Deutsche Bank : Economic policy outlook: Autumnal storms over Europe?

August 12, 2014

The annual Brussels rentrée is fast approaching. Late August will see the beginning of a busy schedule, promising eventful weeks and months to come. Expected events like summits, AQR and EBA stress tests will meet with political and geostrategic risks. Many observers predict a stormy autumn - are they right?

The next European Council on August 30 will mark the end of the Brussels summer recess. This summit will be dominated by heads of state and government making a final push to nominate the new Commission under Jean-Claude Juncker, as well as the Council President and High Representative for Foreign Affairs. A final agreement is imperative if the Commission is to respond effectively to the challenges of the coming months. Also likely to feature prominently on the agenda is the EUR 300 bn growth package for the EU and euro area, announced by incoming Commission President Juncker in July. As yet, this sum remains a purely political benchmark, as it is unclear how the financial burden will be distributed across the European Investment Bank (which currently holds about EUR 60 bn), project bonds, and structural funds from the EU budget. The summit could open debate regarding both the equitable distribution of funds as well as criteria for disbursement. Tensions are likely to emerge between the need for accessibility of funds on the one hand, and a demand for conditionality on the other. A final decision is not expected to be reached at this stage. Finally, the crisis in Ukraine and sanctions imposed on Russia are likely to feature on the informal agenda of the summit.

Once more, all eyes will be on Greece during the Eurogroup summit on October 12 and 13. The second financial assistance package will expire at the end of this year. Greece has demanded a reduction of interest rates for both of its assistance programmes and an extension of their liability term. Euro-area countries are likely to concede, given their 2012 commitment to Greece to alleviate the burden should it consolidate a positive primary balance. Even if a reduction of interest payments is domestically easier to communicate in debtor countries than a partial write-off, Greek demands are likely to spark controversy. Debates have already yielded contemplations of ending the stringent system of economic conditionality imposed by the Troika. Should Greece's financing assistance be transferred to precautionary credit lines, this would certainly be possible.

ECOFIN Council meetings will focus on economic and fiscal surveillance of the member states. A large portion of budgetary surveillance is conducted within the framework of the European Semester in the first half of every year. Nevertheless, the publication of deficit figures on October 1 will show whether euro-area countries are fulfilling their budgetary commitments. Particularly France's fiscal stance gives rise to concerns. In the past years, the Commission has already extended its fiscal adjustment path. It remains to be seen whether the ongoing Excessive Deficit Procedure (EDP) on France will be stepped up, should it miss its - already adjusted - fiscal target. Italy too will be facing renewed pressure to further reduce its debt burden, raising the possibility of a new EDP. Ambitious budgetary plans for 2015, which will have to be submitted to the Commission for inspection by October 15, could prevent the Commission from proposing further measures within the EDP framework in both countries. This would boost their credibility, even if the Commission is limited to establishing ex post whether commitments are indeed implemented.

The financial policy agenda will be dominated by the results of the asset quality review and EBA stress tests of the euro area's 128 largest banks, to be published in October. An audit of balance sheets is a prerequisite to the Single Supervisory Mechanism (SSM) commencing operations in November. Banks that fail the two-staged procedure will be given an additional two weeks to boost their equity ratios. In light of recent uneasiness in Portugal, results will be eagerly awaited. At the same time, political attention could shift back from stress tests to banks' lending trends. Should lending fail to pick up markedly, political pressure on the ECB to increase support of the real economy (e.g. through ABS purchases) is likely to grow. Nevertheless, this would disregard that sluggish lending could in fact be linked to weak demand in view of uncertainty over the willingness of certain countries to embark on reform.

Aside from summitry in Brussels, political risks in key member states could emerge in the coming months.

First, Scotland will decide on independence in a referendum on September 18. While polls give unionists a slight lead of over 10%, the referendum will be closely watched - not least in Catalonia, where a similar referendum is expected be held on November 9. Although this referendum is regarded as unconstitutional by the Spanish government in Madrid, both referenda will give an indication of centrifugal pressures for self-determination in Europe. Drawing inferences about the result of a potential EU-membership referendum in the UK is therefore no stretch. In any case, both referenda are overshadowed by a high risk of being exploited by populists to further their own political aims.

Will this autumn be a calm one after all? This policy outlook shows that recently becalmed debates on the euro crisis are likely to flare up once more. Yet, in order for this debate to bear fruit, the right questions will have to be asked in the euro area - despite a tightly packed agenda and multiple distributional tensions. Demanding more growth is simple, but a debate on the conditions for growth is more demanding and requires a powerful will for change. The long-term path to stability and growth does not lead via deficit spending or an accommodating central bank, but rather through a credible commitment to reform and sound fiscal policies. The ECB again underlined this argument on Thursday, pre-emptively curtailing further political pressure. Whether this wish will be respected after the summer break remains to be seen.