Eurozone: Political risks will test a resilient recovery Global Economic Outlook, Q1 2017

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​While 2016 was a bumpy year politically for the Eurozone due to events such as Brexit and the Italian government’s referendum defeat, surprisingly, the Eurozone economy has shown remarkable resilience overall and has continued its recovery into its fourth year.


Politically, 2016 was a bumpy year for the Eurozone. New political risks materialized, ranging from the unexpected decision of the United Kingdom to leave the European Union to the defeat of the Italian government in a constitutional referendum. Nevertheless and quite surprisingly, the Eurozone economy showed remarkable resilience and continued its recovery, relatively unaffected by political turbulence within and outside the European Union. Although growth rates are still moderate, the recovery has been solid and is about to enter its fourth year.

2016: Not a bad year in economic terms

Unlike within the political sphere, the last year brought some good economic news for the Eurozone:

  • Real GDP finally surpassed its precrisis level, and all Eurozone countries, except Greece, grew in 2016.
  • The output gap—the difference between potential and actual GDP—is narrowing, even if the speed is slow.
  • Labor markets are recovering, and job creation is progressing at a solid pace.
Quite surprisingly, the Eurozone economy showed remarkable resilience and continued its recovery, relatively unaffected by political turbulence within and outside the European Union.

Last year saw two developments on the labor market that are shaping the recovery. First, the unemployment rate dropped from 10.5 percent (November 2015) to 9.8 percent (November 2016). This is the lowest value since mid-2009. To be sure, there are huge differences between member states—unemployment in the Czech Republic stands at 3.7 percent, while it is 23.0 percent in Greece—but the general trend is clearly positive.1

Second, employment and employment rates are increasing. Employment has grown without interruption since mid-2013, and employment growth in 2016 was, at 1.4 percent, the highest since 2008.2 The employment rate in the Eurozone is now close to 66 percent, almost reaching its all-time high from 2008. Coupled with increases in real disposable income, this has led to purchasing power gains.

As a consequence, private consumption has been the main driver of the recovery in 2016. While the contribution of net exports (exports minus imports) was moderate, investments contributed in a minor way. As in the last four years, corporate investments developed more weakly than forecasted in the beginning of the year, hindering higher growth rates.

Nevertheless, the Eurozone’s economy grew at 1.7 percent in 2017, slightly more than rate the in United States and higher than its (long-term) potential growth rate of 1.1 percent.3 What is remarkable is that the Eurozone economy stayed on track despite the Brexit shock, the political crisis in Italy, and concerns about the stability of the European banking system.

The baseline for 2017

Looking at the economic fundamentals, the Eurozone economy is likely to keep its current momentum. The positive development in the labor market is likely to continue, with private consumption likely to remain the key growth driver. Even if higher inflation is to be expected, mainly due to rises in energy prices, the labor market dynamics should compensate for that. Higher consumption will lead to higher imports, so the net effect of foreign trade is not likely to contribute much to growth.

Monetary policy, given its current highly expansive character, is unlikely to be eased further; there are concerns that it has reached its limits. Fiscal policy, on the other hand, will be only moderately expansive, given the still-high debt levels in the Eurozone.

For years, the Eurozone has been waiting for corporate investment to accelerate. Hopes at the beginning of each year have been disappointed year after year.

For years, the Eurozone has been waiting for corporate investment to accelerate. Hopes at the beginning of each year have been disappointed year after year. Despite extremely favorable financing conditions, the highest capacity utilization since 2008, and strong corporate sentiment, investments underperformed expectations in 2016 as well. According to the investment intentions of European CFOs, acceleration is not expected in 2017 either (figure 1).

Investment propensity of European corporates over the next 12 months

One of the key reasons for the continuing investment restraint is political risks and uncertainties. The economic resilience in 2016 does not mean that the political shocks had no effect at all. Uncertainty in the Eurozone reached new heights. The Economic Policy Uncertainty Index, a news-based measure of uncertainty, exploded after the Brexit and Italian constitutional referenda (figure 2), and climbed to a much higher level in 2016 than in previous years, which saw events such as the Greek debt crisis, the Ukraine crisis, and concerns about a hard landing of the Chinese economy.

Economic Policy Uncertainty Index

Uncertainty will continue to shape the cyclical outlook for 2017, as political events and associated risks could easily interfere with economic fundamentals. This is visible in the risk agenda of European corporates (figure 3). European CFOs worry mostly about current political trends and the implications for their business. Geopolitical risks top the risk agenda of CFOs in many European countries.

Key business risks over the next 12 months

Geopolitical risks top the risk agenda of CFOs in many European countries.

Downside risks

Political risks dominate the risk agenda for three reasons. First, there are elections in the Netherlands, France, and Germany: countries that represent close to 60 percent of the Eurozone economy. After the demise of the Italian government, snap elections in Italy are also possible. The recent strength of anti-EU parties in many parts of Europe will turn these elections into a crucial test for the future course of the Eurozone. The risk of fragmentation of the Eurozone and the European Union would rise substantially with successes of anti-EU parties.

Another major political risk is Brexit. While the immediate economic and financial market reactions were milder than anticipated, Brexit is a process and not a one-time event. In the last few months, hopes for a soft Brexit—that is, a continuing close relationship between the United Kingdom and the European Union along the lines of the EU-Norway relationship—have largely disappeared. A hard Brexit seems now much more likely; even an uncontrolled Brexit, if there is no agreement, is conceivable. Once the negotiations start, the Brexit scenarios and the disruptive potential of the more extreme options will add to uncertainty on political, economic, and financial market levels.

A third uncertainty is closely related to the rise of anti-globalization and anti-EU parties in Europe and movements in Europe itself and elsewhere. As a highly export-oriented economy, the Eurozone benefitted substantially from the liberalization of world trade in the post-war era as well as from the removal of trade restrictions within the European Union through the internal market. The rhetoric of deglobalization and higher protectionism within Europe and outside of it therefore directly challenges the Eurozone’s growth prospects and is a fundamental risk to its future.

Upside risks

While the downside risks to the economic outlook seem to be numerous and are firmly in the center of public attention, there is also a flip side. If the downside political risks fail to materialize, there is likely to be strong impetus to the ongoing recovery. For example, if European populist parties lose momentum in the upcoming elections and have no or minimal electoral successes, political uncertainty for business would be significantly reduced. Given the current high capacity utilization in combination with favorable financing conditions, this could be a signal for an acceleration of corporate investments, stabilizing and strengthening the recovery.

In this way, politics will drive economics and financial markets to an unusually high degree in 2017, and key political events will likely result in considerable volatility of economic and financial market expectations. Whether the recovery can keep its resilience and continue to develop irrespective of political uncertainties is therefore the crucial question in 2017.