Published On: Thu, Jul 14th, 2016

Third-Quarter Forecast 2016: Europe


The Impact of the British Referendum

During the third quarter, the European Union will deal with the consequences of the British referendum on EU membership.

The victory of the “leave” camp and Prime Minister David Cameron’s decision to resign have triggered a political crisis in the country, with the ruling Conservative Party and the opposition Labour Party struggling with internal disputes. The United Kingdom will not start formal negotiations to disconnect from the European Union this quarter because a new prime minister will have to be selected first. This will delay the process of Britain’s withdrawal from the European Union by a few months but will do little to ease the economic and political consequences of the referendum.

The United Kingdom will gradually move to accept the result and focus on how to effectively negotiate an exit. Officially, the European Union will continue to refuse to start negotiations until London formally announces its decision to leave. But informal contacts between British officials and their European counterparts will start once a government is in place in the United Kingdom. Brussels will give London time to appoint a new government but will stand firm in its demand that preserving access to the common market also means allowing the free movement of EU workers.

The uncertainty generated by the Brexit will continue to produce volatility in the British economy and, to a lesser extent, hurt the economies on the Continent. Effects on the bloc could include rising bond yields for countries in the eurozone periphery, delayed decisions on spending and investing in the European Union’s main economies, and depreciations of the euro and Eastern European currencies.

The United Kingdom’s territorial integrity will also be debated, but the government in Scotland probably will not make any drastic unilateral moves this quarter. The Scottish government will try to negotiate with Brussels over ways to remain connected with the bloc. But Scottish authorities will wait for the political situation in London to become clear before making any definite moves. The announcement of an independence referendum this quarter is unlikely.

The British situation will also test the stability of the French-German alliance. In the third quarter, Paris and Berlin will make proposals to strengthen the European Union. Considering that both countries will hold elections in 2017, those proposals will probably focus on areas where an agreement is possible instead of issues such as the functioning of the eurozone. These will include EU-wide initiatives on issues such as security and terrorism, protection of the bloc’s external borders, and migration as well as employment and economic growth. Even if there is room for agreement in these areas, implementation will not happen this quarter.

Those proposals on less controversial issues will not stop other EU members from putting forth their own ideas on how to reshape the union. Nor will it stop the political debate in some countries about whether to hold referendums on aspects of their memberships in the bloc. Different regions in the European Union will put forth different proposals on how to prevent the bloc’s disintegration, but those ideas will come from fundamentally opposing directions.

For example, countries in Southern Europe, led by Italy, will push for more EU spending on social policies and more flexibility on fiscal targets for member states. Northern countries, led by Germany, will oppose these moves. Countries such as Poland and Hungary, on the other hand, will push to give a greater role to national parliaments in decision-making. Most EU members oppose changing the Lisbon treaty, so that will not be on the table.

Political Volatility in the Eurozone

Some of the largest eurozone members will see a quarter of political volatility, with social tensions over labor reforms in France, financial and political uncertainty in Italy, a long process of forming a government in Spain and political divisions in the German government.

In France, the government’s authority will continue to erode, and social unrest will remain strong. Despite popular protests, the French government is likely to pass labor reform legislation. But this will probably be the last significant policy introduced by President Francois Hollande, as the controversial reform will leave his Socialist Party weak and divided. The Elysee is likely to announce some reductions in taxes and increases in public spending in a bid to regain popularity, but right-leaning opposition parties are likely to retain popularity. Influenced by the events in the United Kingdom, French politicians will seek to position themselves for the 2017 presidential election by promising various referendums on EU-related issues.

In Germany, the ruling center-right/center-left grand coalition will also be under domestic pressure. Regional elections in Berlin and Mecklenburg-Vorpommern in September will probably result in growing support for emergent opposition parties on both ends of the political spectrum, such as the progressive Greens and the right-wing Alternative for Germany. With Germany’s ruling coalition pulled in different directions as elections draw closer, Berlin will find it increasingly difficult to fill its role as the European Union’s political center of gravity.

In Italy, the government of Prime Minister Matteo Renzi will try to regain the political initiative after the poor performance of the ruling Democratic Party in municipal elections in June and before a key referendum on constitutional reforms in October. The main opposition parties, including the anti-system Five Star Movement and the anti-immigration Northern League, will campaign against the reforms. To win back popular support, Renzi will promise lower taxes and higher public spending. Brexit-induced volatility in financial markets will continue to hurt Italian banks, increasing the probability of government intervention. Italy will seek authorization from Brussels to provide state support for its banks, but Germany is likely to oppose such a move. Should pressure on Italian banks become too strong, Rome and Brussels will reach a compromise.

In Spain, the country’s main political parties will spend the first part of the quarter negotiating the formation of a government after the fragmented parliament produced in June 26 elections. Once a government is formed, the next administration will announce increases in public spending and cuts in taxes, regardless of the EU Commission’s recent threat to sanction Madrid.

The fiscal situation in countries such as Spain and Portugal will create another source of friction between north and south in Europe. Southern countries will press for more flexible fiscal targets, while northern countries will push for sanctions against those that fail to meet commitments. Countries in Southern Europe will avoid sanctions, or receive only symbolic punishment, in exchange for promising to introduce reforms in the future. This will lead only to more north-south frictions.

Europe’s East-West Divide Continues

The next three months will also see the continuation of Europe’s east-west divide, as countries in Central and Eastern Europe continue to resist Brussels’ influence and introduce measures that alienate their western neighbors. For countries in the region, Brexit removes a significant counterweight to the French-German influence on the bloc and a defender of the interests of the nations that are outside the eurozone. In the coming months, countries in Central and Eastern Europe will become the loudest defenders of national sovereignty in the European Union.

In Hungary, the government of Prime Minister Viktor Orban will proceed with plans to hold a referendum in October on a proposal by the European Commission to distribute asylum seekers across the Continent. The authorities in Brussels will criticize the referendum, but the government in Budapest will use that to consolidate its domestic popularity.

Poland will remain committed to its membership in NATO, request a greater allied presence in Eastern Europe and defend a tough stance on Russia.

At the same time, the government in Warsaw will continue to introduce measures that will cause concern in the West. During the quarter, for example, Warsaw will start collecting a tax on retailers, a sector dominated by foreign companies, and pass a plan to convert foreign-denominated loans into zlotys. The final version of the conversion plan will be less costly for banks than the original proposals, but it will still force banks, most of which are controlled by foreign firms, to face losses. The Polish economy will see strong growth this year, but those moves will progressively erode business confidence and weaken the Polish economy.

The Migration Crisis Abates

Since the agreement between the European Union and Turkey designed to stem migrant flows into Europe entered into force in late March, emigration from Turkey has fallen significantly. The drop can be attributed not only to cooperation between Turkish and European authorities to stop migrants from reaching Greece but also to the perception among asylum seekers that reaching Northern Europe has become more difficult because of stronger border controls along the main migration routes.

The agreement should largely hold during the quarter, but its continuity will be under constant pressure. Relations between Turkey and the European Union will remain tense. Brussels desires to preserve the accord but wants Ankara to meet all the necessary criteria to be granted visa liberalization for its citizens. The Turkish government also wants to maintain the deal but is unwilling to submit on issues such as EU-requested changes in terrorism legislation. In addition, recent decisions by Greek appeals committees to prevent deportations of asylum seekers to Turkey could encourage more people to try to reach Greece. In the meantime, border controls along the Balkan migration route will remain in place, as will border controls in the main migrant destinations in Northern Europe.

With the situation relatively stable on the Aegean Sea, most of the migration activity will come on the central Mediterranean route, which connects northern Africa with southern Italy. As weather conditions improve this quarter, more migrants will arrive in Italy. Overall, the number of people reaching Italy will remain much lower than the numbers that flooded Greece during the peak of the crisis last year. The government in Rome will continue to press for a unified approach to the issue. The European Union is likely to make progress on plans to provide financial assistance to migrants’ countries of origin to discourage emigration, and proposals to strengthen EU coastal and border-control forces are likely to be approved during the quarter. At the same time, Italy’s neighbors will reintroduce border controls if they feel that the Italian government is not doing enough to keep the migrants in its territory.

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