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Europe’s Year of Transition

Unlike 2015, the year ahead promises few large political events but some smaller number of ones that greatly matter to business and the markets.

Day-to-day politics will be preoccupied with the work lead up to 2017 elections in German, Italy and Great Britain.

The first thing to note when looking ahead to Europe in 2016 is that big and immediate crises will have been a trend of 2015. Rightly or wrongly, markets have the tendency to focus on big events – for example, this year’s early elections in Greece, or the many make-or-break meetings of the Eurogroup and the European Council. The next series of such large-scale events will take place in 2017 when the leaders of the Eurozone’s three biggest economies will all seek re-election: Matteo Renzi as the Prime Minister of Italy, Francois Hollande as French President, and Angela Merkel as German Chancellor. On top of this, in 2017, British voters will be called to the polls to decide which way to turn in the difficult relationship between Downing Street and the EU: should Britain, the bloc’s third-largest member, remain a part of the Union, or will it embark on a journey towards “Brexit”?

At first sight, 2016 appears to be nothing but a transitory year on the way to the all-decisive 2017. But while markets may indeed frame things this way, the logic of politics is different. Indeed, the outcomes of the four big polls of 2017 will largely be influenced by what happens over the 12 months ahead of us now.

What can the EU and the European Central Bank (ECB) do to help growth return to the Eurozone, and especially to the ailing French and Italian labor markets, thereby enabling the determined reformer Renzi and the embattled Europeanist Hollande to hold on to their posts? Can Prime Minister David Cameron maintain the grip on his rebellious backbenchers at home while also negotiating a deal with Europe that stands any chance of approval with British voters? And how much leeway will domestic German politics (as well as the need to constantly entertain President Vladimir Putin over Ukraine) leave the continent’s most influential politician, Angela Merkel, to steer all these debates at the European level?

Day-to-day politics in 2016 will determine the outcome of these questions in 2017. European politics in the 12 months directly ahead of us may offer a comparably smaller number of visible large-scale events, but they do matter greatly for businesses and markets.

Greece’s Less Risky Prospects

To understand how the 2016 political debate will differ from 2015, take a look at 2015’s most notorious European crisis country: Greece. As 2015 comes to a close, the country is still a member of the Eurozone, the country’s third bailout has been agreed and the ensuing snap elections have been held. What is ahead now is in many ways a return to the usual — certainly problematic, but less large-scale — trajectory we have witnessed in Greece for years now.

In 2016, program implementation will remain thorny, especially as trust between Athens and its lenders has fallen to a level where any sub-tranches of fresh funding will only be disbursed against prior progress on the domestic reform front. Rather than the outstanding events that took the country to the brink of an exit from the common currency, the biggest risk in 2016 remains delays to the implementation of specific reforms and bailout conditions on the ground. From there, a vicious circle ensues: falling government revenues and rising non-performing loans (NPLs) necessitate further budget cuts, with additionally negative effects on the growth outlook. This, in turn, requires further adjustment, and so on.

But with Greek Prime Minister Alexis Tsipras and his reformed SYRIZA committed to the country’s euro membership, it is unlikely that Athens and its creditors would once more embark on a path of direct, large-scale confrontation. Grexit is therefore unlikely to become a real option again soon.

New EU Terms for the UK?

Another example of the importance of 2016 politics for the following year is the British referendum on EU membership. Following his landslide victory in the general elections this year, Cameron will remain both emboldened by his strong performance and under pressure from his eurosceptic backbenchers. Appeasing the latter will be tough, especially because the British Europe question is not simply about the referendum. Before the Prime Minister can go to the country, he will need to negotiate something that can be put before voters. That conversation, which Cameron will have to have in Brussels, will take place over 2016.

Britain will hold the EU Council presidency between June and December 2017; therefore, conducting a referendum in the second half of 2017 would hardly be suitable. Any window for negotiations between the UK and Europe, therefore, is narrow. Cameron will likely be a tough negotiation partner for his European colleagues. On the flipside, his European partners will have their own domestic political rationales to take into account. Facing Cameron are Hollande and Merkel, who will both be eager to keep any debate about the EU’s future architecture out of their 2017 campaigns. On either side of the Rhine, conversations about Europe don’t sell well these days, as witnessed by the surge in the eurosceptic vote in France and the unpopularity of Eurozone bailouts in Germany.

As the UK’s most committed European partner, Berlin is principally more sympathetic to many of the British demands than are the French government or convinced federalists like EU Commission President Jean-Claude Juncker. This even counts for controversial issues such as welfare and fiscal transfers. But as a leading EU country, and with a domestic political culture built around consensus rather than confrontation, Germany has always had a much more pragmatic stance on Europe than the UK. The Germans know that the European project can only be maintained if all sides step back from maximum demands – precisely the message that Cameron has so far found so difficult to convey at home.

This means that there is room for concessions on the margins – potentially on partially repatriating some minor powers on business regulation – but not on fundamental principles such as the freedom of movement, regardless of private sympathies in parts of German politics. On the key issue of migration, the Germans have in the context of the 2015 refugee crisis sided with Juncker’s proposal for a European quota solution for the Schengen area (of which the UK is not part), despite Berlin’s initial rejection of the plan. Progress on largescale changes like Berlin and Paris’ sudden alignment with Juncker’s ideas was brought about, as always, by a joint and coordinated Franco-German proposal. This already highlights the limits of what the continent will be willing to offer to Britain in 2016.

Specifically, Merkel and Hollande will remain unwilling to change EU treaties, given that the French constitution would require a referendum to do so, while a public vote would probably be politically unavoidable in Germany as well after years in which the country has taken on financial obligations on an unprecedented scale in the context of the Eurozone crisis. Winning such votes would be an almost impossible endeavor. This will likely make it tough for Cameron to live up to a key eurosceptic demand at home: boost the role of the UK House of Commons.

Parliament is also a place where the Brexit debate is likely to further intensify in 2016. The government is already struggling to retain its position in the driver’s seat, having lost a vote in the House of Commons on the referendum in 2015. Amid a rebellion among Cameron’s own, eurosceptic backbenchers, Parliament decided that his government will not be allowed to make public announcements or spend financial resources on campaigning during the last 28 days ahead of the referendum. The backbenchers had feared that the cabinet would use public resources to campaign in favor of British EU membership. As Labour’s internal shift to the left – with the election of staunchly far-left Jeremy Corbyn as the party leader in September 2015 – is threatening to push the party into outright irrelevance, the risk of a pro-Brexit vote may rise even further during 2016.

From a business perspective, the risks are clear. If Britain were to decide to leave the EU, this would trigger an economic shock, including a likely GDP contraction on the back of Britain relegating itself to a mere member of the Single Market. Moreover, with migration a key driver for British euroscepticism, the likely ensuing decrease in foreign nationals in the UK would take away a group that has so far greatly benefitted the UK economy, both as workers and consumers. Meanwhile, the repercussions beyond the UK would be no less severe. Berlin’s position would be especially altered as Brexit would lead to a weakening of the liberal camp within the EU, leaving Germany almost alone in facing a strengthened bloc of often protectionist and pro-red tape members led by France.

While respective concerns may motivate some European concessions, the British Prime Minister is likely to present new terms of EU membership to the UK public that involve only marginal changes to the current framework. The exact shape and form of these new terms will be hammered out over 2016.

Merkel’s Election Prospects

But the British EU referendum will not be the only case in which a 2017 decision will prompt talks and negotiations already in the year ahead. The case of the German 2017 Bundestag elections may be less obvious, but it will nevertheless already begin to influence European policy-making in 2016. Commentators highlighting the predictability of the 2017 polls, with Merkel poised to sail to an easy victory, do have a point. However, her dominance over German politics is no coincidence but instead the result of strategic positioning. This was clear from the way in which she won her last landslide victory in 2013, when her Christian Union only narrowly missed an absolute majority in the Bundestag: back then, Merkel virtually put policy-making in the Eurozone on ice for months, successfully preventing uncomfortable debates in the run-up to the vote at home.

2016 will be no different. Merkel start to display a limited appetite for bold policy-making in Brussels. At home, a looming series of second-order elections will also begin to limit the scope for political action. Beginning in March 2016, various parts of the German electorate will be called to the polls roughly every six months, including in regional elections in Baden-Wurttemberg, the core constituency of Merkel’s Christian Union, and in North Rhine-Westphalia, Germany’s single largest regional state.

Merkel’s prospects for a fourth term in office are excellent, as the Social Democrats appear unwilling to utilize a center-left majority to replace her. But the German chancellor will not jeopardize her chances for re-election by bold action in Europe or at home; Merkel knows all too well that Germans support her precisely for her limited activity amid low unemployment and healthy economic data.

EU Build Out limited

The degree to which German and French domestic electoral constraints have already been factored-in by decision-makers in Brussels should be obvious to anyone who has read the much-anticipated Five Presidents’ Report. This 2015 paper offers a road-map for institutional build-out and closer integration in the Eurozone, compiled by the heads of the European Commission, the European Council, the Eurogroup, the European Parliament and the European Central Bank.

Not only has the idea of treaty change been delayed until after the crucial polls in 2017, but the proposals for immediate steps to be achieved in the meantime are mainly a collection of existing policies that are supposed to be strengthened, among them macroeconomic supervisory tools such as the European Semester. But on tricky issues – those entailing the transfer of either financial or decision-making resources to Brussels – progress will remain very limited. This counts, for instance, for the construction of Europe-wide financing mechanisms for banking resolution and deposit insurance. With immediate market pressure off, the appetite for further integration will remain limited.

Central Bank Ready to Do More

That market pressure is off is of course thanks to the one institution that has proven capable of putting an effective floor under the worst of the crisis and preserving the unity of the currency bloc: The European Central Bank (ECB). Ever since 2012, the ECB’s promise of large-scale bond buying has been respected in the market, as no trader ever dared to test ECB President Mario Draghi’s assertion that he would not only do “whatever it takes” to defend the euro – but that “it will be enough.”

In a heroic fight, Draghi managed to save the euro while taking on both markets and skeptical euro members like Germany. But the more entrenched problems of weak growth, high unemployment, and political fragmentation appear to be beyond the central bank’s reach. The ECB launched its much-anticipated quantitative easing (QE) program in 2015, but despite some encouraging effects on the margins – bank-lending to the private sector seems to have picked up again – inflation expectations remain low, nowhere near the ECB’s target rate of 2 percent.

The bottom line is that the big decisions may only occur in 2017. But their outcome will largely be determined by European politics in 2016.

It is against this backdrop that one 2016 decision will occupy the space in the spotlight: when Mario Draghi launched his QE program in 2015, he promised to run it at least until September 2016 – or until inflation expectations come closer again to the Bank’s target. Throughout the second half of 2015, the central bank president has left no doubt that amid risks such as Fed tapering, Chinese growth problems, and global liquidity shortages, the ECB stands ready to do more. But what could and would an enhanced version of QE look like? This will be the debate for the first nine months of 2016.

A mere continuation beyond September 2016 may have already been priced in given the state of the world economy. But any conversation about expanding the asset types under consideration for ECB buying may lead back to the pre-QE debate: Southern European demands and ECB considerations may be met with public opposition in the north, and especially in Germany. Amid the flurry of regional elections in the Eurozone’s largest economy, these arguments may better manage to make themselves heard than before. While ECB activity remains a politically desirable path for Merkel, taking the pressure to act away from politicians, Berlin will be eager not to endorse Draghi’s plans too enthusiastically, while the ECB will watch its German constraints carefully.

The bottom line is that the big decisions may only occur in 2017. But their outcome will largely be determined by European politics in 2016. For businesses, the biggest risk in the coming year may be to assume that risk is off.