Friday, December 17, 2010

Has Ukraine lost appetite for reforms?

In a study on Ukraine published in October, the CER gave President Viktor Yanukovich credit for passing difficult economic reforms but criticised his efforts to suppress political opposition. Since then, reforms have stalled while the concentration of power in the president's hands has continued unabated.

A recent visit to Kyiv has left me deeply worried. The government continues to amass power. This is in part due to the weakness of the opposition – former leaders of the Orange revolution such as former president Viktor Yushchenko and former prime minister Yulia Tymoshenko are genuinely unpopular with voters, who blame them for disappointing economic performance and failure to move Ukraine closer to the EU. Even so, President Yanukovich seems intent on preventing free and fair elections. The October 31st regional poll was marred by widespread use of government powers to help the ruling Party of Regions. The European Parliament notes in its November 25th resolution that "some parties, such as [Yulia Tymoshenko's] Batkivshchyna, were unable to register their candidates". Phil Gordon, the US assistant secretary of state, said that the United States: "does not believe that those elections met the standards of openness and fairness that applied to the presidential election earlier in the year."

The story is not much better on the economic front. Even in those areas, where progress had been made, the government has started to backpedal. For example, the new public procurement law, which the EU helped to draft earlier this year, is being riddled by exceptions: the country's parliament has exempted work on sites for the 2012 European football championship. The EU has viewed the law as key to countering corruption, and its partial reversal dismayed EU ambassadors in Kyiv. Economists also say that the government cheated to comply with a key requirement from the International Monetary Fund (IMF): in order to cut tax refund arrears it simply stopped accepting claims. The IMF is due to decide this month on whether to disburse further aid to Ukraine.

There has been little progress on reforming the country's all-important gas sector. The government has increased domestic gas prices, which has helped to improve the finances of Naftogaz, the country's monopoly – and perennially insolvent – importer and distributor of gas. But there has been no progress on making the company more efficient and transparent. In September 2010 Ukraine acceded to the EU's 'energy community', which groups countries that pledge to uphold each other's security of supply, on the condition that the government separates Naftogaz's gas transit pipelines from other businesses. The Ukrainian parliament passed legislation in July that had ordered Naftogaz to do just that. But nothing has changed: Naftogaz remains untouched and important secondary legislation – to create an independent regulator, for example – is not even under consideration. Meanwhile, Naftogaz is descending into deeper financial trouble. A court in Ukraine has ordered the company to repay nearly $4 billion to one of Ukraine's most powerful businessmen, Dmytro Firtash, who had sued for damages incurred when the previous government cancelled the services of his company in brokering gas purchases from Russia. It is not obvious that Naftogaz has enough money or gas to reimburse Firtash.

The government recently passed a law that would make it easier to explore oil reserves in the Black Sea. These could in the long run lessen Ukraine's dependence on energy imports from Russia. But to extract the reserves, Ukraine needs foreign expertise. So it is baffling that the government has recently imposed a new 40 per cent duty on imports of refined oil (punishing Shell, a key importer) and increased royalties on gas and oil extracted in Ukraine. Foreign energy majors will have little reason to invest in the country. One representative of a Western energy major says that "there is plenty of gas here, in shale and under sea, but no one will tap it because there is zero confidence among investors that they would ever see their money back." Non-energy companies are treated similarly. Deutsche Telekom and Norway's Telenor wanted to buy Ukraine's national telecommunications operator, Ukrtelecom, but the Kyiv government excluded them from the privatisation on a technicality.

Curiously, while the economic reforms have stuttered, relations with the EU have improved, though from a low point. At an EU-Ukraine summit in November, the parties agreed a 'road map' which may eventually allow the Ukrainians to travel to the EU without visas. Talks on a new 'deep and comprehensive free trade agreement' (DCFTA) have also been resumed, after months of paralysis. When the European Commission had threatened in October to cut off talks altogether, President Yanukovich ordered Prime Minister Mykola Azarov "to make all necessary concessions" to restart negotiations. But the order itself is symptomatic of what is wrong with the relationship: Kyiv only pays attention when talks are about to collapse; even then it takes short-term measures: nothing is being done to assess the economic impact of DCFTA on Ukrainian industries or to encourage the losers to move into new lines of business. This guarantees that some of the country's politically powerful oligarchs will eventually revolt against DCFTA.

The EU has limited tools to press for greater political freedoms and proper economic reforms but it is not powerless. The Ukrainians do care what the EU states and institutions think. They have cheered the European Parliament’s November resolution, in which, for the first time, an EU institution (albeit one without decision-making powers in the matter) says that "Ukraine has the right to apply for membership" (something that the Council of Ministers has been reluctant to say). EU High Representative for Foreign Policy Catherine Ashton and senior national diplomats should speak out more forcefully about the state of democracy in Ukraine. EU governments should also use their influence in the IMF to demand real economic reforms. The IMF loans represent the most important leverage that the European governments and the US have in Ukraine today. The current government in Kyiv is capable of tough choices, but only when it feels real pressure.

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

Thursday, December 09, 2010

Eurozone: Time for damage limitation

by Simon Tilford

Time is running out to prevent the eurozone crisis from imperilling Europe's banking system and with it the integrity of the currency union. It is beholden on policy-makers to minimise the economic (and hence political costs) to the EU. Three things need to happen: the debts of Greece, Ireland and Portugal need to be restructured as soon as possible; the European Commission and the European Central Bank (ECB) need to do everything to make sure that the adjustments facing the other struggling euro economies are realistic; and there needs to be policy co-ordination between the member-states aimed at ensuring balanced economic growth across the currency union. This requires leadership and an honest and better informed debate about the causes of the crisis. Both are in short supply.

The adjustments facing Greece, Ireland or Portugal were always a tall order. Now that borrowing costs have ballooned, those adjustments are impossible. Under no plausible economic growth forecasts will these economies be able to pay back their debts. However, eurozone policy-makers continue to treat the crisis as one of liquidity rather than solvency, providing indebted member-states with loans (at punitive interest rates) but doing nothing to improve their chances of being able to service them. This is the worst of all possible worlds. Investors have taken fright and pushed up the borrowing costs of countries whose debts might otherwise have proved manageable. Far from limiting creditor losses, they risk spiralling out of control. Piling up more debt when solvency (not liquidity) is the issue is self-defeating.

The bail-out of Ireland simply increases that country's already unsustainable levels of debt, while insulating investors. The ECB and the Commission opposed restructuring the debts of the Irish banking sector. Instead, they have argued for ever more implausible degrees of fiscal austerity in return for extending costly loans. Unsurprisingly, the Irish government's borrowing costs remain prohibitively high. A bail-out of Portugal will be similarly ineffective. It will benefit lucky investors, but do nothing to improve Portugal's prospects. The loss of confidence in the eurozone and resulting surge in borrowing costs threatens to draw Spain into the insolvent camp, ultimately requiring a Spanish debt restructuring. This would be catastrophic for Europe's banks and would impose huge fiscal costs.

Of course, restructuring the debts of Greece, Ireland and Portugal will be costly for creditors. But if debt positions are unsustainable the problem needs to be addressed sooner rather than later. Banks based in eurozone members such as France and Germany, as well as in non-eurozone countries such as the UK and US, would suffer big losses on their investments in the defaulting countries. The ECB would also book losses. This would be messy and governments would have to bite the bullet and recapitalise their banks. But it would ultimately prove less damaging to economies such as Ireland, Greece and Portugal, and the currency union as a whole, than persisting on a course that promises an even bigger restructuring (and bigger losses) down the line.

The second part of the strategy would be to ensure that the adjustment process facing Spain and other hard-hit economies is a manageable one. The ECB could help by launching an aggressive programme of government bond purchases. Monies from the European Financial Stability Fund (EFSF) could also be used to tide the countries over until they regain access to the financial markets on affordable terms. But these countries' fiscal programmes will also have to be consistent with a return to decent economic growth. Crucially, cuts in spending on education and infrastructure must be kept to a minimum, as these would further reduce growth potential. Reforms of pension and healthcare systems would go a long way to address investors' concerns about the long-term sustainability of countries' fiscal positions. 

The third part of the strategy – rebalancing economic growth in the eurozone – will be the hardest to execute, but is essential if future crises are to be avoided. Governments need to support the Commission's drive to foster closer economic integration and to co-ordinate their policies to ensure that they are compatible with balanced economic growth across the eurozone. Huge current account balances are not consistent with a stable currency union, because one way or another they require massive (and hence politically and economically destabilising) transfers between the participating economies. However, even if trade imbalances are reduced, there will have to be greater fiscal supra-nationalism. This could take the form of a common E-bond, some minimal fiscal union, or ideally a combination of the two. Without some element of fiscal supra-nationalism, the adjustment costs facing countries that cede trade competitiveness within the eurozone will simply be too high.

However unpalatable these measures are to eurozone governments, the European Commission and the ECB, they can all be done if governments can summon the political will. Governments have to explain to their voters why debt relief for Greece, Ireland and Portugal and the resulting injection of public funds into banks is necessary in order to head off far greater costs down the line. They have to summon the political courage to make the case for greater economic integration. A fiscal union can also be fashioned in such a way that limits moral hazard. But all of this requires leadership, not least from Germany. The fact that the alternative – a series of ever larger and ineffective bail-outs, culminating in far bigger defaults and a systemic banking sector crash – is much worse, ought to focus minds. After all, under that scenario the political glue holding the union together could dissolve altogether.

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

Monday, November 29, 2010

The 'new' Poland and its neighbours

by Tomas Valasek

Poland is shedding its 'new member-state' image and is instead trying to join the exclusive club of big EU countries. It is a laudable and so far largely successful goal, but not one without risks. To become a big EU player, Poland needs to continue cultivating its role as a regional leader in Central and Eastern Europe.

Poland is riding high. Whereas all other EU economies slumped last year, Poland's grew by 1.7 per cent. Warsaw has patched up relations with Berlin and Moscow, with noticeable results: German Foreign Minister Guido Westerwelle's first foreign trip was to Warsaw, and Russian politicians handled the tragic plane crash that killed the Polish president and other leaders with unusual tact. Poland's dynamic foreign minister, Radek Sikorski, is all over Europe, dispensing advice on how to reform the EU's neighbourhood policy, democratise Belarus, and revamp NATO's nuclear posture. In a single day alone last month, Russia's Foreign Minister Sergey Lavrov, former US Secretary of State Madeleine Albright, US Assistant Secretary of State Phil Gordon, US Assistant Secretary of Defence Alexander Vershbow and a senior US congressional delegation dropped by Warsaw for separate visits.

The 'new' Poland was born in 2007, when the centre-right government of Prime Minister Donald Tusk replaced the controversial Kaczynski government. Tusk's team decided that Poland was to shed its labels of being reflexively Russophobic, anti-German and Atlanticist – which had led to Warsaw at different points vetoing EU-Russia negotiations and seeking to slow common EU defence policy. Instead, the government briefed Russia on Poland's plans for missile defences (which Moscow felt uneasy about), invited Prime Minister Vladimir Putin to the anniversary of the outbreak of Word War II and launched consultations with Germany on the EU's eastern policy. Warsaw also made common EU defence a priority for its EU presidency in 2011.

Poland's revamped foreign policy has been a great success: along with the country's economic resilience, it has catapulted Poland to a position of prominence in Europe without weakening its bond with the US. Relations with Russia are at their highest point since the end of the Cold War. This transformation has inflated the country's confidence: "We are no longer a playground but a player", boasts one government minister. Poland's view of its place in Europe has been transformed, too. The 'old' Poland was a Central European leader. The 'new' Poland sees itself as a European power on a par with France and Germany. Polish diplomats speak fondly and frequently of a 'Weimar Triangle', in which France, Germany and Poland will discuss matters of European security. In many ways it is already working: Germany's and Poland's foreign ministers wrote a joint paper on strengthening the EU's eastern policy and they went to Minsk together to warn the Belarusian governments against falsifying elections. Diplomats say that lower-level co-operation between German and Polish officials is even more intense.

The Polish-Russian 'reset' has been the most notable result of Warsaw's policy reversal. It started for largely tactical reasons – as a way of boosting Poland's standing in Europe. But Russia's positive response has had an interesting psychological effect. When one speaks to Polish diplomats today they leave the impression that they want the relationship with Russia to look successful almost irrespective of what it delivers because the dialogue with Moscow makes Poland feel relevant and strong. Although most Poles are still wary of Russia, Polish politicians and officials appear more prepared than other Europeans to believe that Russia's 'modernisation partnership' with the EU will transform the country. Polish diplomats also sound less suspicious of Russian intentions, for example in meddling in Central Europe, than most of their EU counterparts.

While Poland has received more attention from West European capitals and improved its ties with Moscow, its links with its immediate neighbours have cooled. Relations with Lithuania are the worst they have been in decades. Diplomats from other 'Visegrad Four' states (Hungary, Czech Republic and Slovakia) grumble that it has become difficult to get their Polish colleagues to focus on regional projects such as new interconnections between oil and gas networks in Central Europe. When the Visegrad countries hold a ministerial meeting, Poland usually sends a deputy to meet with other countries' senior ministers.

This is partly Poland's neighbours' fault; they do not always make attractive partners. Some Central European countries are not serious about defence whereas Poland is a military power and one of a few countries to spend close to the NATO-recommended two per cent of GDP on defence (Hungary and Slovakia are already below, or falling below, the one per cent mark). Others, like the Baltic states, have been reckless with their economies and needed to be bailed out by the IMF, whereas Poland is proudly growing. But Warsaw's relations with new EU members have also cooled because Poland is increasingly adopting a 'big country' mentality. Like the UK, France and Germany, it gives smaller countries less attention than it gives the big ones. Above all, the Poles seem intent on shedding the 'new member' label. A commonly-expressed opinion in Poland is that "the new divisions in Europe are not between the East and West but between the [frugal and responsible] North and the [free-spending and reckless] South". In the eyes of other Central Europeans, Poland appears to be deliberately distancing itself from its traditional friends in the neighbourhood.

This is an understandable instinct; all 'rising powers' grapple with how to balance old friendships with new opportunities for partnership with the big states. But Poland's shift to 'big country' mentality is not without risks. Despite all the notable successes, Poland's new status is still fragile. Germany and France will remain preoccupied with saving the euro for the foreseeable future – an endeavour in which Poland as a non-euro member does not have much of a say. Even in areas where Poland thinks it should play a pivotal role now, it is not always taken seriously. Germany and France held a controversial three-way summit with Russia on European security, much to Poland's dismay (one of the main points of repairing relations with France and Germany was to stop them talking to Russia over Polish heads). Poland's charm offensive also comes at a difficult time: the eurozone crisis has made all EU countries more selfish and tetchy. Poland risks being caught in no-man's land: not yet taken fully seriously by Europe's biggest states but no longer seen by the rest of the new EU countries as a natural leader.

Poland should hedge its bets by simultaneously cultivating links to Germany and France while keeping its old friends close. Paris and Berlin take Warsaw seriously partly because Poland is a regional power: the four Visegrad countries have more votes in the EU's Council of Ministers than the Franco-German duo, and many more when the Baltic states are added. Poland, by virtue of its size and prominence, is the region's natural leader. This gives Warsaw real power in the forthcoming debates such as the one about the next EU budget framework starting in 2014. The more effective Poland becomes at corralling Central European votes, the more likely Paris and Berlin are to seek co-operation with Warsaw.

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

Monday, November 15, 2010

Eurozone policy-makers are playing with fire

By Simon Tilford

There is an awful inevitability about the latest instalment of the eurozone crisis, which looks highly likely to culminate in Ireland being forced to seek a bailout from the European Financial Stability Fund (EFSF). As soon as German and French leaders raised the spectre of private holders of government bonds incurring losses under a permanent crisis resolution mechanism, borrowing costs for the struggling members of the eurozone were only going to increase. Unless the EU changes track and agrees to make the EFSF permanent and the European Central bank (ECB) steps up its purchases of the hard-hit countries’ government bonds, investors will believe that default is inevitable and demand correspondingly punitive interest rates. Contagion to other member-states will be all but inevitable. If, and when, it reaches Spain, the crisis risks spiralling out of control.

Taken out of context there is obviously merit to the Franco-German proposal. But the timing could not have been more damaging. The defence of the proposal – that existing bonds would not be affected, just those issued after 2013 when the new crisis resolution mechanism would replace the EFSF – is illogical. In 2013, Greece, Ireland, Portugal and whichever other countries are in this group by then will have to pay ruinously high interest rates to borrow money. The EU will then have to choose between launching an open-ended bail-out of the countries in question, or push ahead with a restructuring of their debts. The latter would, of course, leave the current holders of these countries’ debts nursing losses, and explains why investors have taken fright.

Investors are calculating that voters in the fiscally sound member-states would baulk at an open-ended bail-out. They are right to be sceptical as the number of countries that would be strong enough to participate in such a bail-out is worrying small. For example, it is unlikely that Italy could really participate in a major bail-out without investors looking askance at its own position. Italy is not confronted with the aftermath of a housing market crash, but the country has a very high level of public debt (around 115 per cent of GDP) and extremely poor economic growth prospects. Belgium is in a similar position.

Instead of making a bad situation worse the eurozone should concentrate its efforts on debating how the EFSF will be made permanent, ideally as the embryo of some kind of minimal fiscal union. Without a permanent mechanism to support member-states, it is hard to see how order is to be restored to the bond markets. The current strategy of austerity and debt-deflation on the struggling member-states is bankrupt and self-defeating. If these countries were able to devalue it might work by boosting the trade competitiveness of their goods and pushing up inflation, hence reducing the risk of deflation. Similarly, if there was going to be serious action to address trade imbalances within the currency union, they might have a chance of generating export-led growth. As it stands a number of member-states are effectively insolvent and caught in a vicious cycle. The collapse of economic growth has devastated tax revenues, while deflation is pushing up the real value of their debts.

For its part, the ECB should be loosening monetary policy and stepping up its strategy of bond purchases in an effort to save the currency union. But the next move in eurozone interest rates will be up, and the ECB is committed to winding-down its bond purchases. In light of the risk of contagion to other member-states, including Spain, the ECB’s current strategy is much riskier than the potentially inflationary impact of such bond purchases. With much of the eurozone economy stagnant and German growth being driven largely by exports rather than domestic demand, the threat of a surge in inflation is imaginary.

The initially slow and disjointed response of eurozone policy-makers to the eurozone crisis was forgivable. After all, the currency union comprises 16 sovereign governments and there had been no contingency planning for such a crisis. Deciding what to do was never going to be easy. What is less forgivable is that they continue to underestimate the severity of the crisis and what is at stake if they fail to contain it. Instead of questioning the rationality of the investors, eurozone policy-makers need to pay more attention to what is driving market sentiment. The eurozone’s strategy for dealing with the crisis now points to default across the currency union’s periphery. The markets can hardly be blamed for pricing in such a likelihood.

Simon Tilford is chief economist at the Centre for European Reform

Wednesday, November 03, 2010

Europe dances to Germany's tune

by Charles Grant

For much of this year, the response of European leaders to the eurozone crisis has been hesitant and fractious. But when the European Council met in Brussels on October 28th and 29th, the EU appeared to be acting with greater purpose and sense of direction. One reason for this change is that most member-states – including France – are now willing to swallow large doses of German leadership. Chancellor Angela Merkel's influence was evident on the three key issues discussed by the summit: tightening rules on economic governance, setting up a new institution to deal with countries unable to borrow in the markets, and revising the EU treaties. However, Germany’s leadership has also brought problems. One is that Germany's determination to get its way has bruised several smaller states, as well as the Commission and the European Central Bank. Another is that its reluctance to discuss imbalances within the eurozone has prevented the EU from taking serious action to tackle them – though the imbalances have (in the view of many countries) contributed to the euro crisis.

On the first key issue, the summit adopted the report of the task force led by Herman Van Rompuy, the European Council president, on 'Strengthening economic governance in the EU'. The implementation of the report will mean stricter and more automatic punishments for countries that borrow too much, as the Germans – backed by the Austrians, Dutch, Finns and Swedes – have called for. Sensibly, the report says that the EU should focus not only on governments' budget deficits, but also the overall level of debt. The task force also considered the delicate subject of economic imbalances in the eurozone (the Germans do not like being told that their unwillingness to spend, and their current account surplus, contribute to inadequate demand and current account deficits in southern Europe). The report says it is more urgent to tackle imbalances in countries with big current account deficits than those in the surplus countries, but it does propose monitoring of imbalances and disciplinary procedures for all those who fail to act on recommendations to tackle imbalances.

On the second issue, the new institution, EU leaders agreed to establish a 'crisis resolution framework' to replace or supplement the European Financial Stability Facility (EFSF) that they designed last May to support governments unable to borrow in the markets. Merkel has been unwilling to prolong the three-year life of the EFSF, fearing that Germany's constitutional court could declare it in breach of the Maastricht treaty's no-bail out rule (she also knew that giving the EFSF a finite life would increase her leverage in the arguments on eurozone governance). EU leaders have not yet agreed on how the new body will work, but it will probably be a kind of European Monetary Fund that both lends money (with strict conditions attached) and facilitates an orderly restructuring of the debt of countries that cannot repay what they have borrowed.

The Germans say this restructuring should lead to private sector creditors taking a loss, and many governments go along with that. But at the summit Jean-Claude Trichet, the president of the European Central Bank, and the leaders of some southern states – who worry about their ability to borrow – argued against establishing that kind of restructuring mechanism at this stage. It could deter investors from lending to eurozone governments, Trichet argued, and make it even harder for them to service their debts. The Germans responded that tax-payers should not bear all the cost of bail-outs, and that markets should fret about potential losses in order to discipline borrowers. The markets now seem to be doing that job – perhaps too well. Since the summit the cost of borrowing for the southern Europeans has risen to as high as it was before the EFSF was hatched in May (though the governments concerned started to tighten their belts several months ago). The Germans will face stiff opposition on the issue of creditors taking losses. But since they will be responsible for providing the biggest share of any rescue package, they are likely to win the argument.

On the third issue, treaty change, the summit asked Van Rompuy to report back in December on whether the current treaties need to be amended to establish the crisis resolution mechanism. The answer to that question is already clear. For many months the Germans have argued that treaty change was needed to ensure that a new mechanism did not fall foul of their constitutional court. However, most governments – having spent the best part of a decade sorting out the Lisbon treaty – did not want another round of treaty change. Then at the Franco-German summit in Deauville on October 19th, Merkel persuaded France's president, Nicolas Sarkozy, to back treaty change (in return for a modest weakening of some sanction mechanisms). At the European Council most other leaders followed them, if only grudgingly – though Luxembourg's Jean-Claude Juncker and the Commission's José Manuel Barroso argued against treaty change.

The heads of government now seem confident that a small treaty change can be achieved without too much pain. They have reached a tacit understanding to limit the change to the establishment of the new institution, and to rule out any other amendments. The Lisbon treaty contains a 'fast track' procedure that allows the heads of government to agree a change, by unanimity, without the need for a convention (the mix of MPs, MEPs and government representatives that drew up the constitutional treaty that later became the Lisbon treaty) or an inter-governmental conference. But two conditions must be satisfied: the change must not transfer powers to the EU, and it must concern the implementation of EU policies, rather than the fundamentals of the Union. The clause the Germans want should meet those conditions.

The fast-track procedure still requires each member-state to ratify the amendment. The Irish and the Danes seem to think they can avoid referendums. In the Netherlands, the populist Dutch Freedom Party and the left-wing Socialist Party are both threatening to demand a referendum, but they lack a parliamentary majority. In the Czech Republic, President Vaclav Klaus could create problems, as he did by delaying the ratification of the Lisbon treaty. In any case Czech eurosceptics are likely to challenge the amendment in the constitutional court, on the grounds that it gives the EU more power and therefore merits a referendum. Britain will not be affected by the new rules on eurozone governance, since it has an opt-out from treaty provisions on the euro. Nevertheless Conservative eurosceptics want Prime Minister David Cameron to block treaty change until the other member-states grant Britain new opt-outs from the treaties in areas such as social policy. Cameron seems determined to face down the eurosceptics. He will accept the amendment so long as other governments help him constrain the growth of the EU budget. At the moment France, Germany and about half the member-states are backing Britain's efforts to hold the rise in next year’s budget to 2.9 per cent.

The Germans did not get everything they wanted at the summit. There was little support for their scheme to deprive governments that borrow too much of voting rights. They have had to accept the Van Rompuy report's argument that imbalances should be monitored. But the Germans achieved most of their key objectives. France had opposed stricter rules and quasi-automatic penalties for over-borrowed countries, a formal debt restructuring mechanism, and treaty change. But now it has accepted those German priorities – without appearing to get a great deal in return.

Visiting Paris just after the summit, I was struck by the deferential tone of some French officials when they talked of Germany. They noted that Germany is in a supremely self-confident mood because of its export surge to emerging markets. They thought this was not the right time to tell the Germans that their economic model was marred by a low level of domestic demand, and that that was aggravating the eurozone crisis. Much better to suggest gingerly that Germany would benefit from taking specific steps such as increasing investment and spending on R&D, lengthening shopping hours and getting more women into the workforce. Such steps would in the long term help to rebalance the eurozone. These French officials may be right on the tactics of how best to deal with the Germans.

In Paris, some senior figures fret about Germany's seemingly superior economic performance, compared to France and other EU countries, and about its economic structure – very focused on emerging markets – which seems to be diverging from that of its partners. "Will Germany lose interest in the EU?" they ask. For several years the French – and many others – have worried about Germany becoming less 'European' and more focused on the east, for example through its special relationship with Russia.

One French response is to stay close to the Germans in order to retain influence with them. That has been evident in Russia policy: in recent years France has emulated Germany's soft approach towards Moscow (which is not to say that that policy is necessarily wrong). And that response has also been evident on the euro. At the Brussels summit several smaller member-states complained about having to fall in behind deals stitched together by Paris and Berlin. But so long as the French continue to back the Germans on eurozone governance, their partners – and the EU institutions – have little choice but to follow.

Charles Grant is director of the Centre for European Reform

Thursday, October 28, 2010

Britain's defence review: Good news for European defence?

by Clara Marina O'Donnell

On October 19th, the UK's coalition government published its 'strategic defence and security review' (SDSR), laying out the future shape of Britain's armed forces. As was to be expected at a time of budget austerity, the SDSR foresees significant cuts in military capabilities. But the review also has some good news. The need to save money has made the UK government more willing to move towards long-overdue European co-operation. In addition, the coalition is keen to see the EU play a role in defence, a pragmatism which stands in stark contrast to the eurosceptic views held by the Conservative party before the general election last May.

As part of its plan to reduce the UK's budget deficit, the government has been forced to cut an already overstretched defence budget by 8 per cent in real terms over the next four years. Prime Minister David Cameron has claimed that Britain will continue "punching above its weight" in the decades to come. But, inevitably, the UK's level of ambition has been scaled back.

Britain will no longer be able to maintain a long-term operation of the size that is currently deployed in Afghanistan: while there are nearly 10,000 British troops in Afghanistan today, the maximum size of such operations in future will be around 6,500. The size of large-scale fighting operations will also be cut back – to around two-thirds of the forces that went into Iraq in 2003. The government has also been forced to give up big items of military equipment. Britain will mothball or sell one of the two new aircraft carriers it has committed to build; the UK is also retiring its Harrier fleet of military jets early, leaving the other carrier without any British aircraft for several years.

Extensive cuts in UK defence capabilities risk further weakening the ability of Europeans to contribute to global crises, already poor as a result of years of insufficient and inefficient defence spending across the continent. But at least the British government is showing an unprecedented interest in closer defence co-operation – not only with the US, but also with its European allies. Acknowledging that it can no longer afford to maintain capabilities alone, the government has committed to exploring the possibilities of joint formations for future operations, joint training and maintenance, and even sharing assets or relying on others to provide some military equipment.

Frustrated by the inefficiencies and cost overruns of large multinational programmes, the coalition wants to focus on bilateral co-operation. In particular, the government wants to work more closely with France, which has a similar defence budget and shared military ambitions. Prime Minister Cameron and President Nicolas Sarkozy are expected to announce a series of common defence projects at a bilateral summit in Paris in early November. Now that both France and the UK will rely on only one aircraft carrier each, this should also lead to new avenues for co-operation. Britain has already decided to redesign its remaining carrier so it can be used by French (and US) aircraft.

The coalition government's plan to work more closely with its allies is both positive and long overdue. For decades, Britain and other European countries have wasted a lot of money by duplicating the development of military equipment. Depending on the outcome of the Franco-British summit, the new UK government might go further in promoting the cause of European defence co-operation than any of its predecessors.

But London must invest the same political energy it has devoted to France towards exploring additional savings with other European countries. In the SDSR, the government opens the possibility of closer defence co-operation with Germany, Italy, the Netherlands and Spain. But other countries could also offer niche savings, including Poland and Sweden which have shown a keen interest in improving their military capabilities in recent years. The UK should also actively encourage its European allies to strengthen co-operation amongst themselves. As Britain's own military preparedness diminishes, it has a greater interest in other European countries taking up the slack.

The second piece of good news in the SDSR is the rather constructive attitude of the UK towards EU defence co-operation. Before the general election last spring, key members of the Conservative party – in particular William Hague, now the Foreign Secretary, and Liam Fox, now in charge of defence – voiced serious reservations about EU efforts in defence. Liam Fox worried that federalists within the EU were trying to develop a European army. He openly opposed some of the steps towards a stronger EU foreign policy foreseen in the Lisbon treaty. And he was keen to withdraw the UK from the European Defence Agency, a body which encourages common efforts amongst EU countries in developing defence capabilities.

But since their arrival in government with the Liberal Democrats, the Conservatives have agreed to support the new institutions created by the Lisbon treaty. The coalition has chosen to remain in the European Defence Agency for a trial period of two years. And the SDSR has recognised that while NATO remains the "bedrock of Britain’s defence", an "outward-facing" EU also has a role to play in “promoting security and prosperity”. In the defence review, the government even stresses its support for EU military and civilian missions – as long as they offer good value for money and NATO does not want to intervene.

The new government's stronger focus on value for money in EU missions has already ruffled feathers in Brussels, as the UK has become more critical of EU deployments that it considers are failing to deliver – such as the EU mission in support of security sector reform in Guinea-Bissau (which was ended in September 2010) or the military training mission for Somali security forces. But the coalition's desire to see EU missions deliver a real impact on the ground should be seen as a good thing. Too often EU deployments have been too small to make a lasting contribution to stability, like the police training mission in Afghanistan, or their effectiveness has been damaged by an ambiguous mandate, as was the case at the beginning of the police mission in Bosnia-Herzegovina.

If the UK government is going to oppose missions which it considers are not adding value, it must also be willing to strengthen those missions which are effective. Britain is actually one of the EU countries keen to maintain the EU's military deployment in Bosnia-Herzegovina (which some other member-states want to dismantle). But the UK should go further and, when appropriate, increase the budget of effective EU operations and send more British personnel – notwithstanding the UK's budgetary troubles.

If the coalition strengthens EU missions, it would help reassure EU partners that the UK is not opposed to EU operations out of principle. More importantly, effective EU military and civilian deployments would contribute to one of Britain's key objectives within its SDSR – to strengthen stabilisation and conflict prevention efforts around the world.

At a time when additional defence cuts cannot be precluded down the road, the UK must work closely with its European partners over the next few years – in developing military capabilities and deploying stabilisation and crisis management missions, including through the EU. Only through co-operation now will Britain feel more comfortable to explore even deeper common efforts when the next SDSR takes place in 2015.

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

Friday, October 15, 2010

What currency wars mean for the eurozone

By Simon Tilford

The dollar has now fallen to $1.40 against the euro. This is still below the low of almost $1.60 that it reached in the middle in July 2008, but it represents a steep decline from under $1.20 in early June. Moreover, the US currency is likely to weaken further. The euro has also risen sharply against the British pound in recent weeks. Why is this happening? And what are the implications for the eurozone economy and, in particular, the member-states currently experiencing difficulties funding their government deficits?

The renewed strength of the euro is not down to optimism about the eurozone’s economic prospects. Most forecasters foresee only modest growth in the eurozone economy next year and in 2012. Nor does the appreciation in the value of the single currency reflect receding investor concerns over the solvency of various eurozone economies. The spreads between the German government’s borrowing costs and those of the struggling member-states of currency union remain very high. The reason for the strength of the euro reflects the differing policies of the US Federal Reserve (and the Bank of England) on the one side and the European Central Bank on the other.

The Federal Reserve will almost certainly embark on a further round of so-called quantitative easing before the end of 2010. The Bank of England may follow suit. Quantitative easing involves pumping money into the economy through the purchase of assets (usually government bonds), ostensibly with the aim of boosting credit growth and hence consumption and investment. Both central banks are considering such action because of the failure of their respective economic recoveries to gain traction and their consequent fears that inflation will fall too low. Weak economic growth and low inflation (or worse, deflation) is very dangerous for highly indebted economies, because it makes it much harder to reduce the real value of their debt.

The ECB has taken a different line. Some of its board members believe that they need to tighten monetary policy. The bank has already reined in its policy of providing unlimited liquidity to eurozone banks, with the result that market interest rates have risen sharply. Axel Weber, head of the influential German Bundesbank, has called for an increase in official interest rates and spoken out strongly against any quantitative easing comparable to that under consideration by the Federal Reserve or the Bank of England. The institutions’ contrasting approaches partly reflect philosophical differences – the ECB believes the potential inflationary risks of quantitative easing outweigh the threat of deflation. But the differing economic outlooks of the various eurozone economies are also a factor. For example, the German economy is expanding rapidly, explaining Weber’s call for tighter policy.

The problem for the eurozone is that unorthodox monetary policy such as quantitative easing tends to depress the currencies of the countries whose central banks are engaged in it. The reason is that some of the money issued flows abroad. The weakness of the dollar (and the pound) has led many to question whether the US and UK are engaging in competitive currency devaluations. In short, they stand accused of attempting to bolster their trade competitiveness at others’ expense. Because the ECB has elected to pursue a different monetary policy course and because – unlike East Asians countries such as China, South Korea and even Japan – the ECB does not intervene in the foreign currency markets to hold down the value of the euro, it is the single currency which is bearing the brunt of a weaker dollar.

There is no doubt that the Federal Reserve and the Bank of England are keen to keep their respective currencies weak. It is not hard to see why. For the best part of three decades, both economies have more or less continuously run current account deficits as their domestic savings have fallen short of their investment levels. They now need to close these external imbalances, which are a drag on their economies, and are one reason why both are running such large fiscal deficits. Savings rates in both countries have certainly picked up and investment remains weak, but a rebalancing of their economies remains elusive. Indeed, after narrowing in the immediate aftermath of the financial crisis, the US trade deficit is widening. A major reason for this is that many countries remain wedded to export-led growth and are unwilling or unable to rebalance their economies in favour of domestic demand.

Global imbalances were one of the key drivers of the financial crisis. They led to excessive capital flows into the US and other fast-growing developed economies. These pushed down the cost of capital and encouraged – together with poor management – excess leverage and risk-taking. US attempts to cajole the Chinese and others to pursue more balanced economic growth have largely fallen on deaf ears. By pumping out lots of dollars, the US central bank hopes to make it more costly for countries to hold down their currencies. China will have to buy more dollars if it is to maintain the renminbi’s peg to the US currency. This will be costly because the dollar will ultimately have to fall in value, reducing the value of China’s dollar holdings. Moreover, the inflows of dollars into China will prove destabilising, exacerbating bubbles and pushing up inflation. This, in turn, should make Chinese goods less competitive on the US market. However, it is impossible to say how long it will take before the Chinese and other East Asian governments blink.

In the meantime, the euro is set to remain very strong. This is bad news for the stability of the eurozone. If it persists, the adjustment facing struggling members of the currency union, such as Spain, will be even harder to bring off. Spain requires strong growth in exports to offset the weakness of its domestic economy, and a strong euro will make its goods and services less competitive in export markets outside the currency bloc. But is the eurozone an innocent bystander in all this? The eurozone’s trade with the rest of the world is broadly in balance, and no-one could accuse of the ECB of adopting policies aimed at weakening the euro. However, to an extent, the eurozone economies are reaping what they have sown.

First, Spain is so dependent on exports to the rest of the world to dig itself out if its current hole because the eurozone has failed to take action to address the trade imbalances between member-states of the currency union itself. Spain must close its external deficit without any corresponding obligation on countries such as Germany and the Netherlands to narrow their surpluses. In short, the eurozone is relying on demand generated elsewhere in the world to bail it out. In essence, its strategy to overcome the crisis involves running a trade surplus with the rest of the world. US action to weaken the dollar combined with the mercantilism of East Asian governments makes this all but impossible. Second, the Chinese were not the only ones who were deaf to US calls for action to rebalance the global economy. The German government was instrumental in preventing any discussion of imbalances within the G20, joining the Chinese in arguing that it is for the deficit countries alone to put their houses in order.

The G20’s failure to agree a global strategy to address imbalances leaves the eurozone in a tricky position. At the very least, the ECB should hold off tightening monetary policy, as this would further increase the attractiveness of the euro relative to the dollar. Secondly, it must get serious about removing barriers to stronger domestic demand across the eurozone. There will be no export-led exit from the eurozone crisis. Signs of a pick-up in German domestic demand are positive in this regard, but it remains to be seen how vulnerable this is to a weakening of external demand for German goods.

Simon Tilford is chief economist at the Centre for European Reform

Tuesday, October 12, 2010

The EU should be much bolder on energy efficiency

by Stephen Tindale

The most pain-free way for European governments to fight climate change is to use energy more efficiently. At a recent energy conference hosted by the European Commission, it struck me that the EU still has a poverty of ambition when it comes to energy efficiency. This is hard to fathom at a time when it could alleviate several of the ills currently troubling European governments: unemployment, energy security and climate change.

EU policy and performance in this area has been disappointing to date. In a speech to a conference on EU energy policy on September 30th 2010, energy commissioner Gṻnther Oettinger identified energy efficiency as his “first priority”. However, he then talked mainly about how energy is used by consumers and the importance of improving the insulation of buildings. This is a significant part of the energy equation, but not the only important part of it. The EU must also focus on how energy is produced.

Too much of the debate on climates focuses on targets. The EU has legally binding targets to reduce greenhouse gas emissions by at least 20 per cent (from 1990 levels) by 2020, and to get 20 per cent of energy from renewables by the same date. A third target, energy savings of 20 per cent by 2020, is so far only for for guidance. Oettinger has said that he will decide whether to make this target binding after evaluating progress made towards the voluntary target in 2012. Targets have some value; they lead to greater political and business attention and help secure agreement on specific policies. However, it would be a waste of political and negotiating capital to spend too much time or effort making the target binding. It would be more sensible for governments, businesses and non-governmental organisations to focus instead on specific regulations and on funding.

The Commission is due to publish a new Energy Efficiency Action Plan before the end of 2010. This should identify regulations and funds to deliver improved efficiency, both in energy use and in energy production. The Energy Performance of Buildings Directive, Energy Services Directive and Cogeneration Directive should be strengthened. The Energy Performance of Buildings Directive mandates that all buildings undergoing major renovation will have to meet minimum energy performance requirements, but these are to be set by member-states. Germany already requires that any building undergoing substantial renovation should meet high energy efficiency standards. Sweden has gone further: every time a building is sold or rented out it must meet high efficiency standards. All member-states should follow the Swedish example, and the new Action Plan should require that strong building regulations be met whenever a building is renovated, sold or rented.

The Energy Services Directive is an attempt to get energy companies to act as energy services companies, delivering not just power and heat but also advice to help their consumers use energy more efficiently and so reduce costs. The directive requires energy suppliers to promote energy efficiency to their customers and to expand energy metering. But it is vaguely worded and has no significant regulatory teeth. It should in future require energy companies to give money to organisations which carry out energy efficiency work at no up-front cost to customers.

The third directive to strengthen is the Congeneration Directive. When a fuel is burnt to generate electricity, heat is also produced. Most of the heat from most power stations is simply wasted up chimneys. Additional fuel is then burnt to provide heat for homes and industry. It is quite possible to use the heat from electricity generation for industrial or domestic heating. Cogeneration is a well-established technology which makes obvious economic, energy security and climate sense. Yet in 2007 only 11 per cent of EU electricity and 13 per cent of heat used came from cogeneration plants.

The Cogeneration Directive requires member-states to remove barriers to cogeneration. It allows, but does not require, them to support cogeneration. Some governments have done so, but the leading countries were doing this well before the directive was adopted in 2004, and the directive has not delivered a significant increase in cogeneration Europe-wide. Cogeneration should therefore be made mandatory. Whenever anything is burnt to generate electricity, the heat must be captured and used.
As well as regulation, the EU must focus on funding. Grants will be necessary to expand cogeneration and district heating networks. In 2008 the Commission allocated €4.8 billion of cohesion policy funds to renewables, decentralised energy production (which makes cogeneration much easier) and district heating. It has recently proposed that €115 million of unspent money from the European Economic Recovery Fund to be allocated to energy efficiency. The Commission should go much further. It should propose a substantial increase in energy efficiency funding, using some of the estimated €112 billion that will be raised by auctioning Emissions Trading Scheme permits.

Whatever the Commission does, most of the finance will have to be mobilised nationally. Much of the funding should come via low-interest loans, as has been done successfully in Germany through the publicly-owned KfW bank, resulting in the improvement of more than 1.5 million homes. The Energy Services Directive allows member-states to establish energy efficiency funds, but does not require them to do so, while the Energy Performance of Buildings Directive merely requires them to list existing and proposed financing schemes. These provisions are too weak. Member-states must be required to set up energy efficiency financing schemes.

The EU likes to claim to be a world leader on tackling climate change. It cannot claim any sort of leadership in energy efficiency, but there are some reasons for optimism that 2011 will at last see significant progress. President Herman Van Rompuy has called a summit on energy in February 2011. This will be a good opportunity to make progress on implementing the Energy Efficiency Action Plan. Hungary, which holds the EU presidency for the first half of 2011, has particularly strong reasons to focus on improving existing buildings. Doing so could reduce its annual gas imports by 40 per cent, and prevent up to 2,500 people dying from hypothermia every winter. Poland, which has the presidency in the second half of 2011, has improved residential energy consumption by almost 20 per cent over the last five years by retro-fitting existing buildings.

Progress is no guaranteed, of course. Raising the price of energy through taxation is one way to encourage less consumption, and would also help reduce fiscal deficits, but energy taxation proposals provoke extensive and often effective lobbying by industry and consumer organisations. Public grants don't face opposition, but will be limited by the economic situation. Nevertheless, the Commission does now appear to be serious about energy efficiency. It has estimated that reducing EU energy consumption by 20 per cent by 2020 would reduce the cost of energy imports by €100-150 billion annually, and could create a million new jobs. The means to achieve this 20 per cent reduction are already known, and the technologies are available. Yet under current policies the EU will only reduce consumption by 10 per cent, so the EU will miss out on at least €50 billion a year in cost savings and half a million new jobs. Stronger policies to save more energy must be the top priority for Oettinger and Jose Manuel Barroso for the rest of 2010 and the whole of 2011.

Stephen Tindale is an associate fellow at the Centre for European Reform.

The arguments outlined above will be expanded in a CER policy brief, 'Delivering EU Energy Efficiency', in November 2010.

Friday, October 08, 2010

Divisions remain over euro reform

by Katinka Barysch

Europeans agree that the management of the euro must be improved to prevent future crises, or deal with them better if and when they happen. The European Commission is hopeful that it can get all 27 EU countries to agree on a package of reforms it published at the end of September. However, recent conversations in various EU capitals left me with the impression that divisions still run deep on crucial aspects of eurozone reform. Not everyone shares the Germans’ sense of urgency, and there is a risk that complacency sets in before a sustainable new framework has been created.

On September 29th, the European Commission published six draft laws designed to improve the management of the euro. The package foresees earlier and tougher sanctions on countries that break agreed limits on budget deficits and debt levels, new procedures for macro-economic co-ordination to avoid harmful imbalances among EU countries, and a harmonisation of the way EU countries draw up their budgets. The conclusions of Herman Van Rompuy’s taskforce on eurozone governance are expected to go broadly in the same direction. The Commission hopes that the proposed reforms can become law by the summer of 2011 – an ambitious timetable even by the Commission’s own admission.

So far, discussions have mainly taken place among finance ministers, either among 16 of them in the Euro Group or all 27 in Van Rompuy’s taskforce (a slightly enlarged version of Ecofin). Finance ministries tend to welcome strict EU rules, which help them to fend off spending pleas from cabinet colleagues. But the same unity of purpose does not exist among the EU’s heads of state.

In rough terms, the EU countries fall into two camps: a German-led one which puts the emphasis on strict rules and automatic sanctions to enforce discipline; and a French-led group of mainly South European countries that – although aware of the need for fiscal discipline – want more political wiggle-room for economic policy co-ordination that could require an effort also from surplus countries, for example by trying to boost demand.

France’s club Med is weaker than the German stability camp: members such as Greece, Portugal and Spain are in the dock and their voices count for less in the current debate. Italy traditionally punches below its weight in European policy debates; and Rome’s opposition to attaching sanctions not only to excessive deficits but also stubbornly high debt levels is a little too predictable (its own debt being the second highest in the EU).

The German camp looks firmer and stronger. Austria and the Netherlands agree on the need for tough spending limits and sanctions. So do the Nordics, including non-euro countries such as Denmark and Sweden. Most of the Central and East European member-states, having imposed fierce austerity programmes at home, are not afraid of strict rules. “We are Germany’s natural allies in this”, insists one Polish official. “That’s why the Germans are stupid to try and keep the East Europeans out of the euro.”

However, the German-led group is not as cohesive as it appears at first sight. The non-euro countries do not only want stronger rules for the eurozone. They also want to forestall the emergence of a two-tier EU where euro countries closely co-ordinate their economic policies while non-euro ones wait outside the door. The price most non-euro countries are willing to pay for this is to be bound by the tough new rules and even accept financial penalties. However, the EU treaties allow eurozone countries to agree on new measures and sanctions among themselves but not to extend them to non-euro countries. Some in Central Europe now silently hope that the euro reform debate will drag on for so long that they can slip into the euro in the meantime. Poland has added a long-standing demand to the eurozone debate, namely that the costs of pension reform be excluded from budget deficit numbers. Other EU countries could complicate the reform effort with their own idiosyncratic issues. The UK is in the special position that it wants stronger rules for the euro – knowing that another eurozone crisis would harm its exports and finance industry – but under no circumstances does it want to be bound by them.

Although Germany has so far dominated the eurozone reform debate, it still faces an uphill struggle to get all 27 governments to back new rules and penalties. A restive European Parliament will also have a say on some of the proposed changes. The most important condition for creating a consensus on swift eurozone reform is still for France and Germany to reach an agreement. Christine Lagarde, France’s finance minister, and her German counterpart, Wolfgang Schäuble, have put on an admirable show of unity in the euro debates. But it is not always clear in how far they speak on behalf of their bosses at home. Divisions between Germany and France still run deep.

French policy-makers and economists think that the single currency suffers from a design flaw: a lack of economic governance. Closer economic policy co-ordination, including on such things as tax levels and industrial policy, is therefore what the French government is aiming for. Most Germans think that the reason for the current mess is that existing fiscal limits were not applied properly [for the reasons why they should re-think see How to save the euro, by Simon Tilford]. Germans demand stricter rules not only at the EU level but also at the national level. They want other EU countries to emulate Germany’s new constitutional clause, which mandates all future German governments to run balanced budgets from 2016 onwards. Germans do not mind that this clause will give the country’s already mighty constitutional court a direct say in economic management.

Policy-making by judicial decree would be anathema to most French. For them, discretion is the essence of politics, at home and in the eurozone. “Leaders need to be able to lead, especially in a crisis. They should not tie their own hands”, says one of Sarkozy’s economic advisors. The Commission proposals already embody a compromise between Germany and France: the fines proposed by the Commission will bite unless a qualified majority of EU countries votes against them. For many Germans, that still leaves too much room for political cop-outs. For most French, the thought of the Commission deciding something so eminently political as fines is still hard to accept.

Another profound disagreement concerns the idea of bolstering the euro through a permanent crisis resolution mechanism. The Commission omitted this from its September reform package, which is looking only at steps that can be implemented without changing the Lisbon treaty. The Commission, alongside the French, also argues that the EU should first see how its €440 billion safety net (the European Financial Stability Facility) works before it talks about new institutions.

But Berlin is in a hurry. It refuses to contemplate extending the EFSF beyond 2013. And it will accept a permanent rescue fund only if it comes with a bankruptcy procedure for countries that can no longer service their debt. “Without a resolution mechanism, we will have endless bail-outs and no incentives for countries to run a responsible fiscal policy”, warns one German finance ministry official. He speculates whether the EU could use the treaty adjustment that will be necessary for Croatia to join the EU over the next couple of years to set up this new mechanism.

French officials argue that talking about a bankruptcy procedure for countries now would only spook the markets. Generally, the French do not appear to feel the same sense of panic about the fate of the euro that has gripped many Germans. “The euro?” asks one Paris intellectual somewhat tongue in cheek. “France suffers from an identity crisis! It fears about its role in the world, its traditional dominance of Europe, its social model, even its way of life.” While France is concerned about losing its AAA credit rating and being ‘decoupled’ from the German economy, it has been less pro-active in the euro reform debate. Without a sense of urgency, France and Germany are unlikely to make the concerted effort that is still needed to get all EU countries to support a comprehensive reform package. The spectre of an EU lurching from crisis to crisis has not been banished.

Katinka Barysch is deputy director at the Centre for European Reform

Monday, September 27, 2010

Immigration: why Brussels will be blamed

By Hugo Brady

Liberal Sweden elects an explicitly anti-immigrant party to parliament for the first time. France's president and the European Commission lacerate each other in public over deportations of Roma. A former German central banker publishes a bestseller warning that immigration is diluting the nation's human stock. And even Britain moves forward with plans to cap economic immigration. The last three weeks have been a startling illustration of how immigration has come to dominate European politics.

At first, the EU seemed only a marginal player in this drama. The European Commission cannot dictate how many immigrants member countries let in, how many refugees they accept or how host societies should integrate newcomers. EU powers over the issuing of work visas are limited. But, as the row between President Sarkozy and Viviane Reding, the EU's justice commissioner, demonstrates, the Union has become a central player in immigration policy, even when governments point to public safety to defend their actions. This is mainly because the Commission is legally obliged to protect the mobility rights of citizens under a 'free movement' directive agreed by governments in 2004. (The law aims to make sure that EU nationals can move to each others' countries without the need for work or residency permits, a commitment originally laid down in the EU's founding treaties.)

This responsibility is unlikely to make the EU any more popular with the public, however. It means EU law limits the powers of national governments to tighten immigration policy in response to popular demand during tough economic times. Britain, for example, will set a cap on the numbers of new immigrants coming to the UK starting next year. But the cap seems largely cosmetic, given that citizens from EU countries will continue to be able to seek work there under free movement rules. Voters tend to value control and security over the freedoms they either do not use or take for granted. And there are a number of reasons to think that – in the febrile political atmosphere created by the 2009 recession - they may begin to regard the EU as part of the problem rather than the solution to immigration challenges.

For starters, EU officials should remember that what they often doctrinally dismiss as merely 'free movement' is immigration in anyone else's language, including Europe's politicians. Tensions over immigrants were evident in Western Europe long before the onset of global recession. And they are bound to continue because the east-west European migration that followed the EU's 2004-2007 enlargement has yet to run its course. Germany and Austria will lift transitional restrictions on the free movement of workers from eight Central and East European countries next year. All EU countries must do the same for Bulgaria and Romania by 2014.

Second, the Commission has plans to toughen up the application of EU rules on asylum seekers over the next two years. It will propose higher standards for the treatment and accommodation of refugees and access to the job market for those who wait a long time for their claims to be heard. But like few other issues, the cost of maintaining asylum seekers touches a very raw nerve, especially in countries that are faced with budgetary austerity. The Sweden Democrats owe their electoral success in part to widespread public concerns over the country's recent generosity to thousands of Iraqi refugees. However high-minded the intention, the cost implications of the Commission's proposals may further erode public support for the EU especially as governments are likely to portray such measures as being imposed by Brussels.

Third – as Commissioner Reding has already made clear in the case of France – she wants EU rules on free movement to be more strictly enforced in every member-state, and is prepared to take miscreant countries to court, if necessary. Reding's zeal to apply the law is laudable: EU rules must be uniformly implemented across the 27 member-states to be effective. However she also risks opening a Pandora's box of national discontent at the wrong time. Several EU countries grumble that the free movement directive is too broad in scope, especially after a 2008 court ruling expanded free movement rights even to non-EU nationals in certain circumstances. Faced with a further ultimatum by Reding, governments might be tempted to support a proposal from Italy to water down the directive and allow governments greater leeway to refuse residency based on economic circumstances or security concerns.

If the Commission refused to table such a draft, it might hand a political platform to far right and eurosceptic forces throughout the EU. On the other hand, the EU's institutions have little choice but to stand firm in the face of pressure to compromise on free movement rights or to ignore their non-implementation. They believe - probably rightly - that if such freedoms were rescinded or weakened now, EU governments would not return to the status quo at a future date. Welcome to Europe's battle over immigration and free movement. Appalled Swedish liberals, a floundering French president and an indignant European commissioner are just the opening salvos.

Hugo Brady is a senior research fellow at the Centre for European Reform.

Thursday, September 23, 2010

Observations from Russia

By Charles Grant

On a recent trip to Russia, I found that the momentum for reform, very evident last year, has dissipated. The more encouraging news is that Russia’s leaders are trying to be civil to Americans and Europeans. In early September I was in Russia with the Valdai Club, a group of think-tankers, academics and journalists that meets Russian leaders and intellectuals once a year. A year ago, the economic crisis was biting and President Dmitri Medvedev’s schemes for ‘modernisation’ were being taken seriously. There was much talk of shifting the economy away from dependency on natural resources – and also of encouraging manufacturing and service industries, boosting innovation and R&D, and fighting corruption. Some Europeans, and the German government especially, became excited about the prospect of helping Russia to modernise.

On this visit Prime Minister Vladimir Putin was less combative than he had been in previous Valdai meetings. He went through the motions of saying that modernisation mattered, but did not engage on the subject. He talked of the need to avoid sudden changes of direction. Stability is his watchword. A number of factors may explain his relaxed mood. Last year the economy shrunk by about 8 per cent, but this year the oil price is above $70 a barrel and there is solid growth. Ukraine is not going to join NATO and is more or less in the Russian camp (this matters hugely to Russian leaders). Relations with the US are quite good, and there has also been an – entirely unreported – ‘reset’ with China.

One senior Russian official who met the Valdai Club was alarmingly frank. “During the crisis, business was mobilised to change its ways; provincial authorities tried harder to think of improving the business environment. But the economy has suffered from oil going to $70 so rapidly,” he said. “We’d have had more progress on modernisation with a slower rise in the oil price. Now we have complacency.” He said corruption had got worse. He had hoped that last year’s budget cuts would help to squeeze corruption out of the system. But this year the budget had grown again and the “shadow sector” had bounced back, siphoning money out of the economy. “The mind-set [for corruption] has now returned to its pre-crisis level.”

None of the Russian intellectuals on this year’s Valdai trip thought that modernisation would go anywhere. They believe that ‘top down’ efforts to modernise – such as giving Rosnano, a state entity, the money to build a nano-technology industry, or creating a ‘silicon valley’ near Moscow at Skolkovo – will not have much impact without broader political change.

One reason for this pessimism is that the position of Medvedev – who has always been more enthusiastic about modernisation than Putin – seems to have weakened. Conservatives never liked him, but some of them now sneer about him with open contempt. Meanwhile Russian liberals, who used to praise Medvedev, have become disdainful. This is because for all his eloquent talk about modernisation, the rule of law and democracy, he has changed so little. Medvedev has sacked some provincial governors, introduced a little judicial reform, made a start on military reform, and responded to Barack Obama’s initiative by agreeing to a ‘reset’ with the US. And that’s about it. The general assumption in Moscow is that Putin will run for president in 2012. Two terms of six years would then mean Putin staying in charge till 2024.

Some of Putin’s most powerful lieutenants show no enthusiasm for Medvedev’s plans for modernisation. Vladimir Yakunin, who runs Russia’s railways and is close to Putin, argued in a letter to The Economist earlier this month that state capitalism “simply works better” than western models. Russia’s past attempts to “reject all history and tradition, combined with the blind imitation of foreign experience, [had] impeded the country’s political and economic development for 20 years”.

For all the gloom about economic modernisation, Russian foreign policy may offer a slightly happier story. Although the oil price has picked up, the swaggering arrogance of a couple of years ago has not reappeared. Last year’s economic crisis brought Russia’s leaders down to earth with a bump. They saw that the growing disparity between the Russian and Chinese economies will be a serious problem in the long term, and that Russia needs to strengthen its position – economically and politically – by looking west. Hence the reset with the US, modest co-operation with the West on Iran and Afghanistan, the deliberate rapprochement with Poland and the settlement of the maritime border dispute with Norway.

Putin confirmed that the reset between Russia and the US still holds by saying that he found Obama “a deep and profound person whose view of the world coincides with ours”. There has also been an improvement in Moscow’s relations with Beijing. Though unreported in the press, “this is more important than the reset with the US”, according to a senior official in the Russian security establishment.

China and its increasingly assertive leaders have been a source of worry to Russia in recent years. But this year there has been a rapprochement. “We now have a relationship that is strategic, pragmatic and based on equal status,” said the official. Each side has agreed not to play off the other one against the US. And the two governments have reached agreement on some difficult issues, such as building a pipeline to take Siberian oil to China, handling the Iranian nuclear problem and co-operating on civil nuclear power. One minister who met the Valdai Club stressed the importance of integrating the Russian Far East and Siberia into the dynamic Asian economies. He saw China not only as a growing market for Russian raw materials but also as a source of investment in areas such as ships, aerospace and high-tech equipment.

Despite the new modus vivendi with China, deep down Russian leaders still fret about the growth of Chinese power. A new Valdai Club report by a group of Russian thinkers calls for a ‘Union of Europe’, including Russia, the EU, Turkey and Ukraine. The report argues that Russia (with its natural resources) and the EU (with its technology) need to get together in order to prevent a ‘G2 world’ run by the US and China. The report therefore proposes a union that would have supranational institutions and its own treaty, covering not only economics and energy but also foreign and security policy. The implication of the report is that if Russia stays on its own it will become a subsidiary of China. The Union of Europe would also help to further the long-held Russian ambition of drawing European states away from the US.

One minister took a similar line when he met the Valdai Club, saying that in the long term he favoured a single market running from the Atlantic to Vladivostok. The Customs Union that Russia has set up with Belarus and Kazakhstan was a first step to a common economic space and then full integration with the EU. But his westward orientation was rather hesitant. “Don’t try to teach us to be civilised or call us black sheep or we will react badly,” he said. “If you push us away we will want to walk away. For all our problems, we are Europe’s salvation, it needs our new blood. But if you don’t want us we will turn to the more dynamic east.”

Despite the rhetoric about integrating with Europe, few Russians are interested in the nitty-gritty of the EU-Russia relationship; the current talks on a new partnership and co-operation agreement have stalled and nobody in Russia seems bothered. There are two obvious problems with the schemes being floated for union between Russia and the EU. One is that most Europeans will not want a closer union with Russia so long as its political system remains authoritarian. The other is that many people in the EU still look to the US for their security, and would not want to join a union that would inevitably weaken transatlantic bonds.

On current trends neither Russia’s economy nor its political system is likely to undergo serious reform anytime soon. That means that China will continue to pull ahead of Russia economically, while the EU will spurn grandiose schemes for ‘union’.

Charles Grant is director of the Centre for European Reform

Thursday, September 02, 2010

Has Germany become Europe's locomotive?

By Philip Whyte

The German economy has been growing exceptionally strongly of late. In the second quarter of 2010, it expanded faster than any other economy in the G7 and faster than at any time since the country’s reunification in 1990. Industrial output is surging. The rate of unemployment has been declining for over a year and is now well below the eurozone average (let alone levels in the US). Consumer spending and business investment are picking up – and households and firms are generally less burdened with debt than their counterparts in highly leveraged economies like the UK and the US. Germany, in short, seems to have emerged strongly from the Great Recession. Indeed, some observers think it has entered a self-sustained recovery – and that it is starting to act as Europe’s ‘growth locomotive’.

If this were true, it would be welcome. Over the past decade, Germany has not been a great source of demand for the world or the European economy: in real terms, domestic demand is only about 3 per cent higher now than it was back in 2000. For most of the noughties, Germany was structurally reliant on exports for its economic growth: without debt-fuelled spending elsewhere in the world economy, it would barely have grown at all. So any sign of a sustained recovery in German domestic demand would be good news for the country itself and the rest of the world. Not only would it reduce Germany’s reliance on unsustainable (and hence destabilising) foreign profligacy. It would also allow the eurozone and the world economy to rebalance at a higher level of output and employment than otherwise.

Sadly, it may be premature to conclude that Germany has embarked on a durable, self-sustained recovery that will help to lift growth elsewhere. Much has been made of the scale of Germany’s rebound in the second quarter of 2010. But it needs to be placed in context. Germany resembles a bungee jumper in the spring-back phase. It is rebounding faster than neighbouring France. But this is partly because it fell much further on the way down. The size of Germany’s manufacturing sector has resulted in greater output volatility. Germany was hit disproportionately hard in 2008-09 when manufacturers scrambled to run down stocks, but it has since benefited as the stock cycle has reversed. Even after its recent rebound, however, German output is still lower relative to pre-crisis levels than in France.

Besides, the pattern of the recent upturn casts doubt on the view that Germany is acting as a ‘locomotive’ for other countries. The pick-up in domestic demand in the second quarter of 2010 came after three consecutive quarters in which household consumption fell. As for business investment, it is still a long way below pre-crisis levels. If Germany really had become a locomotive for the rest of the EU, net trade would be exerting a drag on its own economic growth. Yet the reverse is the case: net trade has boosted German GDP growth in three of the past five quarters. True, exports to Asia are making a greater contribution to growth. But Germany’s recovery is doing little to rebalance activity in the EU. Indeed, Germany’s trade surplus with the rest of the EU has risen compared with the first half of 2009.

There is a final reason to be sceptical about the prospect of Europe’s largest economy becoming a locomotive for the rest of the EU: it is not clear that German policy-makers want it to become one. As far as they are concerned, the global financial crisis has discredited profligacy and vindicated German prudence. The lesson of the crisis, they believe, is that countries must learn to live within their means. For them, the direction of change is clear: it is for the erstwhile dissolute to shape up, not for Germany to become more spend-thrift. Any suggestion that Germany needs to adjust tends to be met with bemusement, irritation and contempt. Germany has no lessons to take (least of all from irresponsible Anglo-Saxons). And any attempt to hobble German ‘competitiveness’ will be fiercely resisted.

The hopes currently being vested in Germany may consequently be misplaced. The strength of the country’s recovery is partly an optical illusion created by the depth of the downturn which preceded it. Much of the recovery is being driven by net trade. Domestic demand is still fragile and could weaken as the government’s fiscal stimulus is withdrawn and the stock cycle becomes less favourable. And German policy-makers have yet to be persuaded that it is in their country’s interest to reduce its reliance on export-led growth. In short, Germany is not yet acting as a ‘growth locomotive’ for the rest of Europe. And other EU countries, particularly in the highly indebted geographical periphery, may have to get used to the idea that the region’s largest economy may not be about to become one any time soon.

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

Friday, July 30, 2010

Is China being beastly to foreign investors?

by Charles Grant

When I visited China a year ago, I was struck by the strong feeling among many foreign firms there that the business environment was getting tougher. Western businessmen complained, in particular, about discrimination against foreigners. On a recent trip to China, I found a more nuanced situation. In some sectors, notably those where intellectual property (IP) is important, there are growing complaints of unfair treatment. But in other sectors foreign companies are making good money, without grumbling much.

Western business leaders are certainly complaining more loudly than they used to. In July, the Financial Times reported Jeffrey Immelt, the chairman of General Electric, as saying that he was “really worried about China. I am not sure that in the end they want any of us to win, or any of us to be successful.” A few days later Jürgen Hambrecht, the CEO of BASF, told Wen Jiabao, the Chinese prime minister, that foreign firms were being forced to transfer know-how to Chinese companies, in return for market access. Hambrecht told him that this did “not exactly correspond to our views of a partnership”. At the same meeting Peter Löscher, the CEO of Siemens, urged Wen to ensure that foreign firms could compete fairly for government procurement contracts. (Like a lot of western business leaders, Löscher had previously taken the Chinese government’s side, as when he criticised German Chancellor Angela Merkel for meeting the Dalai Lama.)

One government measure that has provoked foreign business leaders is the regulation on ‘indigenous innovation’ that was published last November. This would, if enforced, exclude foreign firms from public procurement contracts unless they agreed to hand over IP. The regulation seems to have been driven by the Chinese Communist Party’s belief that market forces alone will not provide a high-tech economy, and that the state therefore needs to get hold of and control advanced technologies. The EU, the US and many other governments lobbied strongly against the measure.

Whether this regulation will bite remains unclear. The government announced a delay in implementation and Chen Deming, the minister of commerce, said the regulation would not affect firms that could prove they added value in China. Some western business lobbies fear that, despite recent reassurances, the regulation will in the long run take effect. If it is enforced, firms like IBM and Microsoft are likely to cut back on R&D in China. On Capitol Hill, Microsoft is now taking a hard line on IP issues in China; until recently, it tended to sympathise with the Chinese point of view. China can no longer assume that US business leaders will, as a bloc, support its interests in Washington.

A similar shift is evident among some European companies. According to the head of one large German firm in China: “They assume their market is so big, that foreigners will stay, and put up with losing IP. That’s a miscalculation. Most foreign investors think IP is very important and that they have a duty not to hand it over.” He thinks that enforcement of the indigenous innovation regulation would dampen FDI in China. Big western manufacturers would not pull out but would source more components to countries such as Vietnam, Taiwan, Malaysia, Indonesia and Singapore. China’s free trade agreements with these countries now make it easier to supply Chinese factories from them.

Within the past two years, some high-tech foreign firms have had to pay higher rates of tax, while new restrictions on representative offices – each is allowed only three non-Chinese staff – are proving irksome. Foreign firms involved in making wind turbines, such as GE, Siemens and Vestas, are particularly annoyed that, as they see it, procurement rules have been skewed to exclude them from the Chinese market (the largest in the world), to the benefit of local firms.

Two-fifths of European businesses in China surveyed by the EU Chamber of Commerce in June 2010 expected the regulatory environment to worsen in the next two years. The same proportion described the discriminatory application of laws and regulations as a ‘significant’ obstacle. The EU Chamber concluded: “Optimism in the overall economic climate has been dampened dramatically by concerns about regulatory interference and unpredictability in the market.”

Some of the shifting balance of power between foreign investors and the Chinese authorities is the inevitable result of the country’s development. A lot of Chinese companies are now stronger and better-equipped to compete with European or American rivals. Twenty years ago the Chinese needed western capital, skills and technology. Now they need the technology, but they have less need of the skills, and plenty of their own capital.

Another issue for foreign investors is that costs are rising, in part due to labour unrest that has been prevalent in the Pearl River Delta area. The emergence of free trade unions is an important and positive step for the country’s future development, signalling the emergence of a civil society that is not controlled by government or party. But many foreign businesses see the new trade unions merely as a source of growing costs.

Mining companies, energy firms, banks and insurers, among others, still face restrictions on their activities in China. Many of them nevertheless make money. That is the case for Shell and BP, which are significant investors, often through joint ventures, but would like to engage in a wider range of activities than they currently do. In many other sectors, such as retailing, advertising, hotels, pharmaceuticals and cars, companies report they are doing well without too much government interference. For example Tesco finds it easier to open stores than two years ago, as central government permission is no longer required; but Tesco says that Chinese retailers face less hassle from red tape than do foreign ones. WPP is allowed to own 100 per cent of local advertising agencies and says that as a foreign firm it faces no discrimination – except that it pays more tax than local competitors. Car companies are doing particularly well: BMW has doubled sales in China over the past year, and Daimler is forming a joint venture to develop electric vehicles.

Since the spring, the government has made an effort to appear friendly to foreign firms: Premier Wen met foreign business leaders to listen to their complaints; several ministries opened their doors to foreign investors in China and asked how they could help; and in July the government appeared to accept a compromise in its dispute with Google, with the result that Chinese citizens can search uncensored via Hong Kong. Chinese analysts point out that many local authorities still compete for FDI and therefore offer special deals (for example, on tax and utilities) to foreign firms.

When China joined the World Trade Organisation in 2002, it failed to sign the agreement on public procurement that prevents discrimination against foreign firms. In July China made new proposals for acceding to this agreement – but western governments think them inadequate (for example, China is not offering to open up local government procurement). Also in July, Chen Deming wrote in the Financial Times that China is “ever more open to business”. He is right that most of the formal rules applying to foreign investors are less restrictive than they were ten years ago. According to his figures, global FDI fell by nearly 40 per cent in 2009, but only by 2.6 per cent in China.

My conclusion is that China still welcomes FDI, but that it is becoming more insistent on setting the terms. For example, it wants to choose the location for big foreign industrial investments – often in the underdeveloped west of the country, where a lot of foreign firms would rather not go. The Chinese government is probably right to calculate that, for all their grumbling, most foreign firms will stay; China is just too big a market to ignore. In any case, despite the difficulties, many foreign investors in China claim that they are managing to hang on to their IP.

China’s strategy is to exploit foreigners’ desire for access to its markets as a means of gaining their technology. From China’s point of view that is a reasonable policy. If a lot of foreign investors clubbed together to speak with one voice and make credible threats to China, they might persuade its leadership to re-examine that strategy. But neither the big foreign companies in China, nor the European and American governments, are likely to get significantly tougher with China. So do not expect much change in China’s policies towards foreign investors.

Charles Grant is director of the Centre for European Reform

Monday, July 19, 2010

Who is winning Eastern Europe's great game?

By Katinka Barysch

The US is withdrawing from the former Soviet space; the European Union struggles to be taken seriously there. Does that leave Russia free to strengthen its influence in the countries around its borders? Not necessarily, for the situation in the region is complex.

Hillary Clinton toured the Caucasus recently to reassure Georgia, Armenia and Azerbaijan that Washington had not abandoned them in its quest to ‘reset’ relations with Russia. Nevertheless, the predominant feeling in those countries is that the US is a lot less interested and engaged than it had been during the presidencies of George W Bush and Bill Clinton. Similarly, many Central Asians feel that the Obama administration pays little attention to them, unless they can serve as launch pads for planes destined for Afghanistan. NATO membership for Ukraine and Georgia is no longer on the cards.

While much of America’s attention has moved elsewhere, the European Union hardly has a foothold in the region. The EU’s neighbourhood policy has proved rather ineffective, and the 2009 ‘Eastern partnership’ has not yet had time to make much of a difference. Ukraine, still smarting that the EU has never offered the prospect of membership, appears to be turning towards Russia. Moldova looks keener than ever to get closer to the EU – with few people in Brussels and other capitals taking notice. The EU’s Central Asia strategy has lacked political backing and consistency. In the Caucasus and Central Asia, the EU is a rather new player and its traditional approach of exporting norms and values as the basis for bilateral relations has not been received well. The fact that the EU’s foreign policy machinery is currently in bureaucratic paralysis does not help.

In theory, US neglect and European weakness could leave Russia free to consolidate what President Medvedev likes to refer to as a ‘sphere of privileged interests’. Russia is certainly trying. But success has been patchy at best.

Although by far the most populous and prosperous country in the region, Russia does not necessarily have the means to project power into the neighbourhood. Its tools looked more formidable before they were actually used. Now some of them have turned out to be blunt.

Russia’s use of military force in Georgia last year backfired when even Moscow’s staunchest allies scrambled to become less reliant on their dangerous-looking big neighbour: Belarus turned to the EU, Armenia started talking to Turkey and not a single one of the former Soviet countries has followed Moscow in recognising the independence of Abkhazia and South Ossetia.

Russia has repeatedly used trade embargoes and other economic means to put pressure on its neighbours, in particular smaller ones where Russia’s own business interests are limited, such as Georgia or Latvia. But there is arguably not a single instance where the use of economic sanctions has got Russia what it wanted. Businesses in the countries affected have reinforced their efforts to find alternative markets and sources of investments, making them less dependent on Russia in the long term. Russia’s strategy of gaining influence through directly controlling local businesses has proven more successful: in Armenia for example, various sectors from banking to transport are dominated by Russian-owned companies. How this will translate into political leverage remains to be seen.

This leaves energy as the most promising tool of Russia’s neighbourhood policy. Russia has used pipeline plans, nuclear projects, gas prices and oil deliveries to get what it wants from its neighbours. But even here, Russia’s success rate is mixed. In Belarus and Ukraine, Russia is making headway towards its aim of gaining control over transit pipelines. The recent standoff between Belarus and Russia over gas prices and transit fees only highlighted Minsk’s lack of options: Lukashenko’s announcement that he would buy gas from Venezuela was little more than symbolic. In Ukraine, Russia managed to use the offer of cheaper gas to get the lease for its Black Sea fleet in Sevastopol extended. It has also successfully pressured Kyiv into at least considering merging parts of the two countries’ gas monopolies, Gazprom and Naftogaz, which would give Moscow effective control over Ukraine’s transit pipelines.

The situation is very different in the Caucasus and Central Asia, where energy producing countries are gaining room for manoeuvre through building stronger links with China, Iran and Turkey. Turkmenistan opened a large gas pipeline to China at the beginning of the year and signed another gas delivery contract with Iran in June. It has invited international oil majors to help build an internal pipeline that could one day deliver Turkmen gas from the massive Yolotan field to the Caspian shores and from there to Europe. It had previously promised to let Russia build the pipeline and buy much of the gas. Azerbaijan has spurned a Russian offer to buy up all the gas from its new Shah Deniz 2 field, instead committing it to Turkey and to European buyers. Russia’s attempts to lock up Caspian gas supplies by foiling pipeline projects such as Nabucco are looking increasingly desperate.

The perceived withdrawal of the US and the ineffectiveness of EU policy in the region has not so far played into Russia’s hands. Russia (like the EU and other players in the region) has had to learn that the former Soviet Union does not constitute a homogenous neighbourhood. There are cocky and cash-rich energy suppliers such as Azerbaijan and Kazakhstan, and there are poor and divided countries such as Moldova and Armenia. Russia can cajole and coerce in one place but it has to plead and please in another. All countries in the region will benefit from being less dependent on Russia, in trade and energy terms as well as in politics. While the US might pay less attention to the region, the EU should redouble its efforts, while also taking more account of the the specific situations of individual countries.

Katinka Barysch is deputy director of the CER