Overcoming Eurozone policy rifts in Q1 2018

By the end of the first quarter, Italians will have cast their votes in a general election and Germany might have a new government in place. To some extent, a grand coalition in Germany would be good news for the Eurozone and all its member countries but several hurdles certainly remain, starting with the SPD party vote on 21 January.

This would end the phase of political uncertainty that has paralysed the European reform agenda for several quarters and should open new horizons. Given the support of the economic cycle and an accommodative central bank, the current window of opportunity to strengthen the Euro area is favourable. The EU Council on 22-23 March could well mark the starting point of a more ambitious agenda.

Germany, the bloc's biggest economy and the largest contributor to the EU budget, holds the key to unlocking the stalled reform process. The draft coalition agreement between Germany's biggest parties shows that Germany would no longer be an obstacle to greater economic and fiscal integration. This draft agreement features European issues (surprisingly) prominently at the top. This document calls for steps to strengthen the Euro area (including a proposal to convert the European Stability Mechanism crisis backstop into a “European Monetary Fund” operating under EU law) and improve fiscal control and economic coordination. Even additional German funding is envisioned to improve the EU’s capacities. To cut a long story short, Germany would finally embrace the reform process of the Euro area. The key hurdle is the endorsement by the junior coalition partner, starting with the SPD party vote on 21 January.

Italian elections are likely to prove a short-term distraction. Cyclical strength is currently outweighing the well-known structural weaknesses of the Italian economy. The Italian recovery has become self-sustained as both business confidence (Composite PMI at 56.5 points) and consumer sentiment (just shy of its record level) have improved markedly since last summer. On a medium-term horizon, debt sustainability has improved, as the average interest rate paid on outstanding debt is falling, the nominal growth rate has picked up and the primary balance should remain intact. As a result, the IMF projects the Italian debt ratio to reach 120% in 2022, down from 133% in 2017. This backdrop explains why election uncertainty should not derail the country’s path. Thanks to the new electoral law, a government formed by anti-establishment parties is very unlikely. A hung parliament -- the most likely outcome -- would not in itself represent a threat to the Eurozone, as a grand coalition could handle the situation.