Eurozone Watch – Europe’s soft approach towards the periphery

by: Aline Schuiling

In this publication: The European Commission decided to postpone its decision about fines for Spain and Portugal until after the Spanish elections … while the countries were granted another year to lower their budget deficits to below the EC’s 3% limit … and Italy got some leeway to lower its debt ratio more slowly than planned. Although the EC’s approach will benefit economic growth in the short term, it might fuel euroscepticism in the core and could create doubts about debt sustainability in the longer run.

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Decision about punishment for Spain and Portugal postponed …

The European Commission postponed its decision about fining Spain and Portugal for missing its targets for the budget deficit until after the Spanish elections of 26 June. On top of that, both countries were granted an extra year to bring their deficits back to levels at or below the EC’s 3% limit. According to the EC’s Excess Deficit Procedure (EDP) Portugal should have met this target in 2015 already, while Spain’s deadline was one year later, in 2016. In contrast, Portugal’s budget deficit turned out at 4.4% GDP (the target was 2.7%) last year, while Spain’s deficit was 5.1%, well above the target of 4.2%. Considering that Spain has been in a state of political deadlock since December 2015 and that new elections will be held on 26 June the chances are very high that the deficit will remain well above 3% this year and in 2017. Indeed, care-taker prime minister Mariano Rajoy has recently promised another round of tax cuts if he were to be re-elected in June. In theory, both Spain and Portugal could be fined by an amount equal to 0.2% of their GDP according to the stricter rules and surveillance system for budgetary and economic policies that was established during the eurozone sovereign debt crisis in 2011-2012.

… while Italy is allowed some extra fiscal breathing space as well

Italy has not breached to EC’s rules for the budget deficit, but its government debt ratio has been persistently too high. It has been rising non-stop since 2007 and last year it increased to 132.7% GDP, up from 132.5% in 2014. According to the EC’s rules it should in contrast have ‘diminished by an adequate rate of 5% per year on average over three years’. Italy has now been granted some budgetary flexibility in that it is allowed extra fiscal room of around EUR 14bn this year, which is equal to 0.85% GDP. In exchange, the country has to implement a deficit reduction programme of at least 0.5% GDP next year, which is more than the 0.35% originally planned by the Italian government.

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Good for growth, but not without risks

The EC’s decision to give some extra budgetary breathing space to the countries in the periphery will be slightly supportive to economic growth this year. Following five years of severe austerity, budgetary policy in the eurozone as a whole was more or less neutral last year and will be slightly expansionary this year, with the structural budget deficit (the deficit corrected for the business cycle and one-off factors) for the eurozone rising somewhat. This positive impact could be marginally higher due to the EC’s decision. Still, the other side of the coin is that the EC’s soft approach towards the periphery might fuel eurosceptic sentiment is some countries in the core of the eurozone, which have their government finances in better shape. Also, if this ‘flexible’ approach of the Commission were to be maintained during the next few years, it might result in more fiscal slippage in high-debt countries such as Italy and Portugal, which might create doubts about debt sustainability in the longer term.