Update: Southern Europe is where the EU crisis is emerging

The fallout from Brexit has now affected Southern Europe with Spain, Italy and Portugal experiencing economic problems that may force the EU into making several compromises. Spain and Portugal have failed to reduce their deficits in line with EU targets whilst Italy is sinking under the weight of bad debt. This crisis has angered Northern Europe who worry about the negative influence of these struggling countries upon the remaining member states particularly in the wake of Britain's exit. The EU will have to adopt short-term measures, foregoing long-term stability to achieve stability and continuity. If they impose harsh rules upon these states they risk alienating the rest of the bloc and create further uncertainty in financial markets.

The British vote to leave the European Union has begun to take a political and economic toll on the Continent.

Italy’s biggest banks, already weighed down by a crushing amount of bad debt, saw the value of their shares and stocks tumble in the referendum’s wake. Spain and Portugal, meanwhile, have failed to reduce their national deficits enough to meet EU targets, drawing the ire of Northern European countries that fear Britain’s departure will boost the influence of Southern Europe’s struggling states.

Neither of these problems is new for Europe, long split between north and south, but both will become more important — and more divisive — as Britain prepares to exit the union. To hold the crumbling bloc together, European officials will try to broker compromises as best they can, trading long-term solutions for temporary stability on the Continent.

Italy’s indebted banks

Over the past decade, sluggish economic growth, rising unemployment and a lack of reform have left Italian banks with some of the biggest amounts of bad debts in the European Union. Together, Italian banks hold some 360 billion euros ($398 billion) in loans that, in all likelihood, will not be paid back in full. These loans represent roughly 17 percent of the country’s total loans, compared to the EU average of about 6 percent. Though the Italian government created a special fund earlier this year to buy bad debt from banks in distress, its 4 billion euros are nowhere near enough to provide a sustainable solution for Italy’s foundering banking sector.

Two recent developments have added to Italian banks’ woes. The first is political instability, particularly ahead of the country’s referendum on constitutional reform, which will be held in late October or early November. Though the vote began as a decision about the constitution, it has evolved into a ruling on the Italian government’s performance after Prime Minister Matteo Renzi threatened to resign in the event that voters oppose his reforms. Should his proposals be rejected, Renzi’s administration will be dealt a heavy blow, opening the door to early elections. Opinion polls currently show that the anti-system Five Star Movement, which has promised to hold a referendum on Italy’s eurozone membership, is the most popular political party in the country. The fragility of the national government, coupled with the prospect of an electoral victory by the Five Star Movement, is raising concern among investors at home and abroad, cutting even deeper into Italian banks’ financial base.

The second development causing problems for Italy is the British referendum. After the vote’s results were announced on June 24, Italy’s stock exchange plummeted, and banks suffered especially steep losses. Monte dei Paschi di Siena, Italy’s third-largest bank, is in a particularly precarious situation. In the two weeks since British voters headed to the polls, the value of the bank’s shares has been cut in half. At the same time, the gap between Italy’s 10-year bond and its German equivalent (considered the safest in the eurozone) has also begun to widen; by July 5, Italy’s bond yields were higher than even those of Spain. In essence, this means that borrowing from financial markets is becoming more and more expensive for Rome. Since Italy’s debt-to-GDP ratio is second only to Greece’s in Europe, increasing borrowing costs could once again call into question Rome’s ability to pay off its debts.

From Italy’s perspective, the European Union should use the British referendum as an opportunity to introduce more flexibility, giving members room to spend and borrow while using more EU funds to invest in southern economies. France shares Italy’s view, but their northern counterparts, led by Germany, do not. The Germans are also skeptical of the Italians’ opinion that the Brexit is reason to bend the bloc’s rules on the assistance governments can give to their banks. According to existing EU regulations, the losses experienced during a banking crisis should be taken on by shareholders, bondholders and large depositors instead of the state. (The goal of this approach is to sever the link between banks and taxpayers, which lay at the heart of the eurozone’s previous banking crises.) But the Italian government believes that such a “bail-in” would be unpopular in the lead-up to the October referendum because it would force many households to shoulder the banks’ losses, in turn leading to widespread panic.

Anxious to avoid this outcome, Rome has asked Brussels to authorize the Italian state to intervene on the banks’ behalf, arguing that existing regulations make room for governments’ temporary assistance in the case of emergencies. Germany, however, has not budged from its position that the EU rules, which came into effect earlier this year, cannot be circumvented only six months after their implementation. Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem has backed Berlin as well, saying that the bail-in rules must be respected.

Deficits in Spain and Portugal

Northern Europe is taking an equally firm stance on the south’s high deficits. On July 7, the European Commission recommended the imposition of sanctions against Spain and Portugal for failing to take the action needed to adequately shrink their deficits. As of 2015, Spain’s deficit hovered around 5.1 percent of gross domestic product while Portugal’s remained at 4.4 percent — well above the commission’s targets of 4.2 and 3 percent, respectively. EU members will make the final decision on whether to impose the sanctions later this month.

Deficit-related sanctions have long been a controversial topic in the European Union. Since the start of the eurozone financial crisis, countries in Northern Europe, including Germany, the Netherlands and Finland, have been wary of being too lenient with their southern peers, fearing that flexibility would reduce the incentive to undertake much-needed structural reforms. But the British referendum has added a layer of complexity to the issue. Northern Europe is now concerned that the loss of Britain, a market-friendly and liberalizing state, will shift the balance of power on the Continent toward the interventionist economies in the south. From the north’s perspective, allowing Spain and Portugal to go unpunished after stalling on reforms would create a dangerous precedent of acquiescing to the south. Countries in Southern Europe, on the other hand, believe the European Union should show greater empathy toward their plight if it hopes to stop the rise of Euroskepticism across the Continent.

The electoral calculations being made within individual EU states are also shaping how this disagreement plays out. Germany, for example, will hold its general elections in 2017, and Chancellor Angela Merkel’s Christian Democratic Union (CDU) is facing mounting competition from its Euroskeptic rival, Alternative for Germany (AfD). Though AfD has recently focused on its anti-immigration agenda, the party is also critical of Mediterranean Europe and has called for the creation of a “northern eurozone” that would include only the fiscally responsible countries of the north. Permitting Italy to bend the rules in its banking sector or tolerating a slower deficit reduction in Spain and Portugal would give the AfD more ammunition to criticize the German government as having a weak stance toward the eurozone’s southern members.

To some extent, the CDU has to worry about competition from its coalition partner, the center-left Social Democratic Party (SPD), as well. European Parliament President Martin Schulz, an SPD member, has used the Brexit referendum to justify his proposal for the creation of a federal EU government, a step that several CDU members have openly criticized. From the CDU’s point of view, European citizens want a Continent that runs more efficiently, not one that is hemmed in by even more layers of bureaucracy. By standing against the federalist agenda of Schulz and the SPD, the CDU is attempting to set itself apart from the center-left before the general elections while warning Southern Europe against introducing measures that share financial risk within the Continent.

But Southern Europe is making electoral calculations of its own. France is set to hold its presidential election in April 2017, and the country’s Socialist government will probably lower taxes and boost spending to increase its popularity. Should Spain and Portugal be sanctioned for their high deficits, France may not be far behind. Paris is also likely concerned about the rising Euroskepticism in Southern Europe, which has been partially driven by Brussels’ strict and unwavering posture toward the region’s stumbling economies. France’s National Front and Italy’s Five Star Movement are already performing well in the polls, and the perception among voters that a weak European Commission is merely submitting to German pressure would do little to improve the bloc’s declining popularity in the south.

Europe’s dilemmas

These debates reveal the dilemmas currently facing the European Union. If the European Commission allows the Italian government to help its banks, politicians in Northern Europe will interpret it as yet another example of southern states bending the rules in their favor. But if Brussels does not reach some sort of agreement with Rome, the Italian banking crisis that would likely ensue would pose an additional threat to the Continent, which is already struggling to digest the results of the British referendum. After all, the deterioration of Italy’s banking sector could destabilize other banks in the eurozone, including Germany’s. In early July, the International Monetary Fund warned that of all the world’s biggest banks, Germany’s Deutsche Bank was the riskiest. Though German banks are not currently in danger, Berlin probably is not keen to create a banking crisis in Italy that could become a contagion to the rest of the currency area.

The situation with southern deficits is similarly tricky. Should the European Union choose not to sanction Spain and Portugal, the credibility of the bloc’s fiscal rules will be undermined, and Northern European governments will likely come under attack from the Euroskeptic opposition or competitors within their own parties. But the use of strong punitive measures against EU members only weeks after the British referendum would create additional uncertainty in financial markets and do little to renew popular support for the bloc. The last thing the European Union needs right now is to alienate its remaining members.

And so, the European Union will have one option: to make difficult but necessary compromises. With regard to Italy’s banks, Rome and Brussels will reach a deal to allow some degree of state intervention and avoid the bail-in mechanism, perhaps in exchange for banking reforms. Meanwhile, the bloc will probably punish Spain and Portugal with symbolic sanctions, rather than fines of up to 0.2 percent of their GDPs. Madrid and Lisbon, for their part, will likely promise to continue reducing their deficits, even though their domestic needs will prevent them from introducing deep reforms for the foreseeable future. These compromises will by no means solve the European Union’s problems, nor will they heal the growing rift between north and south. Instead, they will address the bloc’s most immediate threats and temporarily stave off conflict, which may be all the European Union can really hope for at this point.

This article was published with the permission of Stratfor, the Austin, Texas-based geopolitical-intelligence firm.