, she is turning to populist policies to secure victory in the elections in September or October. Merkel is thus hardening her stance against helping neighbours in financial or other strife. The danger is that the Alternative for Germany is successful enough in Germany’s proportional representative system to limit Merkel’s ability to form a coalition. If Merkel were to lose the election, Europe would be in turmoil.
Trade angle
A more genuine German threat to Europe is the country’s current-account surplus, which has expanded to a record 8.5% of GDP due to Germany’s export prowess but also its reluctance to spend. Essentially, Germany, which comprises about 30% of the eurozone economy, is expanding by drawing demand from its neighbours. This has financial and political consequences. Under a fixed-exchange-rate system like the euro, imbalances on the current account among members can only be adjusted by using fiscal policy to rejig competitiveness. Hence, austerity has long been imposed on current-account deficit countries to lower their production costs, at great social and political cost. Europe’s problem is that Berlin is pursuing austerity in Germany to appease the national mentality to balance the books. This adds to the deflationary pressures that forced the European Central Bank to adopt negative policy rates in 2014 and to engage in quantitative easing from 2015.
But negative interest rates worry Germans because they weaken traditional banking models, which guard the bulk of German savings, and undermine their life insurers because they offer products with guaranteed rates of return. These negative rates are blamed for boosting the popularity of the Alternative for Germany party, which is pushing Merkel to the right. The antidote to Germany’s current-account surplus would be steps to prod domestic demand and the appetite for imports.
The eurozone economy could do with some spark from Germany because the most optimistic projections only predict more modest growth, low inflation and rising government debt, which already averages 91% of GDP across the 19 euro users. Even modest growth wouldn’t be enough to quell the angst that is helping populists. Investors need to guard against more pessimistic results that would only intensify the economic hardship that voters blame on missteps by the mainstream political class, which is even more discredited than Greek budget figures now that, to cite one improvement in Europe over the past eight years, the integrity of these numbers has been restored.
Originally published by Michael Collins, Investment Commentator, Schroders

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