The continuation of a horrible year

The end of 2016 was heralded in the Western media as the finale to the Annus Horribilis.

Not surprisingly. The 2016 timeline of geopolitical events is dotted with the likes of Brexit, the U.S. presidential election, the Italian constitutional referendum and the collapse of the Renzi government in Rome, a narrow miss to populists in Austrian presidential contest and a failed coup, followed by a successful wave of political repressions, in Turkey. Greece, the permanently comatose patient of the EU, keeps coming up to the razor edge of yet another fiscal crisis. Italian banks remain undercapitalized and hemorrhaging assets. Deutsche Bank has steered from one crisis into another with no end to its legal and balance sheet troubles in sight.

All along, conflicts in Syria and Northern Africa, and the tsunami of related refugees flooding into Europe continue with little abatement. Frozen war in Ukraine still poises the risk of re-escalating into a full-blown military conflict. But even more ominous to the country and regional stability is the continued in-fighting within Ukrainian domestic politics and the unrelenting march of endemic corruption and oligarchic power struggles. In South China seas, two superpowers – the U.S. and China – are playing a dangerous game of cat-and-mouse.

The Middle East and Central Asia are now an arena for an extremely complex web of power plays: Egypt’s shifting position on Syria pits it against Russia and Iran and into the arms of Saudi Arabia, while Turkey is hell-bent on carving out a solo play in the war on ISIS. The long-simmering conflict between Armenia and Azerbaijan almost got reignited earlier in 2016 and the war is currently being held back by a precarious rebalancing by Russia and the U.S. that, in the end, is likely to create more tensions than it is to resolve the decades-long stalemate. Uzbekistan, a long-term stable autocracy, has slipped into the highly uncertain regime-change mode with the death of Islam Karimov. The recent election of Shavkat Mirziyoyev suggests an interim presidency, unless the new president pushes aggressively against the existent oppositional currents amongst Uzbekistan’s power brokers.

Latin America provided more political shocks. Brazil, suffering from a horrific recession and political upheaval went through a rather disorderly impeachment of President Dilma Rousseff that culminated in the new government triggering waves of protests in the wake of its efforts to contain fiscal deficits. Haiti and Venezuela are – for different reasons – two ready-to-implode failed states. Venezuela is now an official pariah state within the region’s trade and economic cooperation block, MERCOSUR. Paraguay remains under political control of the judicial-parliamentary coup-installed government, with occasional flaring up in industrial unrest and opposition protests. The latest crisis – a constitutional challenge to stop the presidential candidacy of Fernando Lugo, Paraguay’s leftist president ousted by a parliamentary coup in 2012. In Honduras, where constitution bans presidential re-election, the incumbent President Juan Orlando Hernandez has just announced that he “accepts” the candidacy to run for re-election with his conservative National Party. The contest will be held in 2017 and the presidential decision is already creating centrifugal forces of discontent amongst the opposition and within the ranks of the ruling power brokers – the very same forces that led to Hernandez’ rise to power on foot of the U.S.-backed 2009 military coup that ousted former President Manuel Zelaya on the very same grounds – the accusations that he was trying to seek re-election. Meanwhile, in Bolivia, a water emergency declared over the worst drought in 25 years, is likely to get worse in 2017-2018. The drought is displacing thousands of farmers and rural residents, and is driving mass protests in cities. In November, the government was forced to declare a state of emergency over water supplies. Panama has been hit the tax dodging scandal earlier this year and put simply, 2016 was a year everyone would like to forget. Except those of us who are tracking economic and political trends into 2017. For 2017 is likely to be a logical extension of the year passed.

Apart from continuing build up in geopolitical pressures across the main fault lines of 2016, the new year is likely to see the return of yet another long-forgotten predicament: the euro crisis. This time around, the catalyst for the blow-out will not be the old and predictable source of drama, Greece, nor the minnow of 2011 collapse, Cyprus, but a combination of uncertain electoral politics in the Europe’s core states, plus the continuing acceleration of the banking crisis in Italy.

Italy is a grandmother of Europe. Third largest economy of the euro area and its second largest manufacturing hub, the country also is the largest debtor in the block. As of today, it has a constitutional crisis, a political crisis and a slow-motion train wreck of a banking crisis.
In the world of highly interconnected political and financial risks, the problem of Italy is the problem of Europe.

Currently, some 20 percent of Italian banking loans are classified as being troubled. In simple terms, these loans are either non-performing or are performing under severe strain. One shock – either with regard to interest rates or with regard to economic growth – and the whole house of cards can come tumbling down. At the end of 2015, Italian banks held 40 percent of all troubled and bad loans in the euro area, to the total estimated amount of some USD400 billion. Since then, the problem got worse. Assuming the rate of increases in bad and troubled loans on Italian banks balance sheets remained at its 3-year average (a conservative assumption, given rapid acceleration of banking sector troubles in the second half of 2016) by the end of 2016, Italian banking system should be holding some 50 to 52 percent of all troubled and bad loans in the common currency area, up to US$500 billion.
Interestingly, recent research from Banca d’Italia found that stock of corporate bad debts – with ratings close to or at default – amounted to EUR143 billion at the end of 2015, with roughly EUR90 billion of this debt due to the effects of the two recessions that hit Italy between 2008 and 2015. In simple terms, the failure of Italian banking sector to swiftly deal with business insolvencies is now coming home to the country banks.

The banking system sits on top of an iceberg of hidden corporate insolvencies. Since the start of the global financial crisis and the great recession, Italian industry lost some 25 percent of its productive capacity, helping keep unemployment rate well above the euro area average even as labor force continues to shrink due to demographic aging.

All in, NY Stern’s v-Lab ranks Italian banking sector as the seventh-largest systemic risk pool in the world and the third largest in the euro area. In terms of leverage risk, six Italian banks are ranked amongst top 10 highest risk banking institutions in Europe. The table below summarizes risk metrics for top 20 Italian financial institutions. See chart.

Given the state of Italian economy, its political dynamics and the lack of measurable improvements in the financial sector, Italy is currently on a steady march toward an exit door of the euro house. And unlike the Brexit or the Greek crisis, an Italian meltdown will threaten the very foundations of the EU. The reason for this is that Italy simply cannot be contained in a way the rest of the Euro “periphery” was cordoned off through monetary policies and IMF-involving lending programs. Nor can it be argued that, as in the case of the U.K., Italy was somehow not systemic to the very foundation of the EU.

Worse, the channels for contagion from a flaring up of the Italian crisis to the rest of the European core are already set. France is going into a Presidential election, due in April 2017, with populist Marine Le Pen likely to face a conservative Francois Fillon in this contest. Neither will be a good news for European statists. Holland is set to vote in a general election a month before the French presidential poll. The Party of Freedom, led by Geert Wilders is likely to gain significant support, as the election is likely to follow the same pattern as the 2016 referendum on the EU trade pact with Ukraine. And then there is the German federal election which must take place before the end of October 2017. Here, Angela Merkel is widely expected to lose her popular mandate. Full two-thirds of Germans oppose a fourth term for Merkel, according to early December polls. The anti-immigrant Alternative for Germany (AfD) has been steadily gaining ground, having moved from being a marginal party to securing 15 percent support.

These are the known unknowns in Europe. But there are also unknown ones. No one in the mainstream media is talking about the Hungarian presidential election coming up in 2018, with campaigning likely to start in late 2017. Viktor Orban is running on his highly popular platform of anti-immigration and EU-skeptic policies blending economic populism and nationalism. In Czech Republic, with legislative elections coming up in 2017, some 59 members of the lower chamber of the parliament currently come from EU-skeptic or communist parties. The risk is that these movements can gain further seats in 2017. Once again, outside Prague, no one in the media is addressing this threat.

Earlier this year, Sweden’s Timbro Institute published its annual research on the impact of authoritarian populism in Europe. Quoting from the report: “In Europe as a whole authoritarian parties won 18.7 percent of the votes in the last elections. The increase between 2014 and 2015 was the single biggest yearly increase.” If the trend continues into 2017-2018 elections, by the end of the next year, European politics will see support for authoritarianism rising to around 22 percent. And if the trends in current public opinion polls for 2H 2016 holds, that number can rise to 30 percent.

The political risks are engendering policy stalemate across the continent that increases economic and financial uncertainty. While the recovery from the great recession appears to be relatively robust – based on the headline GDP numbers – there is a dire lack of growth in productivity, stubbornly high youth unemployment and stagnant private incomes. Adding to these woes lack of growth in global trade implies that the euro area recovery is not sustainable in the long run. This conjecture is supported by the anemic private capital investment. In fact, while Spain and Ireland – two “peripheral” euro states with stronger recovery – are experiencing capital inflows, Portugal and Greece, plus France remain stuck in a low investment cycle, while Italy is seeing capital outflows.

In this environment, Italy’s membership within the euro area represents an insurmountable obstacle to the resolution of its financial and fiscal crises. And ditching this obstacle is becoming less and less costly – politically and economically – as the EU approaches the point of no return for traditional centrist and pro-European elites. Spurred by the victory of Donald Trump and the outruns of the Brexit and Italian constitutional referenda, Italian voters only need a slight nudge from the likes of France or Holland to tip the political scales in favor of the key opposition parties that are advocating a public referendum on the country membership in the euro.

Of course, things might play out a bit differently in Europe in 2017. There might be a belated rush toward the center in terms of political movements, and Brussels and Frankfurt might find some new tools to stave off the implosion of the Italian banking. And we might see the Greek crisis finally put to rest. And the raison d’etre for populist right – the migration crisis – abating under the weight of time, seas and Turkish suppression. We might even see the proverbial pigs sailing through the skies.

The balance of risk assessment, however, suggests that the Annus Horribilis of 2016 is likely to be followed by the Anno Clades next.

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