Political Shift in Germany Poses 2019's Premier Risk to Euro Exchange Rates

German politics

Image © Stefan Yang, Adobe Stock.

- Political anxiety could weigh on Euro into mid-year

- Political shift in Germany could end ‘money train’ to the south

- Italian economy could yet be Eurozone flashpoint

The Euro could face downside risks in the middle of 2019 and potentially even another existential crisis if the outcome of European elections impact the fiscal and monetary relationship between Germany and Italy.

This is the view of a leading economist at the Hudson Institute think tank, in Washington DC who believes the proverbial "money train" that travels between Germany and Italy could ultimately be discontinued.

Brendan Brown, an economist at the Hudson Institute, warns European parliamentary elections in May 2019 could trigger another crisis centred on Italy, should the elections collapse the fragile centre-ground coalition currently in power in the German Bundestag.

The coalition is composed of Angela Merkel’s CDU and her centre-left SPD allies. The SPD is seen as an unreliable partner in the coalition and a poor showing in the European elections could be the ‘last straw’ leading them to pull out.

“Italy is very much dependent on what happens in Germany and the wider issue of European monetary policy. There is a risk scenario that the Merkel government falls in the middle of the year,” says Brown. “If that happens the question mark will be does a post-Merkel perhaps very weak coalition government have the backing to support Draghi to do ‘whatever it takes’ to support Italy, or does that essential train of money into Italy come into question, and if it does come into question could that runaway decline in Italian markets continue?”

A wave of populist anti-establishment politics has challenged the centre-ground of European politics recently, with more radical parties taking power, not least in Italy where the new Liga-Five Star coalition government has recently agreed a budget that will increase the country's debt burden substantially.

If the anti-establishment trend is repeated in Germany, as many fear might, it could lead to a more protectionist bias and less help for their Italian neighbours.

Merkel’s CDU party is waning in popularity with under 30% of the vote, indeed “barely” that much, says Brown.

“When you look at the opinion polls and see that the CDU still under 30% - barely - the greens on 20%, and the SPD on 15% or 16% you really have to ask how tenable her coalition is with the SPD,” says Brown in an interview with Bloomberg News.

The Italian economy is currently at risk from a combination of low growth and a rising debt burden. It registered zero growth in Q3 and has the second largest debt burden in the Eurozone after Greece.

If Eurozone interest rates were to raise substantially on the back of increasingly restrictive monetary policy at the ECB, the cost of servicing Italian debt would rocket which would in turn prompt a potential sovereign debt crisis.

If German support for easy policy at the ECB were withdrawn it could cause another debt crisis even more severe than the Greek debt crisis of 2011. Germany has long been opposed to ECB's rock-bottom interest rates owing to the negative effects they have on Germany's long-suffering savers.

In the case of Italy, any sovereign debt crisis could be even larger than that of Greece as its economy is 9 times larger. The fallout for the Euro would almost certainly be negative.

In the short-to-medium term a stronger Euro could itself hasten the onset of crisis. At present the Euro is still relatively weak and this has supported Italy’s vulnerable economy by giving Italian exports a competitive edge, but this is unlikely to last, as the ECB continues with its strategy of tightening monetary conditions and aims to raise interest rates in the third quarter of 2019.

This will likely have the side-effect of pushing up the value of the currency, damaging Italy’s export competitiveness in the process.

There may also be added pressure from the U.S. for the ECB to adopt policies which increase the value of the Euro too, says Brown, since the U.S. has been especially critical of the Eurozone’s large trade surplus and would want a stronger Euro to offset its comparative trade advantage.

A trade war could also adversely affect Italy, however, the US could also come to rely on European surpluses to fund its twin deficits, suggesting a potentially stronger negotiating position for Europe than Brown implies.

The think-tank economist’s analysis suggests that whilst Italy’s debt markets may have stabilised following the end of the standoff with the EU over Italy's budget, fresh risks remain from broader political cross-currents within Europe, especially its strongest economy Germany, and these could have profound knock-on effects on Italy as well as the wider Eurozone.

The end result suggests a risk the single currency could peak mid-year before possibly declining in H2.

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