When it rains, it pours in the Eurozone
16 January 2018
In the scenario outlined in our Global Overview, where markets face more hawkish central banks, a stronger dollar and higher levels of market volatility, the Eurozone would be a contributor to, as well as a casualty of, the malaise. Our central Eurozone forecast is built on the assumption that the Eurozone economy continues to grow at pace, bolstered by positive sentiment among consumers, businesses and investors (see Chart 6). Crucially, underlying this is an assumption that the ECB’s policy withdrawal is appropriate for the underlying growth and inflation environment. However, in a scenario where the economy struggles to withstand tightening policy, and the global economic and market backdrop is less supportive, the Eurozone does not necessarily look sturdy enough to absorb the shock without a hitch.
Warning signs that we were slipping into this scenario would include a sharp increase in market interest rates alongside ECB tapering, especially if these plans accelerate in response to faster inflation. A rise in the global yield structure could also transmit to the currency union. Rapidly tightening financial conditions would pose a threat to buoyant household and business sentiment. As would a more challenging external backdrop, with the Eurozone economy highly exposed to global trade. In particular, our Eurozone growth forecast is based on an assumption that business investment, alongside and linked to trade strength, is a major driver of growth in 2018. A sudden reversal of fortunes to a more uncertain world makes business investment less necessary and less desirable. Additionally, political risk is a clear area of weakness for the currency union; the monetary union lives and dies by the political sword. In a world where markets are more sensitive to political risk, 2018 provides ample potential scenarios for panic: the populist dominated Italian election (see Chart 7); ongoing problems with Catalonia in Spain; and relations with a more protectionist President Trump. Additionally, difficult economic circumstances risk causing populist tensions to flare, creating fresh crises for investors to fret over.
Lower growth and heightened political tensions would renew the test of Eurozone institutions. Would policymakers be able to cope? The Eurozone economy faces particular challenges on this front given pervasive divergences in economic and fiscal conditions across members in the core and periphery, alongside a single monetary policy. It is hard to see how governments could provide significant fiscal policy support given the combination of weak coalitions and concerns about elevated government debt levels. That said, there is nothing like a crisis to expedite the integration agenda in the Eurozone, potentially increasing the likelihood of some progress toward fiscal union. Meanwhile, ECB policy has been crucial to the recovery and we would expect the ECB to follow through on its promise to ‘stand ready’ to intervene if circumstances change. However, this would not come without challenges. The technical barrier of the capital key would return to the fore but, perhaps more importantly, the risk is that its earlier policy misstep creates a crisis of confidence in the ECB. While rules can be bent and changed, trust can be harder to win back.