Monday, October 29, 2007

Can the EU learn to live with Chinese mercantilism?

by Philip Whyte

Not long after its launch, the euro was famously dismissed by a disgruntled currency trader as a “toilet currency”. How things have changed. Since 2003, the euro’s external value has soared despite comparatively sluggish rates of economic growth in many of Europe’s largest economies. The strength of the euro has been a boon to European consumers who have been able to buy DVD players from China for less than the price of a meal at a run-of-the-mill restaurant. But not everyone has been celebrating—least of all France’s hyperactive president, Nicolas Sarkozy, who has been fretting about the economic downsides of a strong euro. Mr Sarkozy believes that the euro is now over-valued and that French companies’ trade competitiveness is being damaged as a result. Ever since he entered office in May, therefore, he has thrashed around looking for a culprit.

At first, he blamed the European Central Bank (ECB) for neglecting the euro’s external value and for pursuing its inflation target at the expense of economic growth. This struck many observers as odd, for at least two reasons. First, a central bank cannot target the inflation rate and the exchange rate simultaneously: was Mr Sarkozy suggesting that the ECB jettison its inflation target? Second, it seemed perverse to accuse the ECB of pursuing an excessively restrictive monetary policy. Real interest rates remain low by historical standards, and were even negative for much of the period between 2003 and 2004. More recent indicators—notably buoyant rates of broad money growth and lending to the private sector—hardly point to a central bank that has sacrificed economic growth on the altar of low inflation. Mr Sarkozy’s broadsides were in any case widely seen as an attack on the ECB’s institutional independence—so no-one was surprised when they were given short shrift.

Mr Sarkozy then shifted his attention across the Atlantic. Authorities in the US, he argued, needed to act to stem the US dollar’s decline against the euro. Again, however, it was not clear what Mr Sarkozy was proposing the US authorities should do. Raise short-term interest rates? You must be joking! The US Federal Reserve is trying to contain the fall-out from the crisis in sub-prime lending which is threatening to push the world’s largest economy into recession. This is why it cut short-term interest rates in September. In any case, it is hard to see what the US Federal Reserve could possibly do to support the US dollar. The dollar is weakening because the US is struggling to attract the capital inflows needed to fund its current-account deficit. As the world’s largest debtor, the US has to attract three-quarters of the world’s capital flows to service its external deficit. This is unsustainable—and not just because US assets have offered investors absolutely terrible returns in recent years. A weak US dollar is imperative if the US’s external deficit is to narrow.

Slowly, it dawned on Mr Sarkozy that the problem might lie to the east rather than the west. In the run-up to the G7 meeting in late October, the French government spoke rather less about the US dollar and rather more about the Chinese yuan. It had taken its time, but at last it had stumbled on the heart of the problem: namely, that parts of the world—mainly China, Japan and oil exporters in the Middle East and elsewhere—are saving vastly more than they are investing. This excess of savings over investment has resulted in colossal outflows of capital which have supported the spending habits of governments and households in the US and, to a lesser extent, Europe. That’s right, you read correctly. Developing economies such as China are now large net creditors to the developed world. This is totally at odds with what one might normally expect. Capital usually flows in the other direction, from the developed to the developing world. So what happened?

The short answer is that China and a number of other Asian economies have spent the best part of the last decade pursuing unashamedly mercantilist policies. There are two reasons for this. One is the abiding attraction of an egregious fallacy: that a country’s primary objective in trade is to export more than it imports. The other is the experience of the Asian crisis in the late 1990s, when countries with large external deficits were unable to defend their currencies in the face of huge capital outflows. Stung by this experience, many Asian countries did not choose to abandon fixed exchange rates. Instead, they decided that they should continue to maintain a peg of sorts against the US dollar—but by actively intervening to keep their currencies artificially weak. Since that date, many Asian countries have turned trade deficits into vast surpluses by accumulating foreign exchange reserves. And the world has been stuck with an asymmetric monetary system in which the euro and the US dollar have floated freely against each other, but not against Asian currencies.

The apparently insatiable appetite of China and other Asian countries for piles of depreciating US dollars has had undoubted benefits for the EU. The most important is the boost to domestic demand that the resulting strength of the euro has provided. This has worked in at least two ways. First, by bearing down on import prices, the strength of the euro has contained inflation—allowing the ECB to keep official interest rates lower than they would otherwise have been. Second, it has boosted consumers’ purchasing power. The Chinese government, in other words, has indirectly given European consumers and mortgage holders something looking like a free ride. The downside is that the yuan’s exchange rate is generating protectionist demands from beleaguered European firms labouring under the weight of a currency that has borne the brunt of global adjustments since 2002. The EU trade commissioner, Peter Mandelson, has been muttering darkly about the speed at which the EU’s trade deficit with China is growing; and hinted that the EU cannot maintain an open market for Chinese goods if the Chinese government does not change policy direction.

In the mid-nineteenth century, the UK famously used gunboats to open Chinese markets to opium. Times have changed and few would now advocate similar methods to persuade the Chinese government to let the yuan appreciate. In fact, there is not much the EU can do, other than to raise the rhetorical volume and wait for the domestic tensions generated by China’s policy to play themselves out. No-one knows how long this process will last. The Chinese people’s capacity for pain is legendary. But the point will surely come when the Chinese government succumbs to internal pressure and refocuses economic policy on raising the living standards of the wretched Chinese people rather than relentlessly acquiring assets in a depreciating foreign currency. When this happens, Mr Sarkozy should pay particularly close attention. For the mercantilism that China has practised looks suspiciously like that which he would be tempted to pursue if ever he were let loose on the ECB!

Philip Whyte is a senior research fellow at the Centre for European Reform.

Friday, October 19, 2007

A grand bargain with Russia?

by Charles Grant

Relations between the Russia and the West have not been so prickly since the break-up of the Soviet Union. Viewed from the US and the EU, Russia is being obstructive across a whole swathe of issues, such as its blockade of trade with Georgia, its refusal to accept independence for Kosovo, and its opposition to further UN sanctions on Iran.

But although Russian foreign policy seems increasingly driven by a strident nationalism, there may be a method behind it. In Washington and Brussels, influential figures (including Henry Kissinger) think Russia may be seeking a ‘grand bargain’. President Vladimir Putin dropped hints that he might be open to such a bargain when he met think-tankers (myself included) at Sochi in September. “If our partners want something from Russia, they must be specific, and not ask for everything at once,” he said. “If you want to talk about Kosovo, OK, if you want to talk about the Iran nuclear problem, OK, but then don’t talk about Russian democracy at the same time.” He has a point: the US has tended to make wide-ranging demands of Russia without prioritising them.

The EU has a central role to play in any set of bargains between the West and Russia, given its extensive trade and investment links. The EU should seek to work with the Russians on three areas where they have mutual interests, and where a bit of horse-trading could be beneficial.

• Russia and the EU share many long-term interests in energy. Europeans want assurances that Russia will develop new gas fields, since a gap between demand and what Russia can supply is likely to emerge within a few years. The Russians worry that the EU’s moves to liberalise the European energy market may prevent Gazprom from buying pipelines there. Russia will have to abide by the EU’s rules on energy markets, just as the EU will have to accept that Russia does not allow foreign firms to buy key energy assets. Mutual dependency should encourage both sides to compromise.

• Both would benefit from Russia’s full integration into the global financial system. Thanks to the high oil price, Russia’s government and leading companies are sitting on funds worth several hundreds of billions of dollars. They want to put some of the cash into foreign firms. But the EU is becoming concerned about ‘sovereign wealth funds’. It should allow these funds to invest in European firms, so long as they are transparent and operate independently of politicians. And the EU should welcome Russian acquisitions of its companies, so long its rules are respected and European firms gain reciprocal rights.

• Both the EU and Russia have an interest in the countries of their common neighbourhood becoming stable, prosperous and well-governed. The EU should offer to work with Russia to promote peaceful change in Belarus, stability and unity in Ukraine, and a resolution of the ‘frozen conflicts’ in Transdnestria, South Ossetia, Abkhazia and Nagorno-Karabakh. The Russians may baulk at this: they fear encirclement by an expanding NATO and more ‘colour revolutions’, like those that loosened their control over Georgia and Ukraine. EU governments should allay Russian concerns by saying they will not support NATO membership for Ukraine or Georgia in the medium term. But the EU should offer such countries closer ties – and make clear to Moscow that they must be free to determine their own destiny.

The EU has a huge stake in the future of Kosovo; it cannot integrate the Western Balkans until that territory’s status is resolved. It will provide most of the money, soldiers, policeman and administrators to make any peace plan work. Russia has almost no interest in Kosovo, other than as a card to play against the West. The EU and the US believe that the least bad option for Kosovo is supervised independence, which Russia rejects.

But what if Russia was offered something in return? The US decision to deploy missile defence systems in Europe, against an Iranian threat that does not yet exist, was unwise. Russia’s anger over the deployment is genuine. Some former US officials claim that the deployment would break the spirit of promises made to Russia in the 1990s: the US said it would have no significant military presence in the Central European countries that joined NATO.

Russia’s heavy-handed over-reaction to US plans for missile defence – threatening to target missiles on Central Europe – makes it hard for Europeans to oppose those plans. Nevertheless, the Europeans should urge Washington to postpone the deployment indefinitely – so long as Russia accepts independence for Kosovo in return. Russia may shun this sort of bargain. But if its rulers are serious about maximising Russian power, they should negotiate with western leaders over their differences, rather than turn their back on them. (A longer version of this article appears in the November edition of

Charles Grant is director of the Centre for European Reform.

Friday, October 05, 2007

What now, Ukraine?

by Tomas Valasek

Ukrainians voters have spoken, sort of. On September 30th, they elected a new parliament. They made some heartening choices, backing forces of reform and sidelining smaller, less relevant parties. Less happily, they also produced a deadlock by giving virtually the same proportion of votes to the main two competing blocs. As a result, we are no wiser four days after the elections about who will lead Ukraine for the next four years.

The biggest winner is electoral democracy itself. Although Kyiv was abuzz with rumours of vote-rigging before the election, Western observers say that the actual poll appears to have been relatively untainted. Turnout – at 65 per cent – was low by Ukrainian standards but this is partly due to fatigue (this was the third national election in as many years). Importantly, the share of votes cast for smaller parties which fail to make the threshold required for entry into the parliament has nearly halved since last elections, from 20 per cent to 12. Far fewer votes are wasted. Four years on since the blatantly rigged 2004 presidential election which triggered the Orange Revolution, Ukraine has conducted three fair national polls. The country’s voters remain committed and take their rights ever more seriously.

Their choices this time around seem encouraging, too. The party of former Prime Minister Yulia Tymoshenko has doubled its share of votes since the 2006 elections, and fell just short of becoming the dominant force in the country. Tymoshenko is an unusual figure – she is suspected, not without reason, of building a cult of personality. Her populist rhetoric can often border on the irresponsible. But she has built a genuine base of support by attacking the cosy business-government relationships that corrode Ukrainian politics. Independently wealthy, she promises to defend the interests of her voters rather than corporate sponsors. And that would be an improvement on the way the two other main parties, President Viktor Yushchenko’s Our Ukraine and Prime Minister Viktor Yanukovich’s Party of Regions, go about their business.

But the poll was not all good news. It has failed to accomplish its main intended goal: to break the standoff between Yanukovich and Yushchenko and to produce a clear leader for Ukraine. The prime minister and the president have been in conflict since spring when Yushchenko accused Yanukovich of bribing parliamentarians to switch sides. The early vote was called to break the impasse.

This has not happened. The ‘blue camp’, the Party of regions and the Communists, and the ‘orange camp’, Yushchenko’s and Tymoshenko’s parties, scored virtually identical per centage results. A smallish independent party, the Lytvyn bloc, which barely made it into the parliament, can in theory break the deadlock.

The trouble is that the key political figures in Ukraine have little faith in the veracity of the results, no matter what Western observers say. None of the leaders seems ready concede an election decided by just a per centage point or two. Voters will suspect the Lytvyn bloc, irrespective of who it sides with, of having sold its votes. To complicate matters further, another small party, the Socialists, are insisting they gained over 3 per cent and are demanding a recount and a share of seats in the parliament. Yanukovich may yet decide to support their claim in the hope of forming a government without Yushchenko or Tymoshenko.

This mess would normally be considered worrying but not dangerous. Elections elsewhere have been decided by lesser margins; in 2000 George W Bush came to the presidency of the United States, a country of 300 million, thanks to 500-odd votes in Florida.

But unlike most democracies, Ukraine lacks a credible and independent judiciary. And in mature democracies the courts have the last say. The US election was eventually settled through a Supreme court ruling. The way the court reached its decision – by a 5-4 vote along ideological lines – was controversial and arguably dented the court’s credibility. But once made, the ruling stood without question. Few believe Ukraine’s own Constitutional court could act with such finality. During the crisis leading up to the elections its rulings have repeatedly been ignored by both the president and the prime minister.

Absent a credible judiciary, it is unlikely that either the ‘blue’ or ‘orange’ bloc will gain all-out power. Their margins are too small, neither side will want to concede such close elections, and no independent body can authoritatively rule in favour of one camp or the other. The odds are that Yushchenko and Yanukovich will settle the elections through an agreement to rule jointly, with or without smaller coalition parties. Their alliance is the only available combination of forces with a majority strong enough to overcome any challenge to election results.

If so, Ukraine would be right back where it started six or so months ago. Yanukovich and Yushchenko, two leaders who utterly failed to co-operate the first time they shared power, would be expected to do so again.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.