22 septembre 2016

Europe: Running Out of Time?

September 22, 2016, by Dr. Christian Witt

Since the onset of the 2007-08 global financial crisis, the European Union (EU) has continuously lurched from one crisis to the next – unfortunately without definitely resolving any of them. This « kicking-the-can-down-the-road » behavior has left a mounting number of unresolved issues behind: Refugee crisis, Italian economic malaise, ailing European banks, soaring youth unemployment and a severe political backlash, to just name a few. Still worse, it seems that several of these issues may no longer be delayed. Thus, is the EU ultimately running out of time?

Let us first focus on the most pressing economic problems:

  • Italian malaise: Since 2007, Italy has experienced three recessions. Over this period, industrial production has tanked and unemployment has soared (see figure 1). Meanwhile, the country’s banking sector has suffered under the weight of souring loans and dwindling capital reserves leaving many regional banks on the brink of collapse (see figure 2). Attempts by policy makers to help resolve the matter did not succeed due to insufficient rescue funds or tight European regulations. Today, the banking sector desperately needs accelerating domestic growth to heal, but remains itself unable to support economic activity. A classical dilemma.
  • European banking weakness: Many European banks, in particular those in the Euro area, have suffered for years. Low economic growth and mismanagement have depleted capital reserves; declining yields have stressed net interest margins. Accordingly, banks have underperformed the wider stock market (see figure 3). Perhaps worst of its class is Deutsche Bank (DB, see figure 4), Germany’s biggest lender. Not only has DB been hit hard by slowing investment banking and skyrocketing legal costs, but also seems to lack the necessary capital cushion to accommodate a turn-around. What makes the bank particular dangerous is its outsized derivatives book (see figure 5). In fact, even CDS on German bonds seem to have responded to worries about DB (see figure 6). An explosive waiting to go off.
  • Youth unemployment: With every new economic shock hitting the EU, youth unemployment has grown larger (see figure 7). Although the peak may have been reached in 2013, the problem impairs the life of millions of young people across the EU.

Against this dire economic background, the refugee crisis may be the issue that could eventually tip the EU over the edge. The lack of a coordinated migration policy touches on all of the above economic challenges and has further facilitated political backlash across all member states. This fundamental tension has contributed to the triumph of Brexit in the UK referendum and the formation of new populist anti-establishment parties. Some of them have an anti-immigrant bias (e.g. AfD, FN, FPÖ), others have not (e.g. Five-star movement, Podemos, Syriza). But what they have all in common is anti-EU sentiment.

This brings us to the current political situation where the political backlash is all-present (we concentrate on the most relevant events):

  • Super-election year 2017: Next year, elections will be held in the Netherlands (March), France (April, June) and Germany (September). All of these EU founding members experience a considerable rise in anti-EU and anti-immigration sentiment. For instance, in the Netherlands, Geert Wilders’ populist anti-immigrant party leads the polls on an anti-EU and de-islamization platform. In France, chances are that populist FN candidate Marine Le Pen will at least arrive in the second round of presidential elections. She too vows to lead the country out of the EU and reestablish control of the borders. Finally, in Germany, the rise of the populist anti-immigrant AfD party may impede the formation of a stable government. If any of these parties succeeds, the EU may be up for a hard ride.
  • Italian referendum: Prime Minister Matteo Renzi will ask Italians for their approval of a constitutional reform that seeks to improve the ease of governing the country. If declined, this would be a success for vested interests opposing any economic reform. Thus, in the short term, Italy’s banking crisis may resurface with unknown consequences for the entire EU banking sector. In the long term, the country’s economic well-being is at stake. However, unfortunately, Renzi’s declining popularity reduces the chances of approval. Investors might grow increasingly nervous about the sustainability of the country within the euro zone.
  • Spanish re-re-election: In the third parliamentary election this year, it remains uncertain whether a stable government could eventually be formed since the rise of the populist Podemos party destroyed the traditional equilibrium of power. Although Podemos may not be part of a new administration, its repeated electoral success demonstrates how unsatisfied Spaniards are with the political status-quo. Any new government might accordingly lean towards protectionist politics.
  • Austrian presidential re-election: Recent polls suggest that Austrians are likely to elect a populist anti-immigrant and EU-sceptic candidate for president.

In our assessment, any of the above political issues could be an existential danger to the EU. Most notably, many of the underlying economic forces and political risks are interrelated. They form a complex system which, by definition, is highly responsive to even small shocks. What is more, we believe that there is a substantial chance that at least one of these risks may materialize even though they may appear remote and independent of each other at first sight. This is why, in our view, today’s most important question is which of the above issues will throw the EU into disarray. Until then, European leaders will seek to hide the dust under the carpet as they did during last week’s summit in Bratislava.

Figure 1: Italy – Industrial Production and Unemployment Rate (%) since 2007

Figure 2: Italy – Non-Performing Loans to Total Gross Loans and Bank Capital to Assets Ratio (in %)

Figure 3: Performance of European stocks and the European Banking Sector


Figure 4: Performance of the European Banking Sector and Deutsche Bank (DBK)

Figure 5: German GDP, EU GDP and Deutsche Bank’s Derivatives Book (in trillion EUR)



Figure 6: 5-Years CDS on German Sovereign Bonds and Deutsche Bank (DBK)

Figure 7: Youth Unemployment in Selected European Countries and the World (in % of Labor Force)