Country risk: 2020 vision brings the eurozone’s risks into focus


Jeremy Weltman
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With the same old problems beguiling single currency members, there is no reason for investors to anticipate rapid improvement in the new year.

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The outlook is poor: GDP growth in the euro area has been slowing since 2017 and analysts see little reason to expect any near-term improvement.

Analysts have taken a dim view of the region’s investor prospects in the presence of rising global trade barriers and limited relief from monetary-policy stimulus, with political and structural factors also to blame.

Cyprus, Greece, Portugal and Ireland have continued their trend improvements as the effects of their debt crises continue to fade. However, no fewer than 11 of the 19 eurozone member states were riskier in 2019, according to experts taking part in Euromoney’s ‘crowd-sourcing’ country risk survey, including Germany, France, Italy and Spain.

Eurozone risk graph

GDP growth has been slowing in the euro area in real terms since 2017. It dipped below 2% on an annual basis in 2018, and further to 1.2% year on year in the second and third quarters of 2019.

Euro Zone Barometer, a monthly survey of economic forecasts by independent experts, predicts growth will drop below 1% in 2020, slowing the decline of unemployment to a crawl and causing the regional average budget deficit to increase for a second successive year, which is hardly a recipe for investor returns.

Many countries are burdened by low scores for demographics and bank stability, underlining parallels with Japanese-style stagnation, though the eurozone has so far avoided the debilitating deflation that Japanese policymakers have sought to address.

Most analysts see little reason to expect any near-term improvement, noting a range of internal and exogenous risks, some of which trace back to the policy choices of the last decade, and some that have only emerged more recently.

These same analysts have little faith in the ability of eurozone policymakers to grasp the opportunities for reforms and establish global leadership.

One of these is Constantin Gurdgiev, associate professor of finance at Middlebury Institute of International Studies, whose multifactor critique of eurozone safety points one accusing finger at the excessive monetary policy accommodation (both the levels and duration) over the last decade as distorting asset prices.

“This has acted to suppress new productive investment in the real economy, created a vast army of zombie firms and tilted the European banking system away from funding organic investment towards continuing with an ‘extend-and-pretend’ approach to dealing with higher-risk borrowers,” he says.

“The ECB is once again deploying active monetary easing measures. These policies have been responsible for strengthening, not weakening, the potential crisis contagion pathways between the euro area fiscal performance and the real and financial sectors of the economy.”

Gurdgiev believes that in 2020 the OECD and EU-led push for tax policy harmonization and coordination, as well as the growing alignment between the French and the German positions on fiscal policies reforms and federalization, are all likely to increase the euro area’s government bond market's reliance on ECB supports.

The EU's abandonment of the capital markets reforms in the area of equity finance, and the re-entry of the EU-10 Financial Transaction Tax agreement into the broader German EU presidency agenda, are “amplifying the corporate investment link to debt markets, and thus to the ECB policies and markets interventions”, he explains.

The bottom line is that the economic slowdown in the euro area is likely to accelerate into 2020 along the same lines as in 2019, and new investment will experience more pressure due to the problem of debt saturation and weak domestic demand.

Gurdgiev mentions that tangible (as opposed to tax-induced or regulatory regimes-induced) foreign investment inflows will face these headwinds, with added ones coming from the newly agreed digital transactions tax reforms and the likely slowdown of investment inflows from China.

“Continued regionalization of international trade will incentivize outflows of European capital to Asia-Pacific, Middle East and North Africa and India, while subdued domestic demand will hold back inflows of new capital into Europe from these regions.”

Rotten to the core

Norbert Gaillard, an independent sovereign risk expert and another of Euromoney’s survey contributors, believes the larger countries must address broadly the same idiosyncratic issues.

Germany, for one, is excessively dependent on international demand, he says.

“Any persistent slowdown there (as observed in 2018/19) will disturb the business climate in the entire eurozone,” he says.

As for France, he adds, it is struggling to implement reforms against the barrage of conventional socialist wisdom stirring the French protesting class.

“The country has been quite resilient so far, but its credit position has been worsening for decades.”

Gaillard still regards Italy as the weakest link for several reasons: “It has the lowest GDP growth forecast among eurozone countries, one of the highest public debt-to-GDP ratios, uncertainty regarding the stability of the current governing majority, the influence of anti-establishment parties, and vulnerability to migration risk, among other factors.”

Italy will not improve its credit position, Gaillard contends, unless there is an investment shock, driven perhaps by German and/or Chinese investors.

Spain on the other hand offers room for optimism following the coalition agreement struck between the Spanish Socialist Workers’ Party (PSOE) and left-wing Unidas Podemos, which could see a loosening of fiscal policy in 2020.

If this shift is in line with what has happened in Portugal, there should be no source of concern, Gaillard believes. 

However, the reversal of some reforms is a negative move and, as he points out: “There are some potential contingent liabilities, in connection with the vulnerability of the banking sector, which concretely means that Spain may be affected by the sluggish macroeconomic environment in Latin America.”

Park Brexit, but prepare for US shocks

Eurozone analysts are also cautiously keeping an eye on Brexit, notably for the fact a no-deal outcome has yet to be taken off the table – though for many analysts the UK’s departure is no longer presenting a big challenge to the rest of Europe as most, if not all, of the worst-case scenario surrounding the UK exiting the EU has already been priced in.

Gurdgiev believes the main geopolitical shocks for the euro area are instead likely to come from the US. These shocks are inevitable, he says, irrespective of which way the 2020 US presidential election goes, as he traces out three possible outcomes of this contest.

One sees Trump re-elected: “This will give him a renewed mandate for restricting trade and investment flows with the EU, re-accelerating the trade war with China and further ‘weaponizing’ the US dollar.”

A second outcome sees a mainstream Democratic candidate such as Joe Biden elected. 

“This could see the return to political crises – triggering the status quo ante of neo-liberalism,” Gaillard says.

“While many observers would welcome this development, it is worth remembering that the neo-liberal consensus of 1995 to 2016 has been associated with growing centrifugal political forces in Europe and the US.

“A return to this state of affairs, in the presence of the new, younger and more economically insecure electorate (Gen-X and the Millennials dominance at the polls) is likely to be a destabilizing factor post-2020.”

The third scenario sees the left wing of the Democrats reclaim the White House and the Senate, dramatically shifting US economic policies toward state-managed economic activities and centralization.

This would have a series of adverse impacts for the euro area, Gurdgiev explains, including the push for increased concentration of market power in the hands of incumbent larger multinational enterprises, a decrease in overall levels of corporate investment, reduced cross-border flows, and lower demand for European exports.

“This development would also amplify geopolitical risks and uncertainty in the short run by altering US global policies and strategies,” Gurdgiev says.

In the long run, however, he says the latter risk will present an opportunity for greater federalization, and closer integration of the European economies.