Thursday, November 29, 2007

China is losing its EU friends

by Katinka Barysch

The EU is getting tough on China. That, at least, is the impression one gets from high-ranking EU officials that arrived for the annual EU-China summit in Beijing this week. Economics is the main reason for Europe’s changing mood. The EU’s trade deficit with China is set to reach €170 billion this year, and European business is losing an estimated €55 million a day because of Chinese red tape, trademark violations and unfair subsidies. The EU’s economic troika – Joaquin Almunia, Jean-Claude Juncker and Jean-Claude Trichet – called on China to let its currency rise against the euro. Commission President Barroso and his trade commissioner, Peter Mandelson, warned that they would no longer be able to withstand rising protectionist pressure in Europe, unless the Chinese made it easier for European companies to sell in their markets.

Will the Chinese be frightened? Maybe they should be. Those industries in the EU that compete directly with Chinese mass manufacturers – think Italian textiles, German light bulbs or Czech consumer electronics – have occasionally lobbied for protection. But European retailers and those industries that rely on cheap Chinese inputs, for example steel, have lobbied against. At the political level, the Chinese could usually rely on Germany, the UK and the Commission to make the case for open markets. However, this may no longer be the case.

The Commission’s patience seems to be wearing thin. Mandelson in October wrote a letter to Barroso that suggested that the EU’s dialogue-based approach to solving economic disputes with China may have run its course.
The British may be instinctive free traders. But British business is unlikely to lobby on China’s behalf. UK companies still sell roughly as much to Denmark and Dubai as they sell to China. On the other hand, China is now Britain’s 5th most important source of imports, with the result that the bilateral trade deficit reached €24 billion in 2006, a third of the UK’s total trade deficit with non-EU countries. Services, where UK companies are world leaders, account for only a tiny fraction of Chinese imports because domestic markets remain heavily protected. A recent survey showed that while globally almost half of company bosses see China as the biggest business opportunity, in the UK the share is only 37 per cent.
Perhaps most worrying for the Chinese is the shifting mood in Berlin, however. Germany alone accounts for around 40 per cent of all EU exports to China, not least because Germany specialises in exactly the kind of machine tools that China needs to build up its industrial sector. Since 2000, Germany’s exports to China have risen threefold. Since the German economy is much more dependent on exports than those of other big EU countries, it has had a strong interest in keeping economic relations with China smooth.

In recent years, however, the rising euro has made German goods expensive outside the eurozone. And German, like other western companies, have suffered from China’s very cavalier attitude towards patents and trade marks. In 2006, German machinery exports to China actually fell. Germany’s trade deficit with China has more than doubled since 2000, to €16 billion in 2006, and it keeps growing. Perhaps unsurprisingly, the share of Germans who see China as an economic threat has jumped by 17 percentage points in just two years, to 55 per cent in 2007 – the biggest public opinion turnaround in any big OECD country.

German awareness of China as a competitor, not only a promising market, will rise further as Chinese industry moves up the value chain. Chinese car output, for example, is growing by 40 per cent a year. Although Chinese cars have a long way to go before they can compete with Volkswagen or BMW, the fact that China now produces more of them than Germany has fuelled some disquiet. As has the fact that China has dethroned Germany as the world’s biggest exporter.

At the same time as economic ties are souring, Germany and China have fallen out politically. The Chinese were very upset when Angela Merkel received the Dalai Lama in her Chancellor’s office in September 2007. Merkel initially said she’d expect Beijing to calm down quickly. It did not. Finance Minister Peer Steinbrueck had to cancel a planned trip to Beijing because his counterpart was no longer available. Chinese state-owned companies pulled out of a China-German trade fare. Scheduled dialogues on human rights, the rule of law and foreign policy co-operation were called off.

At the EU summit, Premier Wen Jiabao said that Germany could still be a partner and a friend – provided that Merkel acknowledged publicly that she had made a mistake by seeing the Dalai Lama. The Chancellor is also under growing pressure from German business groups and her SPD partners in the grand coalition. But she is unlikely to budge. In a speech to parliamentarians at home, she insisted that “human rights and the defence of economic interests are two sides of the same coin”.

While they have put relations with Germany on ice, the Chinese have reached out to France. Nicolas Sarkozy grasped the opportunity at a bilateral summit in Beijing on November 25th. As is customary, he came with a group of French business leaders, who signed deals worth around €20 billion (although such ‘summit deals’ have a habit of falling apart afterwards). However, Sarkozy is unlikely to be as friendly to the Chinese as his famously Sinophile predecessor, Jacques Chirac. While he promised strong ties, Sarkozy also admonished Beijing for its currency policy and warned that Europe may slap ‘carbon tariffs’ on Chinese goods unless the Beijing contributed to a post-Kyoto agreement.

Europe will not make a full turn towards protectionism. But there clearly is growing potential for economic friction with China. Beijing’s usual conciliatory language – promising gradual change and open dialogue – may no longer be enough. It may have to offer concrete action on currency policy and economic opening if it wants to win its European friends back.

Katinka Barysch is deputy director of the Centre for European Reform.

Friday, November 23, 2007

Bringing Syria into the Middle East peace process

by Clara Marina O'Donnell

The nearer the Annapolis conference comes, the less it looks likely to deliver peace between Israelis and Palestinians. The weakness of the key actors and the current conditions on the ground in the Palestinian territories offer little reason for optimism. But there is one thing that could allow Annapolis to make a big difference – bringing Syria into the peace process. And the EU has a special role to play in encouraging this move.

The key actors are too weak to enforce the costly compromises that peace will demand. The end-of-term Bush administration is widely discredited at home and bogged down by other issues in the region – notably Iraq, Afghanistan, and Iran. Israeli prime minister Ehud Olmert is breaking records for low approval ratings at the head of his fragile coalition, and faces allegations of corruption. The most critical shortcomings are on the Palestinian side. Fatah is so divided that the Palestinian Authority's President Mahmoud Abbas can barely claim to speak for the West Bank, still less for the Palestinian territories as a whole. And violent intra-Palestinian feuding worsens every day, as demonstrated most recently by the deadly shooting at the Arafat anniversary rally in sanction-ridden Gaza.

Without an improvement in the political situation on the Palestinian side, there is no chance of progress towards a final peaceful settlement. Israel will never agree to any concessions that could compromise its security if the other side is manifestly incapable of holding up its part of any deal – or worse, is on the brink of civil war.

Unless Gaza and the West Bank can be brought back together under a single and stable government, it is hard to see how sustainable peace is possible. But that objective looks increasingly unattainable. Hamas’ current violence towards other Palestinians is preventing the possibility of any rapprochement with Fatah. Abbas has started openly calling for the Hamas government in Gaza to be toppled, while the Israeli Defence Force is urging wide-scale military intervention in Gaza. But force may not be able to topple Hamas; Israel’s incursion into Lebanon last year showed just how difficult it is to dislodge a group of fighters who can easily blend into the local population. Worse, force could provoke Hamas to destabilise the West Bank, where the movement also has a strong footing.

Outsiders may need to try a tangential approach. Like pieces in a jigsaw, the region’s conflicts are interconnected, and the next step in solving the Israeli-Palestinian conflict may in fact lie in Syria.

Damascus has close ties with Hamas and hosts its leader-in-exile, Khaled Mashaal. At the same time, Syria is wearying of its international diplomatic isolation, and shows signs of wanting to improve relations with Arab nations, the West, and even Israel. It has hinted that it will be willing to attend Annapolis if the agenda includes the Golan Heights. In what looks like a gesture of good will, Damascus has refused to host a ‘spoilers conference’ that Hamas proposed as a foil to the Annapolis conference.

If Syria's relations with the West and Israel improved, Damascus might pressure Hamas to rein in its use of force, and even oblige it to compromise with Fatah. Such a shift in regional balance could also encourage moderate elements within Hamas: fearful of losing a key foreign supporter, they might ease their opposition to Israel, or distance themselves from the more radical elements in Hamas.

Many in the West will find the prospect of working with Syria uncomfortable. There is the suspicion that Syrian agents are linked to the murder of several anti-Syrian Lebanese politicians, and there is concern about a possible nuclear programme. But the idea of using Syria to influence third parties in the Middle East is not new. France cut ties with Damascus after the Hariri murder, but this week controversially sent two top aides of President Nicolas Sarkozy to Damascus. Their task is to woo the sponsors of Hezbollah towards co-operation in the forthcoming Lebanese presidential election.

Going one step further – winning Syrian support for resolving the Israeli-Palestinian conflict – could prove to be Annapolis’ success. Syria's presence at Annapolis and its engagement in the peace process would clip the wings of the radical elements in Palestinian politics. At present, Syria's attendance is still uncertain. The US and Israel are focusing only on the Palestinian issue, and are unwilling to address the Golan Heights. There is a role here for the EU, which has so far been conspicuous by its absence in the preparations for the conference. The EU should encourage the US and Israel to widen the focus of the current peace effort and include Syria. An invitation could be accompanied by a conditional offer to Syria: its claims to the Golan Heights could be put on the agenda at Annapolis, in exchange for constructive engagement with Hamas in the Palestinian territories, and with Hezbollah in Lebanon.

Clara Marina O'Donnell is research fellow at the Centre for European Reform.

Thursday, November 15, 2007

The euro as the world’s reserve currency?

by Simon Tilford

Back in the 1970s President Nixon’s treasury secretary, John Connally, famously quipped that “the dollar may be our currency, but it’s your problem”. One of the arguments in favour of establishing the euro was that it would quickly come to rival the dollar’s status as the world’s principle reserve currency and make it hard for the US to abuse its “exorbitant privilege” – devaluing the dollar imposes few costs on the US because its foreign debt is denominated in dollars. Is the wish of those Europeans that want to see the dollar dethroned about to come true? If so, would this be a win-win scenario for the eurozone?

There is no doubt that the threat to the dollar’s status is bigger than at any time since the end of the Second World War. The most likely outcome is that a rapid narrowing of the US current-account deficit and renewed fiscal discipline will combine to restore confidence in the dollar, and that it will retain its status as the world’s leading reserve currency. Confidence in the long-term prospects of the US economy remains strong, and the country’s huge and liquid financial markets make the dollar highly attractive as a reserve currency. However, a rout is a possibility, and could be triggered by a number of events, such as a debt crisis in the US or a steep rise in inflation, which would undercut the willingness of foreigners, crucially East Asian central banks, to hold so many of their reserves in the American currency. Let’s assume for a moment that the damage to the credibility of dollar is such that its role as the world’s favourite currency is lost.

The euro would be the only plausible replacement. It is the world’s second most important reserve currency, though a distant second to the US. The eurozone economy is huge (though not quite as big as the US), its economy is open, its financial markets increasingly deep and liquid, and the ECB now enjoys considerable credibility in the financial markets. But what would it mean for the eurozone, aside from schadenfreude? It would be easier for European companies to operate internationally as there would be less exchange rate risk. With import and export prices denominated in euros the economy, and the inflation rate, would be less vulnerable to shifts in exchange rates. Much more important than this, however, would be the gains from seignorage. As is the case at present in the US, the eurozone would benefit from what are effectively very low interest loans in the form of large central bank holdings of euros. Also, the growth of international trade would boost demand for euros, with the result that the euro-zone could very cheaply finance an external deficit, much as the US has been doing for decades.

But there are downsides to these potential advantages. As the issuer of a major international reserve currency, the eurozone would have to cope with different external risks, such as structural imbalances in the global economy, that are to a large extent responsible for the weakness of the dollar. The huge US current account deficit is the flipside of mercantilist economic policies being pursued by East Asian governments. Internationalisation of the euro could also make it harder to control the stock of euros in circulation and hence growth in the money supply and potentially inflation. An increase in the demand for euros would either cause the currency to appreciate, making exports less competitive, or require that the eurozone run a substantial external deficit in order to satisfy the external demand for euros. For this to happen, the ECB would need to run a looser monetary policy.

The potential for conflict within the eurozone is obvious. A stronger euro would be anathema to many eurozone countries, not least France and Italy, which are already very worried about euro strength. But a looser monetary policy would be anathema to countries such as Germany and the Netherlands that worry about the inflation implications of cheaper money. Indeed, it is far from obvious how the eurozone could run a sizeable current account deficit without exacerbating existing tensions between members of the single currency area with large current-account surpluses, such as Germany and Netherlands, and those with large or rising external deficits – most notably Spain, but also France and Italy. It would be possible for Germany and the Netherlands to continue to run big surpluses at the same time as the eurozone as a whole ran a bigger deficit, but only if other eurozone countries ran even bigger deficits. This is politically implausible.

Becoming the world’s principle reserve currency might not be worth the bragging rights.

Simon Tilford is chief economist at the Centre for European Reform.

Thursday, November 08, 2007

Sarkonomics – a user’s guide

by Philip Whyte

President Sarkozy is frequently portrayed in France and elsewhere as an “economic liberal”. This is a mistake. He is undoubtedly an economic reformer prepared to take on the privileges of labour market “insiders”; but he retains a French dirigiste’s belief in an active role for the state in economic development. This manifests itself in several areas, including his support for “national champions”, his mercantilist vision of international trade, and his belief that governments should have greater influence over the European Central Bank (ECB).

In a French context at least, Mr Sarkozy’s greatest claim to originality probably rests on his policy towards the labour market. From the mid-1970s until comparatively recently, successive French governments sought to stem the rise in recorded unemployment by strengthening employment protection legislation and pursuing a policy of labour market withdrawals—notably by shortening the working week, discouraging young people from joining the labour force too early, and coaxing older workers out of it by lowering the age of retirement.

In other words, for almost three decades French labour market policy was guided by the lump of labour fallacy—the idea that there is only a fixed amount of work to go around. These ill-conceived supply-side policies gave France one of the lowest employment rates in the EU. Mr Sarkozy’s economic priority is to raise France’s rate of employment by reversing, or at least mitigating, the flawed policies of the past. An early measure has been to relax the 35-hour working hour week by exempting overtime work from income tax (“making work pay”).

Inevitably, Mr Sarkozy’s reforms are facing opposition from “insiders” whose privileges they threaten. Public-sector workers such as train-drivers, who enjoy special pension rights which allow them to retire aged 50, have already been on strike to protest at the government’s proposals to raise the retirement age. In the past, such action could often count on the support of the wider population because reforms were often seen as the “thin end of the wedge”—the first salvo in a broader assault on “acquired social rights” (acquis sociaux).

Successive French governments have had a tendency to back down in the face of popular support for industrial action. This time should be different, for at least two reasons. First, Mr Sarkozy has staked his political reputation on pushing such reforms through: should he back down, his authority would be destroyed and the rest of his presidency shorn of purpose. Second, opinion polls indicate that strikes by privileged public-sector workers no longer enjoy the support of the wider population which realises that it bears the burden of supporting them.

Mr Sarkozy’s labour-market reforms are generally wining plaudits abroad, but other aspects of his economic programme are sparking conflict with France’s neighbours. Mr Sarkozy believes that macroeconomic policy needs to be relaxed while his structural reforms are pushed through. This explains why he has criticised the ECB for neglecting the strength of the euro’s exchange rate and for subordinating economic growth to low inflation. The French president’s broadsides against the ECB have been poorly received elsewhere in the EU—notably in Germany, where they have been seen as attacks on the ECB’s independence.

A similar conflict has emerged in the area of fiscal policy. France has not run a balanced budget since the 1970s and its budget deficit has consistently exceeded the Maastricht limit of 3% of GDP since 2002. Earlier in 2007, the French government (of which Mr Sarkozy was a member) committed itself to balancing its budget by 2010. But the budget for 2008 makes no effort to meet this target because it provides for tax cuts that are not offset by reduction in public expenditure. Commitments to the EU are being subordinated to domestic objectives.

As for Mr Sarkozy’s views on competition and international trade, they are anything but liberal. They spring from a mercantilist mind-set which sees a coincidence of interest between domestic firms and the French state and which believes that a country’s aim in international trade is to export more than it imports. This explains Mr Sarkozy’s support for “national champions”, his opposition to foreign takeovers of leading French firms, and his propensity for intervening to “shape” corporate mergers—witness his role in the tie-ups between Sanofi and Aventis (when he was finance minister) and between GDF and Suez (as president).

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

Thursday, November 01, 2007

EU-Russia: no more ambitions

by Katinka Barysch

The CER organised a conference on EU-Russia relations in Brussels on October 30th, together with ‘Russia Profile’ magazine. I have been to dozens of these EU-Russia meetings in the last couple of years. More often than not, they turn nasty, with the Russians making angry accusations and the Europeans going into a sulk. At our seminar, the atmosphere was strangely subdued.

No doubt, this was partly due to the professionalism of the panellists. People like Vladimir Chizhov, Konstantin Kosachev, Helga Schmid and Christian Cleutinx make a living addressing big problems without sounding alarming (details of the event can be found here

But diplomatic protocol was not the only reason for the lull. A sense of resignation has descended over EU-Russia relations. We have quietly discarded our lofty ambition to build a “strategic partnership based on common values”. Today we just want to get along, somehow.

The same lack of expectations turned last week’s EU-Russia summit in Mafra into a success of sorts. The Portuguese presidency of the EU did not even try to unblock talks on a new EU-Russia treaty. The change of government in Poland has increased the chances that the dispute over meat exports will be resolved and that Warsaw will lift its veto. But neither Russia nor the EU has much enthusiasm for a new treaty. What for? Instead of a shared vision, there is uncertainty: in Russia over its future leadership and direction, and in the EU over whether it can forge a common position among 27 member-states.

Both sides are groping for a path through this period of uncertainty. “Realism” is the term most widely used to describe today’s bilateral relationship. One participant at our seminar called for a “partnership of patience”, another referred to a “carefully crafted holding pattern”.

This total collapse of ambition was probably inevitable. Once Russia started to turn away from pluralist democracy, the EU’s constant talk about ‘common values’ simply antagonised Moscow. The EU ended up frustrated and disappointed. Bitterness grew on both sides. The political rhetoric became so shrill that it started to endanger practical co-operation in energy, investment or security.

Now both sides are trying to reassure each other that things are not that bad after all. Look, trade is growing by 30 per cent a year. EU companies are doing good business in Russia. Russians are coming to the EU in record numbers. The Union is allowed to observe mediation attempts in Transdniestria. Micro-successes are still possible: we now have an ‘early warning mechanism’ in case of disruptions to energy supplies, and a new cultural dialogue. Process matters.

But can the EU and Russia really afford to put their relationship on ice and wait for better days? World politics intrudes in the current lull. Russia has blocked EU-backed plans for Kosovo independence. It is against tougher sanctions aimed at preventing Iran from building a nuclear bomb. Russia behaves as if it didn’t need friends. But when it looks around the world – at a rising China, a disillusioned US, an unstable Middle East – it must conclude that the European countries are still its easiest and most reliable partners.

Vis-à-vis Russia, the EU looks divided, confused and often weaker than it is. That is partly because Russia forces the EU to clarify its own objectives. Can the EU become a more powerful international player while at the same time upholding its founding principles of democracy and human rights? Since different member countries have different answers, the EU tries to avoid the question.

Russia also puts the EU’s energy plans to the test. While paying lip service to a common energy policy, EU member-states are rushing to strike bilateral deals with Gazprom. Energy was supposed to be an area where the EU and Russia have clear common interests. But now the Russians complain about a ‘Gazprom clause’ in the Commission’s latest liberalisation package: state-owned foreign companies would not be allowed to buy gas pipelines in the EU, unless their governments agreed to also give European companies better access to their home markets.

Russia is not well placed to lecture the Europeans on energy market liberalisation. But Moscow has a point when asking the EU what it means by reciprocity. If the concept degenerates from a means for mutual openness to a new protectionist tool, it will do nothing to alleviate EU concerns about Russian underinvestment in its gas fields.

The energy debate shows that the shift from ‘values’ to ‘interests’ in EU-Russia relations can only go so far. Values – or more plainly, the way we see things – determine everything we do. When people and politicians in the EU and Russia talk about energy security, they mean different things. The same holds true for democracy, and other terms that allegedly describe the core objectives of our relationship.

I was an early advocate of the EU focusing less on ‘common values’ and more on mutual interests, on areas where practical co-operation is feasible and desirable (see
But I am also the first one to admit that we have come full circle. Ultimately, the EU and Russia need to agree what they want to get out of their interaction.

Katinka Barysch is deputy director of the Centre for European Reform.