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 Рhaving spent the best part of a decade sorting out the Lisbon treaty Рdid 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 Рthough Luxembourg's Jean-Claude Juncker and the Commission's Jos̩ 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