Eurasia Group Outlook 2013

Crisis and reform continue to define political trajectories

EURASIA GROUP

For European decision-makers, 2013 will in many ways be much the same as 2011 and 2012—that is, no breakup of the eurozone yet no systemic solution or quick fix either. Instead, crisis management will continue to be defined by an incremental approach, especially given that German elections in September will constrain Chancellor Angela Merkel from making any major moves at the EU level. In fact, she will be even more risk-averse than usual.

Fiscal consolidation will remain a policy headline in central and Eastern Europe in 2013, and new consolidation measures entering into force next year are likely to further dampen economic growth. Euro-scepticism is on the rise, as the sovereign debt crisis is widely blamed for the lack of growth across the region. Simultaneously, resistance to reforms is increasing, as the protracted period of austerity affects public sentiment. As a result, the preferences of the electorate will move toward more social protection amid adverse economic conditions, mirrored in the heightened popularity of centre-left parties.

MORE ECONOMIC HEADWINDS IN WESTERN EUROPE

Eurozone decision-making: muddling through all over again
Despite the ongoing turmoil, EU leaders will enter 2013 with a more effective arsenal of policy tools to manage the current situation and lower the risk of sovereign defaults and banking crises. Many of these tools will be used and tested in 2013. First, at the end of October, the eurozone’s main crisis-fighting instrument, the European Stability Mechanism (ESM), became fully operational. The ESM—in conjunction with its predecessor, the European Financial Stability Facility (EFSF)—has a total lending capability of €500 billion ($650 billion) and is designed to support countries undertaking reform efforts. In addition to providing such loans, the ESM is empowered to intervene in primary and secondary bond markets if member states request assistance. This would help to keep market pressure at bay if countries such as Spain or Italy were to face stronger economic difficulties.

Second, the European Central Bank (ECB) has announced a separate bond-buying plan for distressed states called the Outright Monetary Transaction (OMT) scheme. The programme, which will target short and medium-term securities, sets no explicit limit on the scope of ECB intervention in secondary markets. Countries must officially request an EFSF/ ESM programme before they can receive complementary ECB relief via the OMT. By committing to unlimited bond buying in the face of serious market headwinds, the OMT programme has helped to stabilize market sentiment by eliminating the existential risk of a eurozone breakup. That said, serious challenges remain regarding implementation, and these will most likely be tested in 2013. The first issue surrounds the risk that the creation of the OMT programme will remove the incentive for national governments to reform and discourage wider eurozone institution-building. In addition, it is unclear how the ECB will act if countries fail to meet reform commitments. There is also a risk that the bank will push for more austerity if beneficiary countries are deemed to have strayed from their ECB fiscal policy conditions, thereby further worsening the medium-term economic outlook.

Third, on 12 September, the European Commission presented its proposal for a banking union. The most immediate change would be an overhaul of current supervision practices of the eurozone’s 6,000 banks. But there are significant disagreements among member states concerning the pace of implementation, the scope of banking supervision, and the division of supervisory powers between member states and EU institutions. Nonetheless,ECB supervision of banks currently relying on state aid to is likely begin in January; oversight of larger banks would begin in July, with all 6,000 banks falling under the scheme by January 2014. Germany, however, wants the supervisor to focus primarily on the systemic banks, while France wants smaller banks to be covered first. At the same time, given that most member states will fight to reserve as much authority as possible for national regulators, it will be difficult to decide which powers will remain at the national level and which will be held by the EU. The ECB favours a degree of decentralization (with Frankfurt responsible only for the largest banks), though member states will not cede control over their most important financial entities without a fight.

Political stability: key elections and troubled coalitions
In Germany, Merkel is highly likely to secure a third term after general elections are held in September. The most realistic outcome is a grand coalition of her Christian Democratic Union (CDU) with the opposition Social Democrats (SPD). However, any other form of government composition—including a potential coalition comprising the CDU and the Greens—would not fundamentally alter Berlin’s stance on central policy issues.

Europe is likely to feature prominently in the electoral campaign. The German approach to the eurozone crisis will therefore continue to be defined by a mix of strong commitment and the push for conditionality. Although Merkel will try to delay until after the elections any measures that could result in German losses, Berlin will continue to do whatever is required to keep the eurozone intact. In the debate about the banking union and financial sector regulation, Germany will press for closer integration and more stringent oversight, in part to limit moral hazard but also because further integration will win votes from constituents.

For Italy, 2013 will be a year of political uncertainty. General elections will be held in March or April, following the dissolution of parliament six to 10 weeks prior. This effectively means that parliament is likely to be dissolved in January or February, with lawmakers focused for the remainder of the term on passage of the budget, various expiring decrees, and possibly a new electoral law.

Prime Minister Mario Monti, who has improved Italy’s fiscal position and secured a series of much-needed structural reforms, intends to return power to political parties after the vote. Yet it is still somewhat unclear what sort of government will take charge after the elections. While the centre-left has a lead in opinion polls and is expected to win, it is possible that elections may yield a hung parliament. If strong market pressure were to accompany political gridlock, there is an increased probability that Monti could return as prime minister for a second term, backed by a national unity government. A second Monti government would, however, be staffed with ministers from the political parties (and not just technocrats, as in the current cabinet) and would therefore likely be weaker than the current arrangement.

Nevertheless, Monti would lend Italy greater credibility than a multi-party centre-left government, which might suffer from policy paralysis or—in the worst-case scenario—try to soften recent measures such as pension and labour market reforms at the margins. Given Italy’s international commitments, though, fiscal policy is likely to remain on track regardless of the election outcome. What does appear clear at this point is that the vote will likely lead to a shake-up in the party system. In particular, the maverick Five Star Movement is likely to gain a foothold in parliament, posing a new threat to the unpopular traditional parties.

In the Netherlands, the new coalition government comprising the liberal People’s Party for Freedom and Democracy (VVD) and the Labour Party (PvdA) is expected to focus on stability. After the fifth election in 10 years, political leaders are aware of the need to provide the credibility needed to let consumers and businesses regain confidence. But minor risks remain. The VVD-PvdA coalition does not hold a majority in the senate and depends primarily on the Christian Democratic Party. Also, the combination of continued austerity at home and the provision of finance to indebted eurozone countries provide the fringe parties (the Freedom Party and the Socialist Party) with greater leverage. While not directly influencing government stability, the opposition will be vocal. Notwithstanding these pressures, the government will continue to take a pragmatic, pro-European approach in managing the eurozone crisis and remain a close ally of Germany. Fiscal consolidation will remain a key priority and healthcare, housing market, and labour market reforms will be enacted. Several waves of austerity measures will continue to weigh on consumer spending levels and therefore economic growth in 2013.

In Belgium, the victory of the separatist New Flemish Alliance in October’s local elections will put the federal government under pressure. Two of the three Flemish parties comprising the six-party federal government, the liberal Open Flemish Liberals and Democrats and the Christian Democrats, will have to deliver a credible and satisfactory alternative to the separatists in order to meet the population’s demands. They will thereby become a tougher coalition partner for the socialist Walloon Prime Minister Elio di Rupo. Even though he will probably take whatever measures are necessary to keep the coalition together, risks remain. Throughout 2013, negotiations will have to be conducted regarding key state reforms on the further transfer of decision-making powers from the federal to the regional level and the revision of the financing law for the state and its entities. In combination with continued budgetary control to make sure deficit targets are met, the government will face important challenges to its stability. Federal elections in 2014 will prove the greatest test for the state. 

Next year’s political outlook also looks complicated for the two so-called good students among the eurozone bailout countries, Portugal and Ireland, given that their respective coalition governments will likely struggle to remain intact. In Portugal, austerity will further strain the relationship between the ruling Social Democratic Party and the People’s Party (PP), its junior coalition partner. The substantially higher taxes included in next year’s budget recently prompted PP leader Paulo Portas to threaten that his party would quit the coalition. Although last-minute changes to the budget managed to defuse tensions, there could be a new rift between Portas and Prime Minister Pedro Passos Coelho if Portugal underperforms on the fiscal front and more austerity is required. These factors, coupled with the sinking popularity of the ruling parties, greatly raise the risk of a coalition fracture in 2013.

In Ireland, recent developments—including the defection of certain lawmakers and the resignation of a junior minister—are compromising the Fine Gael–Labour coalition’s ability to govern. Next year will not be any easier for Prime Minister Enda Kenny and Deputy Prime Minister Eamonn Gilmore, who will have to enact difficult measures to implement the terms of Ireland’s bailout. For instance, officials will have to create even more savings by cutting public sector costs. If the cuts are excessive, they will likely be opposed by unions. Still, the coalition has a solid chance of staying intact in 2013, given the high level of public trust in the government and the commitment of both party leaders to carry out the terms of the bailout.

Greece will remain under intense pressure as authorities struggle to implement measures aimed at saving €9.3 billion ($12 billion) in 2013. This renewed austerity drive, mandatedby the IMF, the EU, and the ECB, is likely to hurt the government’s popularity and provoke more demonstrations. Despite this worsening political backdrop, the ruling coalition is expected to remain in power for at least the first half of 2013 and possibly beyond. None of the main parties, including the main opposition anti-austerity Syriza, has a major incentive to call for snap polls. The main risk to government stability is posed by the Panhellenic Socialist Movement (PASOK, the second-largest member of the coalition) and not by the opposition and social unrest. The party’s failure to address its ongoing internal fissures and appoint a new leader could prompt further defections from PASOK, which would undermine the coalition’s parliamentary majority (166 seats in the 300-member parliament).

Austerity and reforms to remain key policy
In France, the government will be preoccupied with sticking to European deficit commitments and addressing the increasing competitiveness problem. In the first quarter of 2013, it will become clear whether fiscal performance has been good enough to meet budget deficit targets. If growth numbers are lower than anticipated by the government, additional austerity measures will likely be needed to meet targets. While this is a priority for President Francois Hollande, he will face tough political choices between the need to restore France’s competitiveness and the need to restore fiscal order. Tensions may rise within the Socialist Party, and Hollande will have to try to satisfy party members’ demands. In particular, he will have to balance the need for reforms and potentially austerity with the expectations of the French political left, which will have trouble accepting more budget tightening.

The issue of competitiveness will be at the forefront of the government’s agenda through 2013. Hollande has promised to enact labour reform and identify measures that can make France’s economy more competitive again. In the first quarter of 2013, authorities will work on concrete proposals (with or without agreement among trade unions and employers) to address labour costs, as well as other issues such as education, housing, public services, innovation, research, and investment. Any sweeping measures to liberalize labour markets will, however, almost automatically trigger a backlash from trade unions and probably a vast portion of the left and are therefore not expected.

The absence of regional elections in Spain next year should give Prime Minister Mariano Rajoy more space to implement his reform programme, but he might be forced to make even tougher choices if he has to request additional external assistance. Rajoy is unlikely to move absent heightened market pressure. The People’s Party–led government is uncertain about the benefits of a programme and does not want to pay the political costs that would accompany a second application for external assistance. If markets force the government to apply, the conditions attached to an eventual programme would only make Rajoy more unpopular, as he might have to make cuts in areas that have so far remained untouched, such as pensions. Such developments would likely generate more social discontent, and the number of demonstrations would probably continue to rise next year. That said, the risk of widespread social unrest that forces the government to backtrack on its reform programme remains limited. This is largely because there are almost no ways to translate social discontent into political action, given that trust in trade unions—which have maintained a quasi-monopoly on organizing nationwide mobilizations—is at historical lows.

IN EASTERN EUROPE, FURTHER DEBT REDUCTION AND A SHIFT TO THE LEFT

Fiscal consolidation remains a priority but will weigh on growth
With the exception of Estonia and Bulgaria, whose state finances are in good condition, fiscal consolidation will remain the main policy priority across Eastern Europe. While major cuts to public spending have already been implemented over the past two years, slowing growth and the mounting resistance to austerity are proving to be formidable obstacles standing in the way of more measures to bring deficits below 3% of GDP before the EU’s 2013 deadline. Yet policies aimed at reducing deficits and debt accumulation may have as much of a negative impact on economic expansion as the crisis. Growing tax burdens and government spending cuts are undermining domestic consumption as well as capital investment. And regarding austerity in particular, the outlook remains unchanged as new consolidation measures take effect in several countries as of January. Given the cuts in economic growth forecasts for 2012 and 2013, some countries might miss their budget deficit targets, and therefore additional consolidation measures in 2013 would be likely.

In Poland, the public deficit has ballooned as fiscal easing helped depreciate the currency, keeping the country in the black at the start of the crisis in 2009. A government deficit of nearly 8% in 2010 brought about a significant fiscal consolidation, which cut the deficit by 3% of GDP in 2011. These actions, however, have created a greater than anticipated economic slowdown in 2012, in which domestic demand has slumped and the Eurozone crisis has further dampened foreign demand. As a result, Poland will be unable to meet its deficit target of 2.9% of GDP in 2012 or reach its target balanced budget in 2015.

Euro-scepticism on the rise
The eurozone crisis is widely blamed for the lack of growth in the region because economies in Eastern Europe are open, export-oriented, and depend on eurozone countries in terms of FDI as well as exports. Popular perceptions of the EU in general and the eurozone in particular are increasingly negative. Governments, in response, are espousing more critical rhetoric. Timelines for adopting the euro have slipped everywhere except in Latvia, whose government is still pressing for eurozone entry in 2014. While this does not represent a decisive break with pro-integrationist policies, it has the potential to lead to less accommodative policymaking in the medium term as adverse conditions drag on.

Resistance to reforms
A prolonged period of austerity and low growth is taking its toll on public sentiment. Anti-austerity movements and popular opposition to structural reforms have been strengthening. In Slovenia, plans to establish a so-called bad bank and state holding company are now under threat of being rejected in a referendum, if the government fails to avoid it through negotiations or a decision by the constitutional court. More referendum initiatives are likely as the most controversial measures—pension and labour market reforms—have yet to be passed.

Hungary is another example of this trend. Given a lack of market pressure, the country’s leaders are unlikely to agree on the IMF/EU package they requested in November 2011. The right-wing government led by Fidesz has put populist measures and anti-EU rhetoric at the centre of its platform, and an agreement with the IMF/EU is even less likely because of elections slated for 2014. Even in the event of market pressure, animosity between Hungary and these two multilateral entities remains high, and Fidesz is unlikely to allow the IMF to monitor the government. Fidesz, meanwhile, will increase its power by finalising its takeover of the central bank in March, followed by the constitutional court later next year. The new central bank governor is likely to be a senior Fidesz politician or an ally of Prime Minister Viktor Orban. Economic indicators in 2013 will be broadly unchanged following a drop in GDP by 1%–1.5% in 2012. The key questions are how recession and deteriorating business conditions will translate into a loss in popularity for Fidesz, and how fringe opposition movements could forge an alliance (which is unlikely given the changes in the electoral law). The Orban government is likely to continue implementing extreme measures, as well as taxing foreign businesses to avoid structural reforms.

In contrast, a rupture in Romania’s relationship with its international donors is unlikely despite the government’s populist rhetoric. Prime Minister Victor Ponta, leader of the ruling centre-left Social Liberal Union (USL), has already indicated his intention to negotiate another stand-by agreement in early 2013 to replace the current one, worth €5 billion ($6.5 billion). The disparity between the USL’s rhetoric and actual policies suggests Ponta will broadly comply with donor expectations, even though he is expected to push back against some conditions. After all, he will need to deliver on at least some of his electoral promises.

A shift to the left
The austerity drive, lack of economic growth, unemployment, and social discontent continue to drive shifts in political power across central and Eastern Europe. The electorate is increasingly favouring social spending protections amid the protracted crisis. Two months ago, regional and senate elections in Czech Republic brought a decisive defeat for the ruling centre-right coalition, allowing Social Democrats to form left-wing coalitions with communists in many regions and achieve an absolute majority in the senate. Social Democrats also ousted the centre-right coalition in Lithuania in recent general elections. The crumbling popularity of austerity-linked centre-right parties is likely to persist in forthcoming elections in other parts of the region. Even the dominant centre-right Citizens for European Development of Bulgaria is losing ground and will likely need a coalition partner if it is to stay in power after June’s elections. In Hungary, even though polls show a small surge from the left, the right-wing Fidesz is still likely to win a second term in 2014.

Romanian general elections will take place on 9 December and be dominated by the austerity theme. The Liberal Democratic Party, which presided over harsh austerity measures enacted over the past three years, and its new Romanian Right Alliance are trailing far behind their rivals in polls. The USL, in power since May, has been campaigning on an anti-austerity platform and is likely to win an absolute majority in parliament.

Together with Estonia, Poland is an exception to this trend. Poland’s high growth figures throughout the crisis have helped the ruling centre-right Civic Platform (PO) coalition remain relatively popular. The PO’s approval ratings have dipped since their high of 40% after the elections in October 2011; however, the party still leads in the polls. The opposition has been unable to break the PO’s grip on moderate centrist voters, and the left has posed no real challenge, leaving only the centre-right Law and Justice Party to vie for power.

A MORE DIVISIVE POLITICAL ENVIRONMENT IN TURKEY

Following a period of relative stability, politics in Turkey is expected to become noisier in 2013 because of the ongoing process of revising the constitution and Prime Minister Recep Tayyip Erdogan’s presidential ambitions. Negotiations among the four political parties involved are expected to get more divisive, most likely resulting in the breakdown of the process in the first half of the year. Driven by Erdogan, a polarizing debate on the merits of a presidential system will dominate the policy agenda, with resistance escalating among the majority of the public and the opposition parties, as well as segments of the Islamic community. Meanwhile, necessary changes to tackle structural economic problems are likely to be side-lined in 2013. These include reforms to restrict the black economy, increase R&D and labour market flexibility, and improve value-added domestic production.

As local and presidential elections set for 2014 and parliamentary polls in 2015 approach, the government is likely to adopt an increasingly nationalistic tone regarding the thorny Kurdish question. At the same time, the Kurdistan Workers’ Party (PKK) has stepped up its violent insurgency. Hopes of a new round of negotiations between Ankara and the PKK are fading. After a slowdown in PKK activity over the winter, an escalation is expected in the spring. The government, however, will decline to take meaningful steps to resolve the Kurdish issue through democratic means in 2013.

The Turkish economy is set to grow by more than 4% in 2013, fuelled by domestic demand. And on the eve of elections, authorities will adopt a pro-growth stance. But excessive easing would undermine the country’s rebalancing, exerting upward pressure on still relatively high inflation and a large current account deficit (7.1% of GDP).