Friday, April 17, 2015

Vorsprung durch Grexit

The German political and bureaucratic class is preparing for Grexit, and thinks the risks are containable. Angela Merkel should resist this emerging consensus in Berlin, and make every effort to keep Greece in the euro.

The brinkmanship between Greece and the euro group is entering a decisive phase. Amidst escalating threats – default by Greece, financial cut-off by the eurozone – the most pressing issue is whether Germany would allow a Greek exit from the eurozone, either on purpose (‘Grexit’) or by accident (‘Greccident’). Most of the key decision-makers in Berlin say that unless Greece starts implementing real reforms, it should leave the euro. But Chancellor Angela Merkel needs to consider the geopolitical dimension, as well as pressure from the US and the ECB to keep Greece in – in addition to the unwillingness of the Greek people to leave. For Europe’s sake, she should go the extra mile to avoid Greece departing the eurozone. But the odds of Grexit happening are rising.

Until the Greek government comes up with a serious plan for structural reform, Germany will continue to block further money for Athens. Given that Greece is finding it increasingly difficult to repay debts, and pay salaries and pensions, a Greek default and possibly exit from the euro is looking more likely with every passing week. “We have never been closer to Grexit, and we are close,” said one senior official in Berlin. Officials say they cannot detect any desire from the Greek government to commit to reforming labour markets, fighting corruption, improving tax collection, strengthening fiscal discipline or attacking vested interests. “Faced with Grexit, Tsipras might do a U-turn, and perhaps change his coalition partner. But we have no idea what he’ll do,” said an official. The German government does not know whether Tsipras is playing chicken and waiting for Germany to blink, or simply unable to control the many factions in his government. Or even whether he really wants to keep Greece in the euro.

Germans who favour Grexit argue that it would be good for the Greek economy. Greece currently has an output gap of around 13 per cent of GDP, according to the OECD; the economy is running at well below its economic potential. Autonomous Greek monetary policy and a weaker currency could therefore speed up the recovery, and avoid the further harm to the economy that a long depression would inflict. But a prerequisite for such a successful outcome would be that the exit be properly managed, with the help of the ECB, and with bridge financing for the Greek government from European institutions, to limit short-term disruptions. What is more, the new Greek monetary policy authorities would need to build up trust quickly, to avoid continued instability and high inflation.

Proponents of Grexit tend to underplay the potential downsides. Leaving the euro is more difficult than giving up a currency peg: millions of contracts would need to be rewritten, and foreign debt (in euros or dollars) would balloon when measured in new drachma, forcing companies and especially banks into default. Inflationary pressure would be strong, hurting consumers. It is not a given that, post-Grexit, the Greek financial system would be stable and inflation manageable. The deeper institutional and structural problems of the Greek state and economy would remain unresolved, leading to slow growth after the economy had returned to its potential output.

Some German officials predict that Grexit could be a gradual, drawn out process. Greece would not be pushed out following a decision by the European Council or European Central Bank, they think. Instead, the government would run out of money and have to issue IOUs as a parallel currency, while imposing capital controls and intervening heavily in the banks to prop them up. This would not be a stable situation; the economy would not grow under such a scenario. As a result, the government would probably think it best in the long run to take the plunge and devalue by formally leaving the euro – then at least the economy would regain monetary autonomy, making it easier to boost demand.

German officials are sanguine about the consequences of Grexit. “It would not be problematic for our budget, financial sector or economic growth,” said one. “And one positive result could be that other countries would do their homework and become more disciplined” – an argument that the German council of economic experts has recently made, too. Tax payers are liable for around €240 billon of Greek debt, of which Germans could lose €70 billion. The officials think that would be manageable.

Most officials think the risk of contagion is minimal. “Spain, Portugal and Ireland would be alright because they have done their homework,” said one. Although Italy and France have not done much homework, he thought their fates – and whether they reformed – would be unrelated to what happened in Greece. In any case, Greece was a special case, he said – there was no longer much bank exposure to it.

He acknowledged that if the financial markets asked for a premium before lending to other eurozone countries as a result of Grexit, Germany would have to consider further eurozone integration, such as tighter fiscal discipline or the introduction of ‘economic reform contracts’. “In that case we would need to move fast, so hopefully we would be able to avoid changing the EU treaties.” He may be too nonchalant: if the markets were panicking about the euro’s viability it is highly unlikely that modest steps towards policy-integration or risk-sharing would reassure them.

Is there a difference between the approaches of Finance Minister Wolfgang Schäuble and Angela Merkel? Officials say that on the fundamentals, there is not, even though Merkel’s rhetoric is softer. They both want to keep Greece in the euro, but not under any circumstances, and not if the Greek government cannot get its act together. Some of their officials take a harder line. “As an economist, I am not sure if Greece should stay in the euro; it is structurally uncompetitive and could become a second Mezzogiorno,” said one. He noted that Latvia, Lithuania, Spain and Ireland had known they needed to change, and therefore taken painful decisions, but he thought that sometimes pressure to reform did not work. He worried that keeping Greece in at all costs would undermine European cohesion.

Inevitably, Merkel thinks more about the geopolitical context than Schäuble. She is under discreet pressure from the Obama administration, which worries about the risk of a Greek-Russian rapprochement. The IMF, the European Commission, France and Italy also want to find a way of keeping Greece in. A lot of European governments would be reluctant to make a visible write-down of their loans to Greece. The SPD – Merkel’s coalition partner in Berlin – says in private, though not in public, that Germany has overdone the austerity during the eurozone crisis, and it is against Grexit. Another reason for keeping Greece in the euro is that if it grew strongly outside the currency, anti-euro voices elsewhere would grow bolder.

The ECB, too, remains opposed to Grexit. For now it is taking a hard line on Greece, limiting the ability of Greek banks to fund the Greek government. Yet it was the (still untested) promise of Mario Draghi to do “whatever it takes to preserve the euro” that ensured the single currency’s survival in the summer of 2012. The ECB and others worry that in a future political crisis in another member-state, financial markets might start doubting the commitment of the core countries and the ECB to preserve the integrity of the euro. At that point, the eurozone would be thrown back into the self-fulfilling crisis mode that policy-makers have scrambled to leave behind during the past few years. The ECB would not risk the unravelling of that promise over Greece, unless put under considerable political pressure.

Within Greece, too, it should not be forgotten that a recent poll found 84 per cent of Greeks in favour of keeping the euro. Syriza does not have a mandate to negotiate an exit, and its high approval ratings could soon tumble if the country took steps to prepare for leaving the euro, such as capital controls and bank closures. It may well be that a Greek government which embarked on a path towards Grexit would fall before the event.

One key point for Merkel, apparently, is that Germany should not be blamed for Grexit. One visitor reports her line as being: “If Grexit happens, people will see the cause was that Greece failed to do its homework, not that we withheld solidarity.” In this blame game, Merkel is currently succeeding. It is astonishing how those who agree with Greece that the eurozone has overdone the austerity – like France and Italy, and to some degree the European Commission and the IMF – have been alienated by Syriza’s chaotic and confrontational style of governing, its extreme rhetoric and its inept diplomacy. As a result, Paris, Rome and Brussels are not speaking out on Greece’s behalf. And there are some eurozone governments, notably Finland, the Netherlands, Slovakia and Estonia, which are encouraging Germany to take a hard line. Even the Spanish and the Portuguese, having ‘done their homework’, are in this camp.

But this blame game could easily shift if Germany facilitated or actively pushed for a Greek exit. Not only the US, the IMF and the international press but also probably France and Italy would ultimately criticise Germany for its handling of the euro crisis – during which Greece has suffered from a depression of similar magnitude to that of Germany in the 1930s, the eurozone economy has failed to recover to its pre-crisis size, and the political extremes in Europe have gained much ground. The US has long understood that in its role of the transatlantic alliance’s hegemon, it must accept some costs for the greater good of the alliance’s stability. It expects as much from the EU’s hegemon, Germany, and in the event of a Grexit would hold Berlin largely responsible.

The threats from the Greeks to default on eurozone rescue loans, and from the Germans and their allies to push the Greeks out, are part of a game of brinkmanship: both sides need to be seen as fighting for their voters. A smooth and early agreement would raise suspicion among both sides’ electorates that their politicians could have achieved more from the negotiations. This does not mean, however, that neither Greece nor Germany will step over the brink.

There is no doubt that many powerful voices, within Europe and further afield, will try to prevent Grexit. But Berlin plays a decisive role in eurozone crisis management, and in Berlin key decision-makers believe that Greek membership of the euro is becoming unsustainable. Germany’s friends should help it to see the bigger picture.

Charles Grant is the director and Christian Odendahl is the chief economist at the Centre for European Reform.

Wednesday, April 15, 2015

Not in front of the MPs: Why can’t Parliament have a frank discussion about the EU?

Britain’s Parliament does a poor job of examining EU business. Some simple reforms would improve the way that it scrutinises European legislation.

The British prime minister, David Cameron, wants to make the EU more democratic. National parliamentarians, in his view, understand citizens’ concerns better than MEPs who deliberate in far-away Brussels and Strasbourg; national parliaments should therefore play a greater role in EU decision-making. However, Cameron’s argument would carry more weight if UK parliamentary scrutiny were improved.

The European scrutiny committee of the House of Commons recently questioned whether Cameron means what he says about involving Parliament more in EU law-making. This committee examines EU documents and the British position on them. So if it says the government is not serious about giving Parliament a bigger role in EU affairs, its views deserve attention.

The rule in Britain is that, with a few exceptions (set out in a parliamentary resolution), the government does not agree to any EU proposal until Parliament has expressed a view through the scrutiny process. Each year the European scrutiny committee sifts around 1000-1100 EU documents, including both European Commission legislative proposals and non-legislative texts (such as Commission consultation papers). The committee can either clear them from scrutiny or ask ministers for further explanations.

Whenever the scrutiny committee considers the documents “politically or legally important” it can request a debate on them on the floor of the house, or in one of the Commons’ three EU committees. Each of these committees is responsible for a range of topics; for example, ‘EU Committee A’ deals among other things with energy, climate and environment, food and rural affairs. The three committees do not have a permanent membership. The committee of selection nominates MPs to serve on these committees whenever debates are requested.

In the March 2015 follow-up report to its own 2013 inquiry into the system of scrutinising EU affairs in Parliament, the European scrutiny committee criticised the coalition government for failing to pursue a fruitful dialogue with MPs over European policy. The committee complained that its requests for debates with ministerial participation had fallen on deaf ears in Downing Street.

Six of the plenary debates the committee requested in the current Parliament – just dissolved, pending May’s general election – have not been held. One of the unfulfilled requests was for a debate on the freedom of movement of EU citizens – a central issue in British politics and the general election.

The government’s response to the committee’s criticism has been to argue that few MPs are interested in the EU. William Hague, the Leader of the House (the minister responsible for arranging the government’s business in Parliament), told the committee in February 2015 that the only parliamentarians to request EU debates were members of the scrutiny committee. In other evidence to the committee’s inquiry, the government pointed out that on one occasion, an EU committee meeting on EU law-enforcement co-operation lasted only 13 minutes, because it attracted so little interest among MPs. Only one of the 13 MPs who attended the meeting put a question to the minister present.

Hague has a point. However many debates are scheduled, Parliament can only hold the executive to account if MPs understand the issues. But most MPs have neither the time nor the inclination to learn how the EU works. The EU is seen as too technical and complicated, and many MPs doubt whether voters would reward them for understanding its mechanics. In the 2014-2015 parliamentary session, the scrutiny committee’s overall attendance rate was 48.7 per cent. Julie Elliott, a Labour MP who was shadow energy minister in the last parliament, Linda Riordan MP (Labour) and Stephen Gilbert MP (Liberal Democrat) did not turn up for a single meeting.

Even if all the members of the scrutiny committee had a 100 per cent attendance record, they would need help from other committees to do their job effectively. This is not always forthcoming. To support the scrutiny process, the committee can request an opinion from a departmental select committee, but the latter is not obliged to provide one. Some select committees, like the home affairs and justice committees help, but others are less inclined to do so.

The overall level of knowledge about the EU could improve if the House of Commons spread EU business more equally among MPs. The lower house of the Dutch parliament, for instance, has a decentralised system in which sectoral committees are responsible for scrutiny of documents in their areas of responsibility. But asking Commons’ committees, which already have a full agenda, to take on extra responsibilities for EU scrutiny would not necessarily improve the current situation: committees could well prioritise domestic issues over EU business. The House of Commons should rather take a step-by-step approach which would give MPs time to learn on the job. The European scrutiny committee sensibly suggested that each of the departmental select committees appoint a European rapporteur. The justice committee and the business, innovation and skills committee, which have already nominated such rapporteurs, could serve as an example to others. European rapporteurs could serve as contact points for the chair of the scrutiny committee. They would also ensure that whenever the European scrutiny committee requested an opinion from a select committee on an EU document, it would get an answer. In the next parliament, all departmental select committees should appoint at least one European rapporteur.

MPs should talk to their colleagues in the House of Lords more often. There is a wide gap between MPs and members of the House of Lords in terms of their interest and expertise in European affairs. Peers who sit on the EU select committee and its six sub-committees (jointly referred to as the House of Lords EU committee) often have a better understanding of the EU than their Commons counterparts. Some, like Lord Kerr of Kinlochard (the chair of the CER’s board), worked for the British government and participated in formulating its European policy; other peers worked in the European Commission or served as MEPs. Without the constituency responsibilities of MPs, peers have more time to conduct in-depth inquiries into the EU and British policy on it.

Today, MPs and peers rarely exchange views on the EU. Nor do they co-ordinate their positions on Commission proposals. Since 2006, national parliaments have been able to provide the Commission with direct feedback on its new proposals and consultation papers. After pro-Europeans lost referendums in the Netherlands and France on ratifying the EU constitutional treaty in 2005, the European Commission realised that it needed a dialogue with national parliaments on EU business; it hoped that this would narrow the gap between national and European politics. The House of Lords has grasped the opportunity but the House of Commons has been reluctant to engage in such a dialogue with the Commission. Since December 2009, after the Lisbon treaty entered into force, parliaments have also been able to object to the Commission’s legislative proposals when they think that member-states can better tackle the subject matter themselves (the so-called subsidiarity principle). The House of Commons makes use of this procedure more enthusiastically than the House of Lords: in the years 2012 and 2013 the House of Commons questioned eight of the Commission’s proposals on subsidiarity grounds; in the same period the House of Lords raised objections to only four of them. This lack of co-ordination between the houses weakens Westminster’s ability to get the Commission to take on board British concerns.

MPs and peers should establish a joint committee on the future of the UK’s relationship with the EU, to provide parliamentary oversight in the event of a future government trying to renegotiate the terms of the UK’s EU membership. There are precedents, in the joint committees on human rights and on national security strategy. Such a committee should not replace the existing European scrutiny committee in the Commons or the EU committee in the Lords but rather complement their work. Normal EU business would carry on, despite the government’s efforts to renegotiate the terms of British membership. A joint committee could help to ensure that parliamentarians in both houses were equally well-informed and could contribute fully to a discussion of the UK’s relationship with Europe.

British parliamentarians should make better use of the experience of their colleagues in the European Parliament. The UK national parliament office in Brussels organises joint meetings for MPs, peers and British MEPs twice a year. This is not often enough to support effective co-operation on European affairs. In the German Bundestag and the Polish Sejm (the lower chamber of the Polish parliament), MEPs can participate in meetings of the EU affairs committees. But in the House of Commons only MPs can take part and speak in the scrutiny committee or on the floor of the house; MEPs can only contribute if the scrutiny committee invites them to give evidence as part of an inquiry. It would therefore be difficult to copy German or Polish practice in the UK. Individual MPs, however, should make more use of their party channels to make contact with British MEPs. MEPs could help them to understand the legislative process in Brussels, and in particular in the policy areas that the British care the most about.

Parliamentarians can do a lot to help themselves, but there also are things the British government should do to facilitate Parliament’s knowledge of and interest in EU affairs. The scrutiny committee sensibly proposed that the incoming prime minister allocate sufficient time for debates in the Commons on EU matters, within a month of a request from the committee. MPs also complained that the government refused to circulate to Parliament classified or sensitive EU documents which were relevant to the scrutiny process. The new government could organise informal briefings for MPs from the scrutiny committee and peers from the EU committee on sensitive topics. The government has held such briefings on EU proposals for international sanctions, but only for peers. Briefings should take place on so-called Privy Council terms, whereby parliamentarians promise not to reveal what they learn during the meetings.

The new government should also reinstate regular Commons debates on European Council meetings, before they take place. These were abandoned in 2010 after the Conservative-led government took office. David Cameron has usually reported back to the Commons after EU summits. If the British government wishes to renegotiate the terms of UK membership, it will be up to the European Council to decide whether to consider its proposals for reform, or not. MPs should be able to discuss this process and provide their own input before each summit.

Rather than blaming each other for Parliament’s ineffective contribution to EU policy, MPs and ministers should accept that improving parliamentary scrutiny of EU affairs requires a joint effort. MPs need to be better prepared for discussions on the UK’s approach to the EU. Any British proposal for national parliaments to have a stronger voice in the EU will be more credible if the prime minister of the day is prepared to discuss EU business more openly in Westminster.

Agata Gostyńska is a research fellow at the Centre for European reform. This insight is part of on-going research supported by a grant from the Open Society Foundations.

Friday, April 10, 2015

The slow dance between Minsk and Brussels

The crisis in Ukraine is making Belarus more dependent on Russia. But it has also made the Belarusian leadership keener to balance its close ties to Moscow with a warmer relationship with Brussels.

Most Europeans think little about Belarus, a country of ten million people that nestles between Russia, Ukraine, Poland, Lithuania and Latvia. It has been politically stable for a long time: Alexander Lukashenko was first elected to the presidency in 1994, and is virtually certain to win the next presidential election, in November. But even though the authoritarian political system seems immutable, the economy and the foreign policy may be less so. The EU needs to wake up to the geopolitical opportunities that could arise in Belarus.

Lukashenko has skilfully managed the Belarus-Russia relationship, accepting Moscow’s lead on many but not all issues, and flirting with the EU when Russia’s embrace threatened to become suffocating. With some reluctance, Belarus has joined the Moscow-led Eurasian Economic Union (EEU), on the understanding that Russia will continue to provide cheap energy. But Belarus has still not recognised the independence of Abkhazia and South Ossetia, as Russia requested after its war with Georgia in 2008. And Lukashenko’s line on Crimea is that Belarus recognises Russia’s annexation de facto – but not de jure.

The war in Ukraine and Russia’s economic crisis have created new strains in a Belarusian economy that was already fragile. Belarus has traditionally relied on export industries like lorries and tractors, but these have been slowly losing competitiveness, as wages – largely set by the state – have risen much faster than productivity.

In recent years, excess consumption has contributed to a large current account deficit, which reached $5 billion, or 6.7 per cent of Belarus’s GDP, in 2014. The problems in the Russian economy – the market for around half of Belarus’s exports – have worsened the current account. The collapse of the Russian rouble meant that Belarusian exports to Russia became uncompetitive. Russia’s accession to the World Trade Organisation (WTO) in 2012 had already hit Belarus by allowing goods from other parts of the world to compete against Belarusian products in the Russian market. The shrinkage of the Ukrainian economy – another important export market – has been an additional blow to Belarus.

In recent months, the government has slowed the growth of demand, hoping that this will help the current account to rebalance. It devalued the currency by 40 per cent at the end of last year, in an attempt to maintain exports to Russia, but the result has been inflation that is now approaching 20 per cent. The Belarusian economy may shrink this year. Officially, unemployment is negligible, but it is becoming a problem and many factories are working only a few days a week.

Belarus is habitually short of the foreign currency reserves that may be needed to plug the current account deficit, repay foreign loans or manage the exchange rate. They currently stand at only $4.6 billion. Every year Minsk asks Russia for loans, and sometimes receives them, but in March, when it asked for $2 billion, Moscow offered only $110 million. The IMF recently sent a mission to Minsk but is unlikely to provide major credits because the government will not commit to privatisation or other structural reforms – such as liberalising prices or cutting subsidies for utility bills.

Belarusian ministers say they know they need to embrace the kinds of structural reform that the IMF demands – and in particular to curb the role of the state, which controls more than 70 per cent of output. But they are reluctant to move quickly, lest reform trigger social instability in the run-up to the presidential election. They are particularly wary of privatisation, pointing to the not entirely happy experiences of Russia and Ukraine: the sale of state assets could allow Russian oligarchs to become established in Belarus. Nor is the government enthusiastic about allowing Western firms to take control of key companies.

Belarus’s economic weakness increases its vulnerability to Russian pressure – and the latest proposal from Moscow, which has not gone down well in Minsk, is for the EEU to become a currency union. Russian subsidies to the economy, in the form of cheap oil and gas, have been worth at least 10 per cent of GDP in recent years (Belarus’s main export to the EU is refined oil products, made with cheap Russian oil). Although the drop in the oil price has diminished the value of the subsidy, Belarusians know they cannot stray too far from Russia’s gravitational field.

Nevertheless, within official circles there are divisions on how far Belarus should lean westwards. First deputy foreign minister Alexander Mikhnevich told a recent international round-table in Minsk that Belarus had made a conscious choice to integrate with both the Eurasian Economic Union and the EU, in search of economic relations with the widest possible range of countries. There are various views on how much the economy should liberalise – with the liberalisers, it seems, not winning the argument at the moment. The officials who want to be a bit less dependent on Russia tend to be the same ones who favour some economic opening.

Some senior figures in Minsk acknowledge that the EEU – whose other members are Armenia, Kazakhstan and Russia, with Kyrgyzstan due to join soon – is not really working. There is free movement of labour among its members. But more than 600 products are currently exempt from the EEU’s free trade provisions. There are countless non-tariff barriers and many parts of EEU treaty will not apply till 2025. Recently, without consulting the Eurasian Economic Commission, which manages the EEU, Moscow blocked imports of many Belarusian products – such as meat, fruit and vegetables. This was to punish Minsk for taking advantage of Russia’s ban on certain EU goods by sending large quantities of them into Russia, labelled ‘Belarusian’. In their more candid moments, officials complain that the Russians only follow the EEU’s rules when they suit Russia. Nevertheless everyone understands the implicit bargain with Russia: Belarus accepts the EEU in return for cheap oil and gas.

Events in Crimea and the Donbass have perturbed Belarus’s rulers. They worry about the ‘Putin doctrine’ – that Russia reserves the right to intervene outside its borders to protect ethnic Russian and Russian-speakers. So Belarus’s leaders have given a new priority to improving ties with the EU, to balance Russia’s influence. The EU moves slowly but is now – with the encouragement of the Obama administration – starting to respond.

The EU’s institutions and key governments are in broad agreement that they should seek closer links to Belarus, with a view to lessening its dependence on Russia. This geostrategic approach means the EU will focus somewhat less on human rights. Officials from Minsk and Brussels now meet each other regularly. Belarus’s main demand is that EU sanctions be eased – more than 200 individuals (including Lukashenko) and about 20 companies are blacklisted by the EU on account of human right violations. Brussels’s main demand is that the remaining political prisoners be released (depending on who is counting, there are between three and six of them).

The Belarusians have a particular grievance with the EU. They need to refinance a $1 billion international bond issue that matures in August, and also wish to issue new bonds. But they are barred from the market by Euroclear, the Brussels-based clearing house for international bonds, which interprets EU sanctions to mean that Belarusian issues are prohibited. EU officials say the sanctions should not prevent bond issues and believe that they can fix the problem.

Some opposition activists in Minsk fear that the West will ‘Azerbaijanise’ its relations with Belarus – meaning that it will ignore human rights for the geostrategic gain of strengthening Belarusian independence. But much of civil society would welcome a rapprochement between Minsk and Brussels, in the hope that this could lead to a softer regime, and allow Belarusian NGOs greater access to Western funding and advice.

EU officials are quite optimistic about the possibility of modest change in Belarus, particularly after the presidential election in November. They say that the ministries are comparatively well-organised, efficient and uncorrupt – and sometimes easier to deal with than the government in Ukraine. But this positive mood would soon end if – as has happened in the past – the authorities cracked down on the opposition before or after the presidential election.

If Lukashenko maintains a relatively soft touch, the EU will do a certain amount to help Belarus – even without the release of political prisoners. The two sides have begun a dialogue on the economic modernisation of the country. They have agreed to restart a dialogue on human rights that met on only one previous occasion, in 2009. The EU could assist Belarus’s entry into the World Trade Organisation by forging a bilateral deal with it on WTO issues. It could expand the modest role of the European Bank for Reconstruction and Development in Belarus, and allow the European Investment Bank to operate there.

Much more would happen if the political prisoners were freed. The EU would then lift sanctions. It would make Belarus a full member of its Eastern Partnership (alongside Armenia, Azerbaijan, Georgia, Moldova and Ukraine), thereby giving it access to several sorts of EU funding. Brussels would probably negotiate something similar to the ‘enhanced partnership and co-operation agreement’ that it initialled with the Kazakh government in January.

This slow dance between Minsk and Brussels has begun despite the Ukraine crisis having damaged the EU’s brand in Belarus. The fighting in the Donbass made Belarusians fear that progress towards Europe could lead to chaos. One recent opinion poll showed that 55 per cent of Belarusians view Russia favourably, against 30 per cent for the EU (according to some estimates, two thirds of Belarusians watch Russian TV, which is very biased to Russia’s point of view, and about a third watch Belarusian TV, which is rather less biased in Russia’s favour). But this has not deterred Lukashenko and his ministers from seeking to use the EU as a lever to curb their economic and cultural dependency on Russia.

Since the annexation of Crimea, Lukashenko has tried to encourage a greater sense of national identity, for example by promoting more use of the Belarusian language. He has emphasised his role as a ‘peacemaker’ – hosting the summits which led to the two Minsk agreements on the Donbass – who is neither in Russia’s camp nor the West’s. He has even spoken of the army’s capacity to transfer troops from the west of the country to Vitebsk (in north-east Belarus), which implies a potential threat to the east. Opinion polls suggest that nearly half of Belarusians resent the Russian military bases in their country. And a recent argument over the Belarusian Orthodox church, which comes under that of Russia, annoyed some Belarusians. The Russian church replaced a respected head of the church in Minsk with a Russian who has little feel for the country.

The country’s sense of identity is certainly weak, even compared to Ukraine. Much of it is negative: Belarusians think they are not Russian, not Polish (Poland dominated the country for more centuries than Russia has done) and not Western. A lot of people probably care more about their economic prospects than national feelings. But the Ukraine crisis has given a fillip to some Belarusians’s sense of national identity, in the sense that they do not want to be subsumed into Russia.

The EU should seek to engage not only civil society but also President Lukashenko’s regime. This could help to strengthen the country’s independence, encourage the government to treat NGOs and the opposition more kindly, reduce Belarus’s isolation and make it a little more European. Such outcomes, though far from certain, would be a worthwhile achievement.

Charles Grant is director of the Centre for European Reform. He recently took part in a study trip to Belarus, organised by the European Council on Foreign Relations.

Wednesday, April 08, 2015

Security in the age of austerity: You get what you pay for

Europe’s neighbourhood is too dangerous for decisions on defence budgets to be left to austerity-minded finance ministers. The UK should set a good example.

The EU is in a dangerous neighbourhood, but shrinking European defence budgets suggest that finance ministries either have not noticed or do not care. According to the Stockholm International Peace Research Institute (SIPRI), from 2004 to 2013 defence spending in Europe fell by 6.5 per cent (in constant dollar terms); in some countries, including the UK and Italy, it fell by more than 10 per cent. Over the same period, Russia's defence expenditure more than doubled, and China's rose by 170 per cent. Saudi Arabia is now spending more on defence than the UK.

At the NATO Wales Summit in September 2014, the alliance's member-states agreed that they would "aim to move towards the existing NATO guideline of spending 2 per cent of GDP on defence within a decade". Since then, countries like Belgium and Italy have announced further cuts. Across Europe, defence spending in 2013 (according to NATO figures) averaged around 1.6 per cent of GDP. Only Estonia, Greece and the UK spent 2 per cent or more.

Some European politicians have begun to discuss the threats that Europe faces and the need to invest in countering them. The EU high representative for foreign and security policy, Federica Mogherini, has started work on updating the EU's 2003 security strategy (see Rem Korteweg’s insight of January 19th). Britain's foreign secretary, Philip Hammond, spoke at the Royal United Services Institute on March 10th of the threats to the UK from terrorism and Russia. President Bronisław Komorowski of Poland told the German Marshall Fund's Brussels Forum on March 22nd that the post-Cold War peace dividend had run its course. But what will Europe do to respond?

Prime Minister David Cameron vocally supported the NATO 2 per cent target at the time of the NATO summit. But the UK is likely to undershoot it by 2017, if not sooner. To disguise this, government ministers have been trying to include other spending (especially on the intelligence services) under the heading of 'defence'. The Chancellor the Exchequer, George Osborne, repeatedly avoided endorsing the 2 per cent figure during an interview on March 19th, saying only that the Conservative Party was "committed to keeping our country safe". In election campaigns, the Conservatives have often portrayed themselves as supporters of strong defence; but this time they are trying not to talk about it at all. The Labour Party is poorly placed to exploit this: Shadow Chancellor Ed Balls has suggested that a Labour government would also cut defence spending, though by less than the Conservatives.

The UK's position is bad news for several reasons. First, Britain has traditionally been the strongest link between the US and Europe in the defence and security fields. Now Britain seems to be adopting bad European habits. From President Barack Obama downwards, publicly and privately, the Americans have been critical of the trend of declining defence spending in the UK. Senior Americans like the former defence secretary Robert Gates have long warned that Europe cannot continue to benefit from US defence spending while doing little for itself. If the US cannot even rely on the UK, the risk that America will reduce its commitment to European security will grow.

Second, cuts in the UK's defence capabilities hit the Franco-British relationship, which is central to any serious European defence co-operation. The UK and France provided both the political impetus and military muscle for operations against Colonel Qadhafi in Libya in 2011. But the UK's role in French operations in Mali and the Central African Republic since then has essentially been limited to providing air transport. Paris knows that it cannot lead European defence efforts by itself. French officials have privately expressed strong concerns about the effect of likely budget decisions on the UK's force structures and therefore on its ability to co-operate with France. They are also worried that defence budget cuts, like the 2013 parliamentary vote against intervening in Syria, are signs of a growing British isolationism.

Third, British ministers will no longer have any credibility when they press other European leaders to spend more on defence, if the UK itself is heading in the opposite direction. All governments in Europe are under pressure to reduce expenditure; for most, with honourable exceptions like Poland, it is politically easier to cut defence budgets than health and welfare. Britain may encourage a downward spiral in defence spending in Europe.

Some EU leaders will be happy if the UK stops nagging them to do more on defence. But Commission President Jean-Claude Juncker was wrong to tell Welt am Sonntag on March 8th that “military answers are always the wrong answers”. Sometimes only effective military action can create the space to settle conflicts politically. By repeating the mantra that “there is no military solution” in Ukraine, the West has handed the initiative to Putin, who is ready to impose one. Andrew Wilson of University College London said memorably at the beginning of the Ukraine crisis that the EU “took a baguette to a knife fight”. A frank debate about European defence and security needs to acknowledge that the EU does not just need soft power tools like trade, aid and the rule of law if it is to ensure stability and progress in the neighbourhood. Europe may keep a baguette in one hand; it needs a sharp knife in the other.

Juncker was also wrong to suggest that Europe needed its own army – not just because the idea energises British eurosceptics in a sensitive pre-election period; but because institutions and processes cannot substitute for defence capabilities and political will. Having a European operational headquarters is of no use if there are too few forces to command and no consensus on what to do with those forces that exist. The EU can do more, however – if allowed by the UK and others – to help rationalise European defence markets, ensuring that the money that is available is spent efficiently; and to encourage its member-states to work together better on defence. There are good examples of countries agreeing to share capabilities, rather than duplicating them, among the Benelux and Nordic countries. But Europe needs to get beyond delivering the same output for smaller input, and increase both. That should be the focus of the European Council’s discussions on European defence in June, and of NATO’s spring ministerial meetings.

The next British government also needs to recognise the European dimension of defence and security policy. Britain faces larger and more diverse threats than in 2010 when it published its last national security strategy. But whatever Britain spends on countering them, the impact will be greater if the rest of Europe takes defence more seriously. A good starting point for the government that wins May’s election would be to reinforce Franco-British co-operation, to reassure France that the UK will remain a reliable defence partner. Then these two countries should persuade European finance ministers to stop budgeting on the basis that the world is at peace and defence spending is a luxury.

Ian Bond is director of foreign policy at the Centre for European Reform.

The low-hanging fruit of European capital markets

The planned capital markets union in Europe faces many obstacles. Commissioner Hill was right to start with the lower-hanging fruit but it will not help the eurozone in the short term.

Europe’s economy is too dependent on bank finance. A greater reliance on capital markets would help to boost the region's economic growth and resilience in future financial crises. To this end, the European Commission is aiming to create a capital markets union (CMU) in an effort to lower Europe’s dependence on bank finance and encourage the integration and deepening of its capital markets. But there are plenty of obstacles. Jonathan Hill, the EU’s finance commissioner, is sensibly focusing on the lower hanging fruit. But even these ‘early action’ measures will take time to implement, and as such will not improve Europe’s short-term economic prospects.

Contrary to the US, banks provide the bulk of financing to businesses in Europe. To some extent, this reflects the fact that US firms are on average larger: almost 60 per cent of American employees work for firms with a staff of more than 250; the corresponding figure in Europe is just a third. Participants in capital markets are less willing to invest in smaller firms, because it is relatively more costly to acquire the information needed to determine the risks of lending to them. Banks, with their closer relationship to customers, usually possess that information. Europe's bank dependence also reflects underdeveloped capital markets in Europe.

One problem with bank lending is that it tends to be pro-cyclical, growing strongly during booms and contracting during busts, thus amplifying the business cycle. There are two reasons for this. First, a financial crisis leads to losses and reduces a bank’s capital. Since banks have to finance a share of their loan book with their own capital rather than with deposits or bonds, they need to rebuild their ‘capital ratio’, which often leads them to curtail lending. Second, regulation tends to tighten after crises: often regulators demand that banks finance a larger share of their loan books with their own capital, or change the amount of assets that banks need to hold to remain liquid. Such changes in regulation often lead to further cuts in lending.

To some extent, pro-cyclical regulation is inevitable, but it is more painful in a bank-based economy. Since the crisis, European firms have struggled to access funding because the region’s banks have reined in lending and capital markets were underdeveloped. Regulation was also tightened unduly, for example regarding securitisation. And monetary and fiscal policy failed to offset the negative impact of pro-cyclical bank lending on the economy. Some of these mistakes are being corrected: macroeconomic policies have become less contractionary; and regulation has been relaxed in areas where the post-crisis response went over the top, though arguably not enough.

A fully-fledged CMU would broaden the funding base for firms and infrastructure projects, making the European economy less bank-dependent and more robust. Larger and deeper capital markets would also help the European Central Bank (ECB) to conduct monetary policy: when a central bank lowers interest rates, there are two ways through which they can be transmitted to firms, via bank interest rates and via the cost of funding on capital markets. Moreover, the ECB would have a wider choice of assets (beyond government bonds) to buy in future ‘quantitative easing’ programmes.

However, a fully-fledged CMU requires politically and legally difficult measures like the harmonisation of insolvency, corporate and tax laws – which will take years to implement, if they are ever agreed at all. What is more, the reform momentum is currently strong and should not be spread too thinly over too many projects. The Commission is therefore right to set out three priorities for early action.

First, it wants to make it easier for firms based in one member-state to find investors in others. This requires that information about companies be easily accessible and in a form that analysts all around Europe understand. The prospectuses, the key documents that contain information about an asset such as a corporate bond, are costly to produce and need to be harmonised and simplified. Credit scores should also be made easily available and comparable across the EU.  The Commission is calling for a consultation on the existing prospectus directive and credit scores framework to start the reform process. It also wants to support the growth of the so-called private placement markets in which medium-sized companies can market bonds in volumes that would be too small for public offerings.

Second, the Commission aims to rebuild the European market for securitisation. Securitisation allows banks and financial markets to work together: banks have superior knowledge of local small and medium-sized enterprises (SMEs) and households, and can provide loans to financially sound borrowers; financial markets are eager financiers of such loans but only if they come in the right shapes and sizes. Securitisation allows banks to bundle loans together, and sell tranches to investors. Banks therefore have an incentive to extend more loans if they can sell bundles of them; participants in financial markets, including pension and insurance funds, can invest in SMEs and other assets that are too small to invest in individually; and the ECB has a large asset class that it can buy in its monetary policy operations.

Securitisation has an image problem as it is seen by many in Europe as a cause of the financial crisis. But just as Greek public finances were not the reason for the euro crisis, securitisation was not the reason for the 2008-9 crash: highly leveraged banks, overly complex securitisation, faulty risk models and a run on the refinancing markets of banks and shadow banks all worked together to create a perfect storm. Simple securitisation, on the other hand, was largely blameless. This is especially true in the EU, where the default rate of all ‘structured finance products’ was only 1.6 per cent between mid-2007 and mid-2014, compared to almost 20 per cent in the US. The key is to make the process of securitisation transparent and comparable across the EU. This is what the Commission aims to help achieve, and has started a consultation process on the issue.

The last ‘early action’ aims to boost long-term investments, especially the use of European long-term investment funds (ELTIFs). In essence, ELTIFs are a new regulatory class of funds which allow issuers to ‘lock up’ investors’ money for a long time, and market them across Europe. The aim is to make it easier for capital to flow across borders into long-term projects such as infrastructure. Here again, the Commission is consulting on how to support the use of these instruments.

These three measures are realistic first steps: they focus on relevant issues (access to funding, securitisation and long-term investment); and they cover areas where there is a role for the Commission to drive the process forward. Moreover, the Commission has a powerful ally in the ECB, especially on securitisation, and the support of the German and British governments. But even plucking the lower hanging fruit of the CMU will take time. For example, a new regulatory framework for securitisation could take two years until it is fully operational. The construction of the CMU is a long-term goal, not a solution to Europe’s immediate economic problems.

Christian Odendahl is chief economist at the Centre for European Reform.

Thursday, April 02, 2015

It’s the geopolitics, stupid: Why TTIP matters

A transatlantic free-trade agreement offers geopolitical benefits for the EU and the West. Supporters of a deal should make this point to claim back ground from the anti-TTIP camp.

Proponents of the transatlantic trade and investment partnership between the US and the EU, better known as TTIP, face an uphill struggle. Since negotiations started in 2013, the momentum has been with TTIP’s opponents. In Europe, they have mobilised support on social media, in parliaments and on the streets. Anti-TTIP protests shut down parts of Brussels in December. Nobody is demonstrating in favour of a deal.

TTIP’s advocates focus on the economic benefits: removing the remaining tariffs, aligning rules and standards, and reducing the paperwork required for doing transatlantic business should all lead to economic growth. But the full economic gains of TTIP are unlikely to be visible for several years after its implementation. In contrast, TTIP’s European opponents are exploiting protectionist, anti-American and eurosceptic sentiment. Critics such as trade unions and left-of-centre parties in Germany, France and Austria warn that TTIP is a secretive agreement that would force Europe to adopt inferior, American standards and would subordinate European democracies to US corporate interests. In response, the European Commission has decided to make many of its negotiating documents public. But that will not satisfy many opponents to a deal. Policy-makers and politicians must therefore focus their message on the undecided and those whose interests are not purely economic. While the economic benefits of TTIP are difficult to quantify, the geostrategic impact warrants closer attention in Europe.

A successful TTIP would bring Europe a number of strategic benefits. TTIP would allow the West to set global trade standards, strengthen Western diplomacy, improve European energy security and reaffirm transatlantic ties.

States use economic competition in pursuit of geopolitical objectives. After years of crises, low growth and political tension in the West, some countries in Asia, Latin America and Africa have become attracted to state-led economic models such as that of Beijing. China and other undemocratic emerging economies are therefore using their economic success as a springboard to political influence. Russia – though certainly not an economic success – has created the Eurasian Economic Union to look like a quasi-EU while promoting Russian political and economic interests in its neighbourhood. China is trying to set up alternatives to Western-dominated international financial institutions. The UK, France and Germany provoked American irritation when they announced that they would join the Asian Infrastructure Investment Bank as founding members. The US is concerned that the Chinese-led institution could be a means to circumvent the World Bank. The creation of a transatlantic trade bloc, however, would strengthen the Western economic model against the growing influence of undemocratic states.

Size matters, particularly in the geopolitics of trade. A new, seamless market based on a transatlantic tariff-free zone with a large degree of regulatory convergence would be a major attraction for others. If two economic giants agreed to align consumer safety, environmental, investment protection and other standards, their combined pull would bring others to copy these standards to gain market access. This would expand Western influence.

The EU and the US are negotiating TTIP mainly for the benefit of European and American citizens, consumers and companies, but the negotiators are surely aware of the deal’s potential impact on other trading partners. TTIP can become a new centre of gravity for global trade. Once an agreement has been reached, countries which already have far-reaching agreements with either the US or the EU should be offered access to TTIP. For some it would be relatively straightforward to ‘dock’ to the deal: Canada recently signed an EU trade agreement seen by many as a precursor to TTIP, and Norway is a member of the European Economic Area, and will have to accept TTIP’s standards. But for a country like Turkey it will be different. Turkey’s customs union with the EU does not include areas that are covered by TTIP, such as agriculture and public procurement: in these areas, US firms would have an advantage over Turkish firms in Europe. TTIP would therefore give Ankara a strong interest in deepening the customs union. The EU should talk to Turkey about TTIP, but Western concern over President Tayyip Erdogan’s creeping authoritarianism and his controversial foreign policies suggest the talks may be icy. The EU should use the additional diplomatic leverage TTIP would generate.

In spite of the attention it gets in Europe, Brussels and Washington are not pursuing TTIP in isolation. In Asia, the EU has bilateral free-trade talks with Japan, India and five south-east Asian countries underway, and it has concluded deals with South Korea and Singapore. The United States is negotiating a ‘mega-regional’ trade agreement, called the Trans Pacific Partnership (TPP), with eleven Pacific countries including Japan, Malaysia, Australia and Mexico. In a way, TPP is TTIP’s Pacific counterpart: it would also set regional standards and reduce non-tariff barriers. These twin trade talks involve more than a billion people in 40 countries producing 60 per cent of global GDP (based on 2013 World Bank figures). The WTO’s Doha round has been stalled, perhaps indefinitely, and the TPP-TTIP tandem could become the basis of a new-style multilateral trade accord, centred around Western leadership.

Despite their complementarity, TPP figures more prominently in Washington’s policy debate than TTIP: TPP is likely to conclude sooner, President Barack Obama has made it a central element in his Asia strategy, and some of TPP’s Congressional champions say that Asia is the future, while dismissing the eurozone’s glacial growth prospects. European diplomats in Washington should not enter both deals into a beauty contest, rather they should impress their combined strategic value upon the Americans.

TTIP would also set an example for other trade talks. The European Union and China are discussing an investment agreement, though the negotiations are slow-moving. Investment protection is one of the EU’s principal demands: it wants to see a Chinese economy that is more transparent, where the rule of law protects foreign intellectual property and investment. Herein lies the strategic value of a robust investor-state dispute settlement mechanism in TTIP – even if it is one of the main issues fuelling opposition in Europe. An EU-US deal with a strong clause on investor protection would make it more difficult for Beijing to push for an EU-China investment treaty without one.

Then there is TTIP’s energy dimension. The US fracking revolution has put the country on the cusp of exporting liquid natural gas (LNG). The EU thinks American LNG will help to diversify European energy imports and reduce reliance on Russian gas. A free-trade deal would allow EU gas companies to avoid the hassle of securing licences for LNG imports from the US government. This should be a compelling reason in favour of TTIP for those countries concerned about their dependence on Russia. Although some European leaders will have to do a better job at explaining one irony: why they are happy to import US shale gas, but unwilling to drill for it at home.

American oil also features in transatlantic energy discussions. Innovations like those that have spurred shale gas production have turned the US into the world’s largest producer of oil and refined petroleum products. But the US has banned crude oil exports since the 1973 oil crisis. While the European Commission would like TTIP to cover oil, Congress is hesitant to loosen its grip on this national treasure. Trade in crude oil would be a major boon for Europe, and EU negotiators should demand it: it would help European refiners and the petrochemical industry, improve European energy security and increase market pressure on other major oil exporters, particularly Russia. In the United States, a growing chorus is pointing to the benefits for US foreign policy of lifting the oil export ban.

A deal on TTIP would help to keep the US committed to Europe. NATO remains the bedrock of the transatlantic security partnership, but America’s strategic gaze is increasingly drawn towards the Far East. Most European defence budgets continue to decline. This makes US politicians more and more reluctant to invest in the NATO alliance. TTIP could be a ‘second anchor’ for US commitment to Europe. A deal would not be a substitute for NATO, but TTIP could offer Americans a persuasive economic rationale for continuing to support a strong transatlantic bond. Mike Froman, the US Trade Representative who negotiates TTIP, said in 2013 that a deal “would complement one of the greatest alliances of all time with an equally compelling economic relationship.”

But trade negotiations are hard and could drag on, or even fail. German Chancellor Angela Merkel and European Commission President Jean-Claude Juncker said on March 4th that a deal should be reached in 2015. The US negotiator said a deal should be done on ‘one tank of gas’, meaning within President Obama’s term in office. This may not be realistic. A delay is one thing, but if the two sides fail to reach a meaningful agreement, there would be a number of negative consequences.

Besides the West’s unity, the EU’s credibility as a global actor is at stake. Brussels sees itself as an economic power, not a military power. If anything, the size and depth of the European single market is a magnet of attraction for other countries; that gives the EU global influence. Investing in TTIP’s success but then failing to deliver it would be a blow to the EU’s geopolitical standing.

Should the negotiations collapse, mutual recrimination would lead to a deeper transatlantic divide. If TTIP broke down and TPP succeeded, it would cement America’s pivot to Asia and raise further doubts about Europe’s importance to the US. Moscow would see a collapse of the talks as a new opportunity to exploit, energising its anti-Western rhetoric. Beijing would still have concerns about TPP, but it would be relieved that Brussels and Washington could not impose their trade standards in unison. And finally, a failed TTIP would do nothing for the EU’s reputation in the UK and other free-trading member states. For Britain, in particular, this would be dangerous if the failure coincided with a referendum campaign on EU membership. Pro-EU Tories rely on Europe’s ability to negotiate important free-trade agreements as an argument for staying in.

Rem Korteweg is a senior research fellow at the Centre for European Reform.

Wednesday, March 25, 2015

A Marxist take on the 'Brexit' general election

The ideas of Karl Marx suggest that Britain’s general election will not define the country's relationship with the EU.

It is tempting to see the British general election, to be held on May 7th, as a pivotal moment in Britain’s relationship with the EU. If the Conservatives form a government, there will be a referendum on Britain’s EU membership by the end of 2017. If Labour does so, there will not. At the time of writing, the election is impossible to call, with both parties neck and neck in the polls, but neither likely to win enough seats for an outright majority.

Karl Marx’s theory of history should lead us to the opposite conclusion, however: that the election will determine nothing. “The mode of production of material life,” he wrote, “conditions the general process of social, political and intellectual life”: economic developments give rise to politics, not the other way round. And economics will determine the politics of Britain’s relationship with the EU.

The underlying problem is the eurozone, but not, as many argue, because it is more dirigiste than the UK. Those who believe that the Continent loves red tape have not noticed that, on average, eurozone member-states’ propensity to regulate their economies is now only slightly stronger than the UK’s, as measured by OECD indicators. The Juncker Commission’s agenda, which seeks to further integrate the supply side of the European economy, could have been written in Westminster (the absence of meaningful services liberalisation aside). Rather, the problem has been the eurozone’s macroeconomic policies since the crisis began in 2008, which derailed Britain’s hopes for an export-led recovery.

The eurozone’s crisis response was this: the periphery would regain competitiveness through falls in real wages by way of a prolonged period of high unemployment. This would not have been too harmful to British exports had the core provided an offsetting boost to eurozone consumption, but the periphery shouldered the burden alone. Monetary policy was kept tight, partly because the European Central Bank forecast that the economy would rebound and partly because quantitative easing was too difficult politically, at least until every other tool had been tried. The result: eurozone demand was so weakened that the value of British exports to the eurozone fell by 11 per cent in real terms from their peak in 2006 to 2013. The UK’s current account deficit ballooned to 4.4 per cent of GDP in 2014, even as British exports to the rest of the world grew quickly. The IMF forecasts the eurozone’s trend rate growth to be 1.6 per cent a year – far lower than the rest of the world. The consequence: Britain will continue the slow process of decoupling from the rest of Europe.

The idea that the opposed interests of capitalists and labour drives social change – and hence politics – was central to Marx’s theory. This is also pertinent to the ‘Brexit’ question. Business is largely in favour of staying in the EU, since investors hate uncertainty and they rightly fret about diminished access to the single market after withdrawal. Meanwhile, people who have less capital, either of the financial or human kind, are more fearful of the greater competition that arises from immigration and international trade.

Immigration from the EU to Britain is likely to remain high in the next few years, as unemployment will only fall slowly in many eurozone countries, and Italian and Spanish workers will continue to move to Britain in search of work. It is almost certain that the UK economy will grow faster than the eurozone, and its flexible labour market is easily capable of absorbing the current rate of immigration from the EU. But British workers are increasingly hostile to immigration, and, despite liberals’ best efforts to convince them that it is beneficial, this will make them more antagonistic to the EU.

Capitalists, on the other hand, see poor prospects for investment in the rest of Europe. While they are unlikely to want the costs of trade and investment with rich countries on Britain’s doorstep to rise, even as Britain’s economic ties with Europe become less important, their enthusiasm for the Union will wane. The current pro-membership coalition of multinational firms, half of the Conservative party, Labour and most of the smaller parties, bar UKIP, will weaken unless the eurozone becomes a faster-growing place. Big business will not become eurosceptic. But as Britain’s decoupling progresses, business will become less willing to forcefully challenge a future Conservative government that favours EU withdrawal.

If the Conservatives lose the election, the price of becoming next Tory leader might be to offer a more radical EU policy than Cameron’s. To win the leadership, candidates might be forced to demand a more drastic renegotiation than Cameron’s moderate set of reforms, or even promise to campaign to leave the EU in a referendum. Conservative party members are more eurosceptic than its MPs, and they get to decide who becomes leader if more than one candidate stands. And when the Conservatives next win a parliamentary majority the pro-European coalition will have been weakened by slow eurozone growth, and continued neurosis about immigration.

There is a glimmer of hope for pro-Europeans. Marx’s great mistake was to fail to consider that governments would establish welfare states, as well as public education, health, and progressive taxation systems to prevent inequality from destroying the capitalist order. So far, in times of crisis, the eurozone’s leaders have done just enough to hold the bloc together. It will probably require another recession to force them to tackle the currency union’s design flaws. And unless the eurozone overcomes its problems, the risk of ‘Brexit’ can only grow.

John Springford is a senior research fellow at the Centre for European Reform.

Wednesday, March 04, 2015

David Cameron, Janan Ganesh and renegotiating EU membership

David Cameron is receiving a lot of advice on how to ‘renegotiate’ the terms of Britain’s EU membership, if he wins May’s general election. Janan Ganesh’s recent Open Europe essay, ‘From a reluctant European: a memo to the prime minister’, is an excellent contribution to this debate. However, Ganesh mistakenly urges Cameron to seek UK opt-outs from EU social policy and financial regulation, neither of which is feasible, and he misreads the German position on some key dossiers.

The paper starts with a strong analysis of why the alternatives to full EU membership are pretty hopeless. Ganesh realises that a UK seeking to leave the EU would be in a weaker position to negotiate access to the single market than many Conservatives imagine. If the British followed the Norwegian or Swiss models, they would have to accept most EU regulations, the free movement of labour and the obligation to make big payments into the EU budget. The UK is much more dependent on the EU’s market than vice versa: Britain’s exports to the EU account for 14 per cent of its GDP, while the rest of the EU exports only 2.5 per cent of its GDP to Britain. As Ganesh says, “Our working assumption must be that the EU would go out of its way to make life for a departing member as difficult as possible, pour encourager les autres”.

He also points out that the British economy has thrived inside the EU and that its rules cannot therefore be too awful. He sees Britain as playing a similar role in the EU to that played by California in the US, as “the place where young and able people converge to make money or breathe freer air”.

A hard-headed realist, Ganesh argues that Cameron should – as many eurosceptics insist – threaten to campaign for withdrawal if he does not get what he wants in a renegotiation. It is possible that such threats could achieve more than a softer approach. But it is more likely that – by grating against the EU’s culture of compromise and consensus – they would alienate the allies that Cameron will need if he wishes to reform the EU.

One piece of good advice is that Cameron should drop the idea of deleting “ever closer union” from the EU treaties. “The EU is integrationist because its members want it to be, not because a legal clause mandates it”. He is also probably right to urge the prime minister to concentrate on policies, rather than institutions, since it would be easier to reform the former. So he tells Cameron not to focus on the European Court of Human Rights, the complexities of Justice and Home Affairs or the role of national parliaments, but rather on migration, the City and social policy.

Limiting the welfare benefits available to EU migrants will inevitably – given the political context in the UK – be one of Cameron’s chief demands. Ganesh rightly points to the benefits of migration and urges Cameron to keep his demands modest. Then Cameron would probably find allies, notably among North European governments, for reforming EU rules.

As for protecting the City from EU regulation, Ganesh is correct that there is a potential problem. Though it accounts for more than 60 per cent of the EU’s net financial services exports, the UK has only 12 per cent of the votes in the Council of Ministers. Countries that know very little about finance could theoretically gang up to impose rules on the City.

Ganesh therefore urges Cameron to demand an ‘emergency brake’ procedure for financial regulation: a government that had lost a vote could refer a matter of vital importance to the European Council, which operates by unanimity. Unless the brake is time-limited, the government applying it has a de facto veto.

The problem with this idea is that special pleading for the City is not popular with other governments, especially Berlin. The Germans remember the summit of December 2011 with horror: they had hoped that EU leaders would agree on a small treaty to strengthen fiscal discipline. But at the last minute Cameron came up with a set of demands as the price for his signature, some of which would have changed voting procedures on rules affecting the City. Angela Merkel was not prepared to tolerate what she saw as an attempt to opt out of part of the single market, lest others attempt their own carve-outs. The ‘fiscal compact’ went ahead without the British, as a non-EU treaty, and the Germans remain adamantly opposed to City opt-outs.

Ganesh argues that, since France has a de facto veto on agricultural questions, Britain should have one on the City. But he exaggerates France’s privileged position on agriculture. True, France is seldom outvoted. But that is because France is almost never isolated. It works hard to build alliances with other countries that share its views on the Common Agricultural Policy, such as Spain, Romania, Ireland and Poland.

In any case, Britain’s partners have almost always respected its sensitivities on City regulation. Thus in December 2012, the Council of Ministers agreed that decisions in the European Banking Authority should be taken by a ‘double majority’ system – requiring a majority of both euro and non-euro members to vote in favour. It is extremely rare for the UK to be outvoted on financial regulation: the one high-profile case was in March 2013, when the European Parliament had added limits on bankers’ bonuses to a directive on capital requirements, and Britain’s attempt to overturn the limits was defeated 26-1. (The UK also lost a more technical vote in 2012, when the Council gave the European Securities and Markets Authority the power to ban short-selling in an emergency.)

One key British concern has been the European Central Bank’s ‘location policy’. Four years ago the ECB stated that clearing houses dealing with euro-denominated financial instruments should be situated in the eurozone. The UK complained to the European Court of Justice that this policy breached the principles of the single market and won its case on March 4th.

Rather than seek a privileged status for the City, Britain should focus on the broader relationship between the single market – including financial regulation – and the eurozone. There is a risk that if the eurozone countries started to caucus on single market issues, they could turn up at the Council of Ministers and impose their views on the 28. This has not happened yet, and is highly unlikely, given the wide range of economic philosophies that divides the eurozone. But it could happen one day and the UK has a legitimate interest in trying to prevent such caucusing.

If the UK proposed protecting the single market, rather than, as Ganesh suggests, simply the City, it would find allies among ‘euro-outs’ such as Poland, Sweden and Denmark, eurozone countries that are economically liberal such as Ireland, Finland and (on a good day) Germany, and the European Commission (which wants to prevent the eurozone building its own institutions).

The UK should ask for euro-outs to be allowed to send observers into eurozone discussions (see Chapter 1.6 of our ‘How to build a modern EU’). And then, if and when the treaties are changed, the UK could ask for an article specifying that nothing done by the eurozone should damage the single market. It could also request a specific procedure that would allow a government to use an emergency brake, if it believed that a eurozone decision harmed the market. But the brake would have to be time-limited, to say a year, in order to be acceptable to other governments. And there may be a case for amending the treaties to facilitate the extension of double majority voting on sensitive issues.

Ganesh’s other major demand, that Cameron should claim an opt-out from European social policy, is unattainable – and even if achieved would make very little difference to British workers. Almost all labour market law in the EU is national, which is why the rules are so varied across the Union. There have been only a few significant EU social measures – covering areas such as working time, agency workers, maternity leave and non-discrimination. There are no more on the way because most member-states (France being an exception) do not want more social measures. The OECD’s employment protection indicators show that Britain has amongst the least regulated labour markets of all its members, comparable to Canada, the US and New Zealand (see Chapter 2 of our ‘The economic consequences of leaving the EU’. Even the Confederation of British Industry does not claim that EU labour laws are a significant problem for the UK economy.

Although British workers are allowed to opt out of most of its provisions, the working time directive – and the associated rulings of the ECJ – did create problems for the National Health Service. But the NHS has now adapted to the 48-hour working week and the ECJ’s definitions of rest periods. Many of its managers and younger doctors would not want to change the rules (see our ‘The working time directive: What’s the fuss about?’.

Britain’s partners would almost certainly not concede it an opt-out from EU social policy. Although John Major won such an opt-out in 1991, the circumstances were very different then: everyone else needed British consent for the Maastricht treaty that would establish the euro, so he was in a strong position. These days many member-states, and not only France, would be virulently opposed to any opt-out that – in their view – would allow an ‘ultra-liberal’ Britain to attract investment ‘unfairly’ by undercutting their social standards.

In the past few years Cameron has talked much less about the evils of European social policy, perhaps because he realises that this is a straw man. He probably understands that any attempt to repeal the principle of the 48-hour working week and the guarantee of four weeks’ paid holiday a year would be unpopular with British voters. He may also see that in a referendum campaign, many trade unions would refuse to campaign to keep Britain in the EU if the renegotiation had taken the country out of social policy.

Having laid out his three priorities, Ganesh has some other suggestions for Cameron, including shrinking the EU’s budget by excluding richer countries from its structural funds, and extending the single market in services. Both ideas are sensible. But when Gordon Brown proposed the former he did not get far, because many richer countries, and most notably Germany, did not want their poorer regions to lose access to EU funds. In any case, reopening the ‘multi-annual financial framework’, which set EU budget rules for the period 2014-20, would require unanimity and is therefore very unlikely.

The Germans have also long been the blockers – alongside France, Austria and Luxembourg – of the liberalisation of general services. So the British government cannot pursue this objective without developing a strategy for overcoming German opposition. For example, it could team up with other economically liberal governments and propose initially to deregulate those services in which Germany’s vested interests are weaker, such as construction and health.

Ganesh’s paper would have been stronger if it had taken more account of German preferences. For example, he buys the view that one often hears at the top of the British government, that Cameron has a good chance of forging agreement on a new EU treaty before a 2017 referendum. He quotes Wolfgang Schäuble, Germany’s finance minister, on the need for a new treaty. But Schäuble is often isolated in Berlin debates on this issue. The view in the chancellery is that in the long run some modest treaty changes would be desirable, to strengthen eurozone governance, but that they are not urgent and now is not the time. One reason for this reticence is the dire state of Franco-German relations: there is not enough trust between Paris and Berlin for them to come together and agree on the next steps on eurozone integration. As for the other 26 governments, none of them wants a new treaty.

Many of the reforms that Ganesh proposes would require treaty change. But the best that Cameron could hope to achieve by 2017 would be a political agreement in the European Council to change the treaties at some point in the future. Cameron’s problem is that many eurosceptics will not find promises of future EU reform convincing.

Ganesh concludes his essay with some strong geopolitical arguments for the UK to remain in the EU. He believes that the liberal Western order faces many threats, and not only from Vladimir Putin, and that the EU is a bulwark against them. He argues, rightly, that the case for closer collaboration on EU foreign and defence policy – areas where Britain would often lead – is a strong one. Let us hope many Conservatives read this stimulating essay.

Charles Grant is director of the Centre for European Reform.

Friday, February 27, 2015

The Commission’s energy union ‘strategy’: A rebranded work programme

The European Commission’s grandly-titled ‘Framework strategy for a resilient energy union with a forward-looking climate change policy’ was published on February 25th. It contains sensible proposals. If all were enacted, EU energy and climate policies would be significantly improved. But they will not all be enacted – at least not in the lifetime of this Commission. A credible strategy needs priorities, resources and a clear timetable. This publication identifies only one very general priority (‘obey the rules’) and one very specific one (extend the energy market in South-East Europe). A forward-looking climate policy initiative would contain some new proposals: this paper does not. This paper is essentially a restatement of the Commission’s existing work programme, now rebranded as an energy union.

European integration has always been rules-based. Yet the Commission identifies “the implementation and enforcement of existing EU legislation” as the first priority of its new strategy. Specifically, it promises to insist that member-states implement the third energy market package. This is sensible, but not new: the Commission has been insisting that national governments implement this package ever since it was adopted in 2009.

The paper reiterates the Commission’s desire to centralise regulation. “Today, the European Union has energy rules set at the European level, but in practice it has 28 national regulatory frameworks. This cannot continue.” Whatever the Commission thinks, this will continue. In the late 1980s the Commission proposed a European Environment Agency to regulate Europe-wide. When the agency was created in 1990, national governments had changed its role to one of collection and dissemination of information: more of an environmental Eurostat than a green policeman.

The Commission’s attempts to centralise energy regulation face the same strong opposition in the Council. In 2009, as part of the third energy package, the EU set up the Agency for the Co-operation of Energy Regulators (ACER). As the name suggests, this is a forum for discussion between national regulators, not a body that actually regulates EU markets. In the Energy Union paper the Commission says that ACER should “carry out regulatory functions at the European level”. The Council is not likely to agree.

Apart from the statement that obeying existing rules is its first concern, the Commission identifies only one other priority: the integration of Central and South-Eastern European energy markets into the wider European market. It promises that it “will take concrete initiatives in this regard as an urgent priority” – though does not reveal what these might be. Central and South-Eastern European countries are indeed very important for Europe’s energy and climate policies: CER will publish a paper on this subject next month. But a credible strategy for an energy union would have set priorities for shaping the whole of Europe’s energy market, not simply identified how that market should be enlarged. The strategy paper ends with a section called “the Energy Union in 15 action points”. Several of these have bullet points, so in total there are 27 items on the Commission’s ‘to do’ list. President Jean-Claude Juncker and his team have not said which of these it considers to be the most important. It is very unlikely to be able to do all of them.

So what should be the priorities for building an energy union? First should be energy efficiency. The Commission should propose that most new power stations must be combined heat and power. Heat that is produced when anything is burnt should be used rather than being wasted up cooling towers. The Commission suggested this as part of the 2012 ‘energy efficiency directive’, but the Council rejected the proposal. The Commission should try again.

The second priority should be the construction of an efficient Europe-wide electricity grid. An improved and extended grid would enable member-states to harness much more renewable energy, so increasing energy security and reducing carbon emissions. With a Europe-wide grid, the EU could generate wind and tidal power in the north of the continent, and wind and solar power in the south. Electricity could be transmitted north to south during nights, when solar panels do not generate, and south to north during days when the wind is not blowing. (However good the grid, it cannot cater for all scenarios. Electricity storage or gas power stations as back up capacity will be required to ensure that the lights stay on during calm nights.)

The third priority should be energy subsidy reform. In 2009 the G20 promised to end inefficient fossil fuel subsidies. Little progress has been made since then. The paper notes that “collectively, the EU spent over €120 billion per year – directly or indirectly – on energy subsidies, often not justified”. It declares that “environmentally harmful subsidies need to be phased out altogether”. But all it proposes to do on energy subsidies is an “analysis of energy prices and costs (including taxes and subsidies)”. This is just a delaying tactic. The International Energy Agency and the International Monetary Fund have both conducted this analysis, and published the results, in the last two years. There is no need for more analysis. There is a need for action. The Commission should use its state aid powers to reduce existing subsidies to coal power stations, and prevent new subsidies to coal (other than for carbon capture and storage demonstration projects). In July 2014, the Barroso Commission gave state aid clearance to the UK for new subsidies to existing coal fired power stations. London argued that this was necessary to provide a back up for intermittent renewables. Gas power stations are more economically efficient in this role, and much less polluting. The Juncker Commission should reverse the state aid clearance for new subsidies to old coal.

The fourth priority should be diversification of gas suppliers. On the day that the Commission published its paper, Russian president Vladimir Putin threatened to cut off gas supplies to Ukraine. This was predictable. The paper stresses the need for Europe to reduce energy imports and dependence on single suppliers of hydrocarbons. (Russia is not named in this context; it does not need to be named.) The suggestion that Council President Donald Tusk made when he was Polish prime minister – that member-states should club together to become single gas buyers when negotiating with the Kremlin – is given a polite nod but nothing more: it will be “assessed”.

Instead, the paper stresses the need to find alternative suppliers of gas. The Commission promises to work on gas interconnectors within the EU. These are necessary, particularly for countries which import most or all of their gas from Russia, and are likely to receive EU funds. The Commission will also work on the Southern Gas Corridor to bring gas from Central Asia to Europe. And it will “encourage” Central and Eastern European and Mediterranean countries to build liquefied natural gas (LNG) facilities, as Northern European countries have done. More LNG facilities would be good for energy security. They would also be good for climate action. The greenhouse gas footprint of LNG is higher than that of piped gas, because of the energy used during its transformation. But even when turned into liquid and then back into gas, natural gas is less bad for the climate than coal is. 

So, the energy union priorities should be energy efficiency through combined heat and power, an improved and expanded electricity grid, reform of energy subsidies and diversification of gas suppliers. What proposals should be added to achieve forward-looking climate policies? First, the Commission should propose an Emissions Performance Standard (EPS), to limit the amount of carbon dioxide that power stations and industrial plants are allowed to emit. The European Parliament tried to include an EPS in the 2010 ‘industrial emissions directive’. The Barroso Commission blocked Parliament’s effort on the grounds that a regulatory approach was inconsistent with the market-based approach of the Emissions Trading System (ETS). This line of reasoning is not convincing. It is perfectly possible to combine an EPS with emissions trading, as the Californian government shows. What is more, emissions trading in Europe has not delivered a significant or predictable carbon price, which is needed to channel investment into low-carbon energy. Rejecting a new measure because it is (allegedly) inconsistent with an unsuccessful existing policy is not sensible. Last month, the Juncker Commission agreed to consider an EPS. But the Energy Union strategy does not mention it.

Second, the Commission should propose financial support for modern nuclear power technologies which will be even safer than existing nuclear stations and which can use radioactive waste and plutonium (of which the UK and France have large stockpiles) as fuel. The Commission accepts that the EU should maintain technological leadership “in the nuclear domain”, but argues that this should include the International Thermonuclear Experimental Reactor (ITER), the nuclear fusion project in France. ITER is a partnership between the EU, China, India, Japan, Russia, South Korea and the United States. The EU is ‘leading’ in the sense that the money from the EU Budget covers 45 per cent of the total; the other six partners cover just 9 per cent each. Billions have already been spent, but the earliest date that nuclear fusion could generate electricity commercially is 2050. ITER is a waste of money, and should be abandoned. The EU should instead invest the money in nuclear technologies which could contribute to energy security and decarbonisation in the 2020s.

Third, the Commission should spend more of the EU Budget on innovative renewable energy technologies. Wave and tidal power could make a major contribution to European electricity. But these technologies are still at the development or demonstration stage, so need significant grants. The Commission should transfer money from the transport part of its Connecting Europe facility into research and development of new renewables. 

Fourth, the Commission should promote a price floor for the ETS. Carbon trading has two objectives: cap the total amount of greenhouse gas pollution, and put a price on carbon so that more investment goes into low-carbon energy sources and less into dirty coal. Greenhouse gas levels are below the cap which the ETS sets – though this is due more to the economic downturn than to the ETS. But the current carbon price (around €7 per tonne of carbon dioxide emitted) is far too low to have any significant impact on investment decisions. The Commission should propose a minimum price at which allowances can be traded. The price floor should be introduced at €30, and go up each year.

Juncker’s Commissioners regard energy as an issue on which ‘more Europe’ is needed. They are not alone in thinking this: Finnish prime minister Alexander Stubb made the same point at a CER event in October 2014. The energy union paper says that national policies provide insufficient predictability for potential investors. EU regulations are more stable than national regulations are, because they are difficult to change once agreed. However, attempts to alter the tier of government at which policy is made – from member-state to EU level or vice-versa – cause more unpredictability and so increase the cost of capital. The Commission estimates that “over €1 trillion needs to be invested into the energy sector in the EU by 2020”. This at a time when the European economy is weak. The Commission, Parliament and national governments must not allow inter-institutional arguments to increase the price tag. They should focus on energy and climate issues, not on constitutional squabbles.

President Juncker promised to lead a more political Commission. Sadly, the energy union framework strategy is not political enough. It is too bureaucratic and too timid, and needs more focus.

Stephen Tindale is a research fellow at the Centre for European Reform.

Monday, February 23, 2015

Reduced to rouble? An update on the Russian economy

Recent events in Ukraine have shown that Russia is determined to change the balance of power in Europe. Whether Vladimir Putin can be stopped by diplomacy or sanctions remains an open question (and is the subject of a forthcoming CER policy brief). Russia’s economy, however, is in deep trouble. Although the oil price and the rouble have stabilised, the Russian economy will go through a long, deep and painful recession as high interest rates and poor access to finance hits investment, inflation erodes customers’ disposable incomes and the government tightens fiscal policy. A renewed fall in the oil price and the rouble would be likely to lead to a severe crisis, as Russia’s foreign reserves are dwindling, and renewed capital flight could lead to the imposition of capital controls. The problem is that a collapse and subsequent bailout of Russia is not in the interest of the West.

Putin’s first decade in power was underpinned by rising oil prices, which allowed a rent-seeking elite to earn fortunes from Russia’s mineral wealth. As a result of the resource boom, the rouble’s real effective exchange rate (which takes Russia’s high inflation into account) rose strongly from 1999 to 2008. This made non-resource export industries uncompetitive – a common phenomenon of resource-rich countries called ‘Dutch disease’ (see chart 1).

Chart 1: The oil price and Russia’s exchange rate

Source: Federal Reserve Economic Data (FRED)
Notes: The nominal effective exchange rate weighs all the exchange rates of the rouble with other currencies by the share of Russian trade with these countries. The REER adjust these exchange rates for the difference in inflation between pairs of countries.

Ordinary Russians also saw their incomes grow, but the rule of law weakened and corruption flourished: Russia ranked 136th out of 172 countries surveyed by Transparency International in 2014. Long before the hammer blows of sanctions, falling oil prices and a collapsing currency, the Russian economy was stagnating. Now Russia is in recession. In January, confidence indicators in the service and manufacturing sectors dropped to new five-year lows, pointing to a large contraction in activity. The IMF predicts a contraction of 3 per cent of GDP in 2015, but it could be much worse. 

The two main reasons for the recession are the fall in the oil price and the decline in the value of the rouble (see chart 1), which are closely connected. Lower oil revenues (in US dollars) mean less demand for the Russian currency. In addition, the loss of confidence in the Russian economy, combined with financial sanctions and political uncertainty, has led to capital flight as wealthy Russians and foreign investors dump rouble assets. That is not only leading to a collapse in investment, which further weakens the economy, but also exacerbating the fall in the currency. Overall, $151.5 billion of private capital left Russia in 2014. To put that figure into perspective, foreigners held direct and portfolio investments in Russia in the order of $477 billion and $225 billion respectively (at the end of September).

The Russian central bank has intervened heavily to defend the rouble (see chart 2). At the end of January 2015, Russia had $376 billion in reserves, down from $499 billion a year earlier. Nearly half of the remaining reserves, however, are not under the full control of the central bank. Two sovereign wealth funds, the Reserve Fund (current foreign and domestic assets of roughly $88 billion) and the National Wealth Fund of the Russian Federation ($78 billion, down from $89 billion a year ago), hold large reserves and are under the control of the Kremlin. 

In recent weeks, the oil price, and as a result the rouble, have stabilised and somewhat recovered from their lows. But the risk of a further fall in the rouble is still large. If investors expect that currency reserves will run out and that the central bank will have to impose strict capital controls to stop outflows, investors and Russians might opt to reduce their exposure to rouble assets quickly. And any capital controls would be a major obstacle to foreign investment in Russia.

Chart 2: Currency interventions by the Russian central bank
Source: Bank of Russia

One negative impact of a falling rouble is inflation. Food prices in particular have risen dramatically in recent months, in part because of Russian counter-sanctions on food imports, which were imposed on August 6th 2014 (see chart 3). Such imported inflation lowers the real incomes of households; as a consequence, they are spending less on Russian goods, hurting the economy.

Chart 3: Inflation in Russia
Source: Federal Reserve Economic Data (FRED)

Another negative effect of a falling rouble is high interest rates. In an attempt to stabilise the currency in mid-December, the Bank of Russia raised its key rate to 17 per cent. With non-food inflation at 9 per cent, that means that real interest rates are prohibitively high at around 8 per cent, which is depressing consumption and investment. This is a classic dilemma of emerging markets in crisis: the central bank is trapped between having to stabilise the currency by means of higher interest rates and helping the wider economy, which would benefit from lower rates. The central bank cut interest to 15 per cent in late January, but this will only marginally lower the negative impact on the domestic economy.

The final problem of a falling rouble is that it causes the value of debt in foreign currency to balloon. The current external debt of banks and firms stands at $600 billion. It has fallen by $130 billion over the past six months, as international investors were unwilling to roll over maturing debt. But calculated in roubles, the foreign debt increased from 24.9 trillion to 33.8 trillion over that period. In 2015, these banks and firms have to repay $110 billion in 2015, and another $53 billion in the first nine months of 2016 (see chart, late 2015 and 2016 data quarterly). Russia’s current account surplus, from which that external debt could be repaid, is just below $60 billion a year – and bound to fall because of the decline in the oil price. This means that Russia will need to run down foreign currency assets in 2015 to cover the difference.

Chart 4: Repayment schedule of Russian external debt
Source: Bank of Russia

Chart 5: Russia’s current account surplus in million USD
Source: Bank of Russia

There could be one silver lining: a weaker currency benefits exporters. But business surveys find that manufacturers have suffered from declining export orders for their products for 17 months in a row – including the last couple of months during which the fall in the rouble would be expected to have some positive effect on export orders. One reason is that Russian manufacturers often supply investment goods to the global energy sector, which is suffering from falling energy prices. Another reason is years of under-investment in other sectors of the economy. 

Falling oil prices have hit the state budget hard. Although President Putin has said lower oil prices are not “a tragedy”, Russia relies on fossil fuel revenues to finance half its budget. Russia’s 2015 budget was originally based on oil prices of $100 a barrel, but the government currently expects an average price of just $50, which given average market forecasts of around $55 for 2015 is reasonable. Since military spending is forecast to increase, the government must make big cuts elsewhere. Such fiscal retrenchment will further depress economic activity. The Russian government will struggle to borrow from abroad: one of the three main rating agencies, Standard & Poor’s, has already downgraded Russian government bonds to non-investment grade status (also known as ‘junk’), and the rating of the other two, Moody’s and Fitch, are just a whisker above the threshold. 

EU and US sanctions have cut off some Russian banks and companies from direct access to western financing. Some key companies and banks now need to turn to the central bank and the government for funding, putting further strain on Russia’s foreign exchange reserves. But western finance is also hard to tap for those firms and banks that are not among the sanctioned, as western banks are afraid to fund them, fearing that Russia’s deteriorating economic situation or potential further sanctions will lead to future losses. Even if sanctions are eventually lifted, fear of a repeat scenario could impair Russia’s access to international capital markets for years to come. 

The downgrade of government bonds also has knock-on effects for banks and firms in Russia, as a weaker sovereign rating usually leads to lower ratings for banks and firms as well. This further impairs their access to funding. Fitch, for example, downgraded 13 firms in mid-January, following the downgrade of the Russian government. The strained funding of banks will induce them to tighten lending conditions for companies and households. The most recent bank survey shows that credit standards tightened considerably across the board in the third quarter of 2014, and will have tightened further since then.

Chart 6: Bank lending conditions for Russian firms and households
Source: Bank of Russia
Notes: The chart shows the balance of answers of banks to the question of whether they have loosened or tightened credit standards.

The recent stabilisation of the oil price and the rouble gives Russia temporary relief from the acute economic and financial pressures at the end of 2014. But the country’s considerable foreign debt, high inflation and real interest rates, restrictive access to finance for businesses and cuts in public spending, will lead to a long and deep recession. A renewed fall in the oil price and the rouble could lead to intensifying capital flight and the imposition of capital controls. What is more, a further fall in oil revenues for the Russian government and higher inflation, especially in food prices, would lead to steep falls in living standards of ordinary Russians, of whom more than 15 million already live below the poverty line.

A Russian economic collapse on the scale of the late 1980s (also a time of low oil prices and high defence expenditure), would give the West a difficult dilemma. On the one hand, the world cannot afford a failed state with nuclear weapons; and political leaders in the West will be susceptible to arguments that Russia is ‘too big (and dangerous) to fail’. On the other hand, bailing out Russia under any version of its current leadership and system looks very unattractive: as in the 1990s, much of the bail-out money would end up helping the elite both to stay in power and further enrich itself. European policy-makers should be prepared to target support on those parts of the Russian economy that might at some point become the backbone of a stable middle class in Russia – and they should hope that the oil price does not take another deep dive.

Jennifer Rankin contributed to an earlier version of this insight. I am grateful to Ian Bond for guidance on Russian politics.

Christian Odendahl is chief economist at the Centre for European Reform.