European reform efforts are fading and political risks rising: Moody’s

So far, structural reform has been limited at both national and euro area level, the Moody’s report says, and support for further reform is eroding. Additionally, the United Kingdom’s potential exit from the EU could create further obstacles to reform. As well, the ongoing refugee crisis “is a further source of disunity in the EU that adds another obstacle to longer-term integration within the euro area, impairing the currency union’s capacity to absorb shocks by increasing political tensions within and between member countries,” the Moody’s report says.

In the short term, however, the credit quality of euro area sovereigns is “supported by moderate economic growth and stabilizing debt-to-GDP ratios,” the report says. The main downside risk that Moody’s sees is the prospect of much lower than expected growth in China, which would damage the global economy. This is not, however, Moody’s base case.

“Moody’s expects growth across the euro area to be around 1.5% of GDP in 2016. While that is low by historical standards, it will support euro area sovereigns’ credit profiles over the coming year or so,” says Thorsten Nestmann, vice president and senior analyst at Moody’s, in a statement. “However, we see little upside to ratings, and a number of clouds gathering.”

In addition to the long-term political headwinds, the Moody’s report notes that debt loads remain stubbornly high in the region, and that the deleveraging process is being hampered by a combination of low growth and low inflation.

“We expect inflation to be around 0% on average in 2016 and to only gradually increase towards 1% in 2017. The longer inflation stays low, the longer the deleveraging process will take and the longer the euro area economy will be vulnerable to negative shocks,” adds Nestmann.