Monday, April 28, 2014

Quantitative easing alone will not do the trick

Very low inflation poses a mounting threat to the economic stability of the eurozone. The rate of consumer price inflation has been below 1 per cent since October, and hence far below the European Central Bank’s (ECB) target of just below 2 per cent. This highlights the degree of weakness in the eurozone economy – and reinforces it – notwithstanding the optimism generated by a return to modest growth. And it further increases doubts over debt sustainability across the currency union: without a healthy dose of inflation, it is much harder for households, firms and governments to reduce their debt burdens.  To make things worse, in the most indebted countries, such as Greece, Portugal, Spain and Italy, inflation is even lower than the eurozone average. In response, many observers argue that the ECB should employ unconventional tools like quantitative easing (QE) to boost inflation. The problem is that QE alone is unlikely to be effective without a significant change in the ECB’s approach to monetary policy. The ECB needs to manage people’s expectations about the future path of demand, income and inflation more forcefully if it is to generate a proper economic recovery across the Eurozone.

According to one view of monetary policy, central banks set short-term interest rates to keep the economy close to full employment and inflation at the target level. In exceptional cases, this interest rate can fall to zero, but not below. In such circumstances, the central bank has to find other ways to stimulate the economy. One approach is QE: buying long-term assets like government bonds in order to drive up their price and bring down their ‘yield’, or interest rate (the price and yield of a bond are inversely related). Buying these bonds also tends to drive up the prices of other long-term assets like corporate bonds, equities and even property. QE thus lowers long-term interest rates, increases the value of firms and real estate, and drives up the wealth of households. Ideally, this induces firms and households to invest and consume more, and help the central bank reach its target on inflation.

A different view of monetary policy claims that interest rate setting or bond buying are just tools to keep firms’ and households’ expectations about the future path of income, demand and inflation on a reasonably stable and appropriately optimistic path. Such stable and optimistic expectations are a precondition for the investment and consumption decisions that keep an economy close to full employment, and inflation close to target. Of course, effective tools are necessary so that people believe that the central bank can steer the economy and, hence, so that the central bank can influence people’s expectations. But without properly managing economic expectations, the tools alone will be ineffective, according to this second view. Tools and expectations are thus complementary.

With these two approaches in mind, the ‘tools view’ and the ‘expectations view’, it is worth assessing the potential for QE to revive the eurozone economy, and hence, inflation. Starting with the tools view, there are several channels of transmission of QE.

* Lower long-term market interest rates could boost (larger) firms’ investment. But European firms raise finance predominantly from banks, not capital markets where the impact of QE would be directly felt. QE will therefore affect firms’ financing costs less than in the US, where capital markets are more important and where QE has effectively reduced long-term rates for firms. Given that banks are currently reluctant to lend in the most troubled southern European economies, the impact of QE on firms’ investment decisions in these countries is therefore likely to be low – just as in core countries like Germany where rates are already very low. If the ECB were able to buy bundles of bank loans to firms, QE would be more effective in lowering borrowing costs; but the current eurozone market for bundles of such loans is small.

* For households and investors, lower interest rates would make buying property more attractive. A rise in property prices usually stimulates the economy via construction and real estate services; the UK knows a thing or two about that. In the eurozone, however, a property-led boost to the economy is unlikely to be large. Spain and Ireland just came out of property bubbles and are healing only slowly; others, including core countries like the Netherlands, are struggling with falling prices whereas prices in France are already at very high levels and bound to fall. A slight boost in these countries means softening the hit, not driving a recovery. In Germany, the effect could be stronger but rising prices (and hence rents) would depress the consumption of the more than 50 per cent of Germans who rent. The effects of QE on the property market are therefore likely to be weaker in the eurozone than in the US or the UK.

* Property and other assets are also part of households’ wealth: QE would push up the prices of such assets, and households could thus consume more and save less (the so-called 'wealth effect'). However, the evidence on the size of this effect is mixed. According to an ECB paper, housing wealth does not seem to have much of an impact on consumption in the eurozone at all; financial wealth has a larger impact but it is still lower than in the US where households often own stocks and property for their pensions. Banks, as large owners of assets, are likely to benefit from QE. In current circumstances, where banks have insufficient capital and the ECB is likely to require many of them to raise more, higher asset prices help banks to repair their balance sheets and raise capital if need be. How much that would impact the overall economy is debatable: a pretty impressive recovery in asset values has already taken place without QE; banks’ ability to raise equity in markets is currently not in doubt; and banks’ lack of capital is only one of several reasons that prevent them from increasing lending to firms and households.

* By reducing long-term interest rates, QE would make the euro less attractive to investors, lowering its value, all else being equal. The fall in the value of the Japanese yen in the past 15 months, after the Bank of Japan’s (BoJ) aggressive QE programme, can attest to that. A lower euro would in turn support world demand for European exports, especially from southern Europe. Herein lies possibly the strongest channel through which QE can boost the eurozone economy directly.

* Finally, QE would help the treasuries of troubled countries such as Italy or Spain. By lowering the yield on their sovereign bonds – real yields are still high – QE would lower the cost of government borrowing. This lowers the pressure on governments to implement (mostly self-defeating) budget cuts in times of recession or weak growth, which would help the economy. It takes time for this effect to play out, however, as the costs of servicing existing debt are unaffected.

Overall, these direct channels are weaker in the eurozone than they are in the US or the UK. This is one reason to be sceptical about the likely impact of QE on the eurozone economy.

The second approach to thinking about monetary policy, the expectations view, induces further pessimism: firms' and households' expectations would be unlikely to change much for the better if the ECB simply implemented QE. And without such a change in expectations, the direct channels discussed above would do little to change firms' and households' behaviour.

The reason is that the ECB has failed to convince households and firms that it is doing all it can to lift the economy out of recession. It raised rates in mid-2011 at the height of the eurozone crisis when more stimulus would have been warranted and the bout of inflation was clearly temporary. Then it was slow to cut rates, even though the underlying price dynamic signalled clearly the future low inflation which has now shown up in headline figures. And the ECB has been reluctant to use unconventional tools at a time when high unemployment and a weak economy would have called for more aggressive measures than incremental cuts in interest rates – not least because inflationary dangers were non-existent. Starting QE now, after inflation has undershot the ECB's own forecasts repeatedly – essentially being dragged to the QE altar – is unlikely to convince anyone. The conservative approach of the ECB towards the economy and inflation, its hawkishness, is now firmly entrenched.

To make QE a success, the ECB needs to accompany it with the sort of strong commitments the BoJ in Japan or the Fed in the US have made: the BoJ said that it intends to continue a policy of QE and low rates until it has reached the new inflation target of 2 per cent (up from a de facto target of zero); the Fed has tied the duration of its unlimited QE programme to reaching certain targets on economic activity and unemployment. Both approaches led firms and households to change their expectations about the economy – about demand for their products or their income and future inflation – which in turn shaped their consumption and investment decisions.

A higher inflation target is, of course, out of the question for the ECB. With a mandate that is strictly focused on price stability and not much else (contrary to that of the Fed), it is also difficult for the ECB to tie QE to unemployment or economic growth – though reasonable people disagree on this.

However, the ECB does have the power to make a commitment that is purely focused on inflation (and hence firmly in line with its mandate). The ECB should announce that it aims to reach 2 per cent inflation on average over the next five years (an approach called ‘price-level targeting’). It might sound innocuous, but the word 'average' makes all the difference: since inflation is currently low and likely to remain low for a while, the ECB would commit to overshooting on inflation in the future. In other words, such a target would require the ECB to tolerate a mild boom in the eurozone to get the 3 per cent inflation necessary to reach a 2 per cent average over five years. Anticipating this, firms and consumers, financial markets and banks would increase consumption and investment.

If the ECB were to combine unlimited QE with a temporary price-level target – 2 per cent on average for five years – it could stimulate the economy and inflation, while remaining true to its mandate of price stability close to 2 per cent. Such a temporary price-level target would be new territory for the ECB, as would QE. But after years of misjudging the state of the economy and inflation, it is time for the ECB to be bold and innovative. The 19 million unemployed in the eurozone certainly deserve that the ECB makes every attempt at spurring a recovery worthy of the name.

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

Thursday, April 17, 2014

Why a British exit is not inevitable

As someone who wants Britain to remain in the EU, I have long been sceptical of my side’s ability to win a referendum on that question. The two televised debates between Nick Clegg and Nigel Farage, on March 26th and April 2nd, only reinforced the gloom of pro-Europeans: opinion polls found that a clear majority of those watching thought the UKIP leader had out-performed the deputy prime minister. However, having read the latest polling from Lord Ashcroft, based on an unusually large sample of 20,000 people, and having taken part in a panel discussion with a representative sample of British voters that he had brought together, I now think that a referendum is winnable (the polling was carried out before the Clegg-Farage debates).

I see three reasons for optimism. First, as the audience made clear during the panel discussion, a lot of people want to know more about the EU. They know that some of the media cannot be relied upon to give the facts, that the issues concerning membership are very complicated and that they would like to be better informed.

If and when a British referendum comes, I hope that those involved will agree to copy an idea from the last Irish referendum on the Lisbon treaty, in 2009. An independent Referendum Commission, which took responsibility for providing both sides of the argument, and the key facts about the Lisbon treaty, won the respect of both sides of the campaign.

I am glad to see that a new body, Full Fact, has recently been established in Britain. Its mission is to ensure that British politicians’ statements are accurate – on the EU and every other subject. Full Fact, which has no view on whether Britain should remain in the EU, monitored and commented on the Clegg-Farage debates in real time.

Second, several of those who spoke from the floor during the panel discussion were concerned that very few people in the UK are making the case for the EU. Though the British people are in some respects eurosceptic, many of them have noticed that the country’s European debate has been lop-sided. On the anti-EU side there are a lot of outspoken politicians in UKIP and the Conservative Party, most of the tabloid newspapers and some well-funded lobbies. On the other side are a small number of newspapers, the Liberal Democrat Party, a few ageing Conservatives and business lobbies such as the Confederation of British Industry.

I recall ministers telling me during the time that Labour was in power (1997-2010) that they were pro-European but had been advised not to make the case for the EU because many voters were either hostile or indifferent to that subject. My own conversations with Conservative MPs have led me to believe that more of them than one might imagine are sympathetic to the EU, but for obvious reasons they hide views that are heretical in their party. To some extent, the pro-Europeans have lost the argument by default. In a referendum campaign politicians would, one hopes, say what they really thought. But they should not postpone speaking frankly until the campaign itself, by which time it may be too late to shift opinion. More of them need to find the courage to try and shape the current debate.

Third, Lord Ashcroft’s polling reveals that the key group of voters in any referendum campaign will be those he describes as ‘discontented sceptics’, who make up 27 per cent of the electorate. Most of them want to leave the Union, but their priority is jobs and the state of the economy, and they accept that the EU delivers some benefits. They do not like the EU because of the migration that stems from membership, the loss of sovereignty, the regulations and the cost of Britain’s contribution to the EU budget. They also think that the other EU members tend to club together against British interests. But this group is open to argument, and if significant numbers can be persuaded that the EU is good for jobs – or that the problems may be less acute than they had imagined – the referendum is winnable. That means that those in favour of membership need to be more effective at getting across the best facts and arguments.

If I was advising the Yes campaign on the arguments to use in a referendum, I would make five points. The first three are economic. One, if Britain leaves the EU it will lose foreign direct investment. In recent months companies such as Airbus, Ford, Goldman Sachs, Hitachi, Nissan and Siemens have all said that they are keen for the country to stay in the EU. Some of them add that they would review their investments if Britain were to leave.

Second, membership of the EU provides access to the world’s biggest single market, in terms of value. Quitters have yet to explain a viable alternative for the British economy. Norway and Switzerland have access to parts of the market but have to accept the EU regulations that govern it, without having a vote on them. Although neither of those countries is a member of the EU, they have to pay into its budget: Norway’s per capita net contribution is 83 per cent that of Britain, whereas Switzerland’s is 40 per cent (according to the House of Commons library). They must put up with the principle of free movement (the Swiss recently voted in a referendum to limit the right of EU migrants to work in Switzerland; as a result the Swiss will lose some of their privileged access to EU markets). Switzerland has never had access to EU services markets, which are of particular importance to the British economy.

Third, the EU is forging trade-liberalising deals with many other parts of the world. For example, British exports to South Korea have doubled since the EU-South Korean free trade agreement came into force in 2011. Deals are in the pipeline with Canada, India, Japan, Thailand and – because the UK and Germany pushed to get talks started – the United States. Of course, small countries that are on their own can also negotiate trade deals, but only a big trading bloc like the EU gives Britain the leverage to extract significant concessions from trading giants like the US or China. The Scotch Whisky Association, for instance, argues that its distilleries need the EU to open up protected markets (the European Commission has recently negotiated the opening of Canadian, Colombian and Peruvian markets to exports of Scotch, and hopes to do the same for India).

The final two points are political. The West no longer dominates the world. China, Russia, India, Brazil and many other powers have a lot of influence, which is natural as their economies become larger. The US, these emerging powers and the EU are the key players in shaping global rules, on trade, financial regulation, climate change and security. If a medium-sized European country like Britain wants to be able to influence the emerging global order, it needs to be a leading member of the EU. On its own it does not have a great deal of clout.

It makes sense for the British to work with the other European countries because, despite our differences, we share not only many interests but also – and this is the fifth point – values. Just about everybody in the EU is committed to democracy, the rule of law and a free press. When Russia starts using force to change international borders, as it has done recently, the EU states do not react in an identical way. But they have shown that they can respond by taking a series of steps, together, that help to defend the principles they believe in. The European states are more likely to influence Russia when they concert their efforts. The bottom line is, we are stronger when working with our partners.

Charles Grant is director of the Centre for European Reform.

Monday, April 07, 2014

How to reduce dependence on Russian gas

At the European Summit on March 20th and 21st, government leaders were supposed to agree climate and energy targets for 2030. Instead, they discussed Crimea, Ukraine and Russia. Leaders were right to postpone discussion of the targets, but wrong to postpone action on reducing Europe’s dependence on Russian gas.

Russia supplies around a third of the EU’s gas. So the Union is to an extent dependent on Moscow – as it discovered when the Russians turned off the gas flow though Ukraine in 2009. But the Kremlin is, to a greater extent, dependent on revenue from oil, gas and coal exports – above all to the EU. Indeed, over half of the Russian government’s revenue comes from the sale of fossil fuels: 19 per cent each from gas and oil and 14 per cent from coal. The EU summit conclusions did refer to the need to diversify sources of gas, and asked the European Commission to prepare a report on this. That approach lacks the urgency which the situation in Ukraine demands. If EU leaders want to impose sanctions on Russia which may change its behaviour, rather than simply slapping Putin’s wrist, they should reduce purchases of Russian energy as far and fast as possible. To do that, they must develop alternative energy sources. That would cost money, but deliver major energy security, foreign policy and climate benefits.

The Swedish and Danish foreign ministers, Carl Bildt and Martin Lidegaard, have emphasised the importance of energy in responding to Russia’s invasion of Crimea. In March they wrote in European Voice that the EU must improve its energy efficiency, develop infrastructure to import fossil fuels from countries other than Russia, and increase alternative energy sources such as renewables. Swedish and Danish ministers are well placed to make these points: Sweden gets more of its energy from renewables than any other member-state, while Denmark is the only country to have set out plans to become 100 per cent reliant on renewables (by 2050). Poland buys nearly 90 per cent of its imported gas from Russia. So Polish Foreign Minister Radek Sikorski has shown courage in leading the calls for reducing energy dependence on Moscow (though Poland uses coal for most of its energy needs).

Europe’s post-Crimea energy strategy should focus on five strands:
* energy efficiency;
* alternative sources of gas;
* renewable energy;
* coal and gas with carbon capture and storage (CCS);
* nuclear power.

Greater energy efficiency is the goal that could be achieved most quickly. A rapid and ambitious programme of retrofitting double glazing and insulation to existing buildings, Europe-wide, could reduce energy demand for heating. It would also create thousands of new jobs. Less rapid but equally effective would be a major programme to upgrade and expand district heating: networks which transport heat from power stations or other combustion plants to homes and commercial buildings. District heating is widespread in Central and Eastern Europe, but most of it is old and inefficient, losing up to half of the heat during transport. (District heating networks in Scandinavia, by contrast, lose less than 10 per cent of the heat.) On alternative sources of gas, the quickest measure would be to expand the EU’s capacity to import liquefied natural gas (LNG). The Commission should stress, in all its contacts with the US government, the strategic advantages of the US exporting LNG. But increased imports of LNG are not dependent solely on successful trade negotiations with the USA; such gas is available from other non-Russian sources, notably Qatar. Greater use of LNG will require new infrastructure and any state that has a coast can develop LNG facilities. The Commission should give priority to less wealthy member-states that are highly dependent on Russian gas: the Baltic states, Bulgaria and Poland. This would not improve Europe’s overall energy security, but would help those countries highly dependent on Russian gas: the five countries mentioned above plus the Czech Republic, Finland, Hungary and Slovakia.

To improve EU energy security overall, EU institutions should do all they can to ensure that new pipelines are constructed to transport non-Russian gas from the Caspian Sea to Europe. Contracts have been signed for a Trans-Anatolian pipeline from Azerbaijan to the Mediterranean coast of Turkey, and a Trans-Adriatic pipeline from there to Italy. But construction has yet to begin. This pipeline would reduce EU dependence on Moscow, unlike Gazprom’s South Stream, which would simply be an alternative way of transporting Russian gas to the EU (while avoiding Ukraine).

Indigenous shale gas is another source of non-Russian gas. Governments which have banned fracking, either formally (France and Bulgaria) or informally (Germany) should now reverse this position. Renewable gas, which can be created from food and farm waste, manure and sewage, should also be expanded as much and as fast as possible. This is already widely used in Germany and Austria. Using these wastes to produce renewable gas would improve water quality, because the residue can be used as fertiliser rather than being discharged into rivers or seas. Greater use of renewable gas would help achieve climate policy objectives, as well as greater energy security. Renewable electricity must also be expanded. This would reduce the need to use gas for electricity generation, and also for heating (since heat can be provided in domestic and commercial buildings by electricity rather than by gas). The Commission could co-ordinate national subsidy schemes for renewables more closely, as this would cut administration costs for developers and reduce regulatory risk, so cutting the cost of capital. And all European institutions must work together to expand and improve the electricity grid, with a focus on the Baltic, Mediterranean and North Seas, and around the Pyrenees.

What role should coal play in future energy policy? Here the need for energy security conflicts with the need for climate protection. A quarter of the coal which the EU imports comes from Russia. The EU could survive easily without Russian coal, by mining more within its own borders and by importing more from other countries. However, coal is extremely polluting. Burning coal can cause high levels of toxic air pollution, damaging human health and harming the environment. EU rules have been effective in reducing toxic pollution from coal combustion. Coal generation also emits high levels of greenhouse gases – about twice as much pollution per unit of electricity as gas combustion does. Yet technology exists to cut greenhouse gases from coal combustion. CCS has been demonstrated at small scale, but not yet at large scale. The EU is falling behind Australia, Canada, China and USA in its attempt to roll it out.

CCS is not popular with the German public. But it is less unpopular than nuclear power. Before the 2011 Fukushima accident in Japan, Chancellor Angela Merkel said that low-carbon bridge technologies were necessary, to protect the climate while the world moves from fossil fuels to renewables. She was right. The transition to renewables will take at least half a century – probably longer. Gas is less bad for the climate than coal is, but not low-carbon enough to prevent dangerous climate change unless combined with CCS. Merkel’s post-Fukushima energy policy sets out an end point – total reliance on renewables – but pays no attention to what happens during the transition. The result – as statistics from Germany demonstrate – is increased greenhouse gas emissions.

Even the German desire for energy security and reduced dependence on Russian gas seems unlikely to persuade most Germans to reconsider nuclear power. There is more chance that they will reconsider CCS. But the most likely outcome is that Germany will become even more willing to burn coal without CCS. This would seriously compromise EU climate action. To avoid this outcome, EU institutions should set an emissions performance standard to regulate the maximum amount of greenhouse gas that can be emitted per unit of electricity generated. This would ban coal without CCS. However, demonstration and deployment of CCS will require subsidy. Renewables and nuclear power will also require some form of financial support. All these technologies are needed for climate protection. They could also help make Europe’s response to Russia’s annexation of Crimea more credible.

Reduced reliance on Russian energy sources, and increase in resilience in the event of a supply cut off, should be central elements in a long-term re-orientation of EU energy policy. European institutions and member-states should implement the five-strand strategy outlined above: use energy much more efficiently; develop all alternative gas sources; maximise renewable energy; demonstrate and deploy CCS; and build new nuclear power stations. This strategy will not be cheap. But the economic, security and climate action advantages will justify the cost. IMF managing director Christine Lagarde is right to say that climate change is “by far the greatest economic threat of the 21st century”.

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

Thursday, April 03, 2014

Can the EU help Belarus to guard its independence?

Belarus is the forgotten member of the EU’s Eastern Partnership. The EU has negotiated ‘action plans’ with the other five members – Armenia, Azerbaijan, Georgia, Moldova and Ukraine. These involve the EU promising benefits in return for commitments to reform. And of those five, all but Armenia and Azerbaijan have signed or will sign association agreements with the EU. Belarus has been excluded because of its human rights record. However, following Russia’s annexation of Crimea, both Minsk and Brussels are thinking seriously about a closer relationship.

Events in Ukraine have worried the regime of Alexander Lukashenko, Belarus’s president since 1994. His government, of course, dislikes popular revolutions of the sort that overthrew Viktor Yanukovych in Kyiv. But it also opposes the dismembering of a country like Ukraine. On a recent visit to Belarus, I noticed that officials became visibly nervous when asked about the new ‘Putin doctrine’ – the assertion of Russia’s right to intervene in neighbouring states to protect the interests of Russians or Russian-speakers (ethnic Russians make up 8 per cent of the population of Belarus; everyone speaks Russian but 15-20 per cent also speak Belarusian regularly).

Belarus’s response to the Ukraine crisis has therefore been ambiguous. It has condemned the disorder of the Maidan protests, blaming the fall of Yanukovych on Ukraine’s economic mismanagement and corruption (Belarus is indeed richer and less corrupt than Ukraine). But in the early phases of the crisis, Lukashenko and his ministers spoke out in favour of Ukraine’s territorial integrity and against its ‘Yugoslavisation’. But then – presumably because of growing pressure from Moscow – Minsk stopped repeating this implied criticism of Russia. Lukashenko’s most recent public comment was to say that Crimea was now part of Russia and that, if forced to choose “Belarus will always be with Russia”. But he added that the annexation “sets a bad precedent”.

One thing that some government officials and opposition leaders agree on is that in the long term, there is a danger of the country losing its independence. Belarusians both for and against the government muse openly on whether, post-Lukashenko, there will be anyone strong enough to stand up to Russia. The self-styled ‘father of the nation’ has long played a clever game with Russia, extracting economic benefits to allow Belarusians to maintain a reasonable standard of living, in return for making promises that he often wriggles out of (per capita GDP is about 50 per cent higher than in Ukraine, and almost as high as in Russia). Around 10-15 per cent of the country’s GDP derives from Russian subsidies, mainly in the form of cheap oil and gas. Recent Russian credits were tied to the privatisation of state-owned industries, so that Russian industrial groups would be able to buy them, but the privatisations never happened.

Though Lukashenko’s slippery behaviour has infuriated Russia’s leaders, they have tolerated it since they see him – as Franklin Roosevelt supposedly said of Nicaragua’s President Somoza – as ‘our son-of-a-bitch’. Russia and Belarus share a common travel area and an air-defence system; recently Russia sent a squadron of fighter jets to a Belarusian airbase.

But although almost all Belarusians want their country to be independent, they are divided on where its future lies. Opinion pollsters and political analysts say that support for the EU has grown in recent years. Some of them reckon that about a third of the people want Belarus to be democratic and closer to the EU, a third want to stay close to Russia and a third do not care. But these analysts reckon that the crisis in Ukraine has boosted support for Lukashenko: he is seen as a bulwark against the instability and chaos of their southern neighbour. The state media, of course, reinforce this message.

The main reason to worry about Belarus losing its independence is the dire state of its economy. Unemployment is negligible, thanks in part to at least 70 per cent of the workforce being employed by the state. But economic growth has almost come to a halt and the factories are full of unsold goods. Apart from a respectable IT sector, Belarus has little modern industry. It sells refined oil products to the EU, and tractors, lorries and heavy vehicles to Russia. Sales to Russia have slumped, not only because of Russia’s own economic slow-down, but also because of Moscow’s entry into the WTO; Belarus’s goods now face stiff competition from emerging economies in the Russian market. They are not competitive because productivity growth in Belarus’s state-owned industries has been minimal. Another problem is that earnings from the staple export of potash have slumped: last year a Russian potash firm pulled out of its cartel with a Belarusian partner, leading to a sharp fall in the global price.

All these problems led to Belarus’s current account deficit ballooning from 3 per cent of GDP in 2012 to 10 per cent last year – that is $7.3 billion. Although the Belarusian rouble has depreciated by 15 per cent since 2011, when there was a sudden devaluation of 36 per cent, this deficit is likely to worsen in 2014. The central bank only has $6 billion of reserves, which means that the country is going to have to borrow a lot of money. It is hard to see Western governments or institutions lending substantial sums. Which leaves only Russia, and the regional bodies it controls. But Moscow will set tough conditions on any loans, and given the weakness of the Belarusian economy, Lukashenko may be less able to resist the conditionality than in the past.

Russia’s first demand is for supportive statements on Crimea, which Belarus has more-or-less complied with (in 2008, after Russia invaded Georgia, Belarus was less compliant: it refused to recognise the independence of Abkhazia and South Ossetia). The second demand is for the privatisation of state-owned industrial assets. The third demand is that Belarus agree to the Customs Union between Russia, Belarus and Kazakhstan being transformed into a stronger ‘Eurasian Economic Community’ (EEC).

That last demand is already the subject of tense negotiations between Moscow, Minsk and Astana. The Eurasian Economic Community is a pet project of President Vladimir Putin, who says that its rationale is economic but seems to see it as a geopolitical counterweight to the EU.

The Customs Union, up and running since 2010, has many holes in it. About a third of all goods and two-thirds of all services are excluded from its rules, so that the three members can protect cherished industries. Belarus and Kazakhstan have to accept the high external tariffs that Russia has insisted on, to protect sectors such as car manufacturing. Independent economists in Belarus say that it does not benefit much, since it had free trade with Russia before the Customs Union started – with one important proviso. Russia bought Belarus’s support for the Customs Union by offering it cheaper energy prices than those available to other export customers. Officials in Minsk are more positive about the economic benefits of the Customs Union, but still worry that its institutions – notably the Commission (in theory, modelled on the European Commission) that is based in Moscow – are dominated by Russians.

The plan is for Presidents Putin, Lukashenko and Nursultan Nazarbayev of Kazakhstan to sign an agreement on the Eurasian Economic Community in May. Armenia (which last September decided not to sign the EU association agreement that it had negotiated) and Kyrgyzstan have expressed an interest in joining but are several years away from doing so. The EEC is supposed to cover the ‘four freedoms’, meaning free movement of goods, services, capital and labour. However, the rules are still being haggled over. Belarusian officials say proudly that they and the Kazakhs have blocked Russian plans for the EEC to become a political organisation; they insist that they will thwart Russia’s desire to re-establish parts of the USSR via the Eurasian Economic Community. They are also reluctant to accept free movement of capital, since that would enable Russian oligarchs to start buying up Belarus.

Many Belarusian economists think that the Eurasian Economic Community would not bring much in the way of economic benefits. However, as with the Customs Union, there is an important qualification. Every year Belarus has to transfer about $4 billion to Russia, from the export duties paid on refined products made with Russian oil. Belarus is desperate to hold on to that money, and Russia may agree – in return for the EEC treaty being signed.

Lukashenko and his ministers are keen not to become too dependent on Russia, and have therefore renewed their on-off flirtation with the EU. Foreign Minister Vladimir Makei attended the EU’s Eastern Partnership summit in Vilnius last November, since Belarus is allowed to take part in the partnership’s multilateral discussions. That visit led to the EU and Belarus starting talks on ‘visa facilitation’ (a softer visa regime) and a readmission agreement (whereby Minsk would agree to take back those who enter the EU illegally from Belarus). They are also talking about talks on what the EU might do to help the Belarusian economy.

However, EU sanctions on Belarus, imposed because of its human rights record, remain in place. There are visa bans and asset freezes on 232 individuals associated with the regime. A number of companies close to the government are also sanctioned. Belarusian ministers argue that the EU’s stigmatisation of Belarus is unfair, given that Azerbaijan is a full member of the Eastern Partnership, despite having a human rights record no better than that of Belarus.

But despite a certain degree of bitterness towards the EU, some senior figures in the Belarusian government hope for a rapprochement. Opinion in the EU is divided. Those who oppose re-engaging Belarus point out that the last attempt to do so ended in tears. After the 2008 war in Georgia, Javier Solana, the then High Representative, visited Minsk and brokered a deal with Lukashenko. In 2009 his government released all political prisoners and in return the EU suspended sanctions and encouraged the IMF to lend. But at the time of the December 2010 presidential election, the security forces clamped down hard on demonstrators, presidential candidates were locked up and then in February 2012 the EU withdrew its ambassadors. Belarusian opponents of rapprochement, such as Andrei Sannikov – a former presidential candidate who was in prison and is now in exile – argue that the regime will never change as long as Lukashenko is in power, and that engagement is futile.

But advocates of engagement, who include senior figures in Lithuania, Poland and Sweden, draw a different lesson from Solana’s efforts: that in the right circumstances the regime is capable of softening, for example by releasing prisoners. There is talk of appointing an independent mediator to broker a deal between Brussels and Belarus. One name mentioned is Solana himself, now in retirement; another is Alexander Kwasniewski, the former Polish president, who last autumn tried and failed to bridge the gap between Yanukovych and the EU. The geopolitical fall-out from the Crimean crisis seems likely to ensure that the advocates of engagement win the argument. It is not in the EU’s interests for Belarus to become a complete satellite of Russia.

In May the Ice Hockey World Championship will take place in Minsk, which may give Lukashenko an excuse to release political prisoners (the EU counts six of them) and soften aspects of his regime. Nevertheless there are clear limits to how far any rapprochement can go. The IMF is unlikely to lend billions of dollars to a country with a state-run economy that is undemocratic. That means that Belarus needs Russia’s good will and money in order to sustain its economy. If Minsk moved too close to Brussels, Moscow would have plenty of levers to pull, in order to yank it back.

Charles Grant is director of the Centre for European Reform.

Tuesday, April 01, 2014

Europe and Russia: Continental divide?

In annexing Crimea, President Vladimir Putin violated a powerful post-1945 taboo against incorporating other countries’ territory into your own. So far, not only does he seem to be getting away with his land grab, but he has moved on to demanding that Ukraine becomes a looser federation and gives Russia a veto over its international relations. The EU and the US should be united in rejecting this attempt to reduce Ukraine to a satellite of Russia; and they should ensure that any larger ambitions Putin may have are contained.

Putin’s March 18th speech to Russia’s Federal Assembly should have triggered a comprehensive reappraisal of the West’s relationship with Russia. Through it ran a worrying thread of ethno-nationalism. Putin claimed that in creating Soviet Ukraine after the Russian Revolution, the Bolsheviks incorporated in it territory from the “historical south of Russia”, inhabited by ethnic Russians. He expressed his resentment that Russians had become the world’s largest “divided population” after the fall of the Soviet Union. And he spoke of “the striving of the Russian world, of historical Russia, to re-establish its unity”.

The West has consistently underestimated the extent to which Putin means what he says: he told George W Bush in 2008 that Ukraine was “not even a state”, and he is now acting accordingly. In 2006 he said that Russian ‘peacekeeping’ forces would stay in the Georgian separatist regions of Abkhazia and South Ossetia despite Georgian “provocations”; in 2008, using the excuse of such provocations, Russia took military action against Georgia, effectively annexed the two enclaves and strengthened its forces there. In 2005 Putin denied that Estonia had been occupied by the Soviet Union after the Second World War, and suggested that it had only existed as an independent state between 1918 and 1939 because of a deal between the Soviet Union and Germany (when in fact it fought a war of independence to escape from Russian control).

Despite Estonia’s NATO and EU membership, the West should not wholly discount the possibility that Putin still thinks of the independence of the Baltic States as a mistake that could be reversed. Indeed, Andrei Illarionov, a former senior economic adviser to Putin, believes that Putin’s ultimate aim is to re-establish Russia’s rule over the lands it held before the 1917 revolution – which would include Finland, the Baltic States and part of Poland as well as the former Soviet Union.

Given the state of Russia’s economy, such a goal would be pure fantasy; but Eastern and Central Europe, as well as Russia itself, would suffer enormous damage from any attempt to make it a reality. Both the EU and NATO need therefore to take measures to deter further intervention by Russia, whether in Ukraine or elsewhere; to reinforce the freedom of action of allies and partners in Europe; and to encourage change in Russia itself.

The immediate need is for deterrence. The Western response has to change Putin’s calculus. The US and Europe need to make clear that if Russia moves into more Ukrainian territory, they will deny Russian financial institutions access to dollar- and euro-denominated financial markets in a way that will cause serious damage to the Russian economy and specifically to the elite around Putin. Russia’s economy barely grew last year, and the World Bank has forecast a contraction of 1.8 per cent and record capital flight of $150 billion this year (capital flight in the first quarter of 2014 was $70 billion). As a result of the Ukraine crisis, Russia’s cost of borrowing is rising, and downward pressure on the ruble will lead to increased inflation. But these effects may not last if the West returns quickly to business as usual.

It will be hard to get agreement on more comprehensive economic sanctions against Russia, particularly in the EU, where countries like Italy (heavily dependent on Russian gas and industrial contracts) and Cyprus (still tied to Russia through its off-shore financial services sector) will resist. Germany is Russia’s largest trading partner in Europe, and German businesses would clearly prefer to avoid further action against Russia; a number, including Siemens, ThyssenKrupp, Adidas and Deutsche Post have publicly criticised the EU’s approach. The German government is sending mixed signals, with Vice Chancellor and Economy Minister Sigmar Gabriel telling ARD TV that Germany did not want sanctions but had to show that it did not accept Putin’s “imperial policy”.

The risk is that the limited measures taken so far and the obvious divisions in the EU may lead Putin to think that the West will in the long term tolerate action in Eastern and Southern Ukraine as well as Crimea. One element in achieving agreement on tougher sanctions may be a ‘solidarity package’ to support states which would suffer disproportionately from their imposition, at the expense of others who are less affected. Lithuania is already feeling the economic impact of Russia blocking some imports via the port of Klaipeda; and the Latvian Prime Minister has indicated that in the worst case scenario a total shut off of trade with Russia could reduce Latvia’s GDP by 10 per cent.

Deterrence should not be limited to financial steps. Though the immediate threat is to Ukraine, Russia has also made threatening moves in the Baltic, with surprise military exercises including amphibious landings in its Kaliningrad exclave. In an interview with German ARD TV on March 23rd, German Defence Minister Ursula von der Leyen urged increased NATO support for the Baltic states. She was right. NATO has already increased the size of its air policing mission, based in Lithuania (the UK will send four aircraft to join the mission in April), and the US has moved 12 F-16 aircraft to Poland. But so far NATO has not deployed any ground forces in the region. It should place small multinational contingents near the eastern borders of the Baltic States and Poland, as a visible statement of intent to live up to NATO’s Article 5 commitment to assist any ally subject to armed attack.

President Barack Obama and other Western leaders have made a serious mistake in categorically ruling out military involvement in Ukraine on the grounds that NATO’s security guarantee does not cover non-members. In doing this, they have reassured Putin that the West’s reaction will be diplomatic and economic; knowing that so far the EU has been split on imposing tough sanctions, he may feel that the price of further intervention is worth paying. Obama might instead have reminded Putin that Kuwait was not a NATO member, but the US-led coalition nonetheless intervened to restore its independence when Iraq sought to annex it in 1990. Western leaders should follow the Royal Navy motto: “Si vis pacem, para bellum” (“If you want peace, prepare war”). They should state publicly that if Ukraine were attacked and called for assistance in exercising its right to self-defence, they would be ready to deploy NATO forces. And to underline that this is more than empty rhetoric, they should open discussions with the Ukrainian government on concrete arrangements for such a deployment.

If such deterrent measures succeed in preventing any rash Russian action in the immediate future, they will still leave a changed security picture in Europe. A quarter century of (relatively) low levels of tension between the major powers in Europe is over. As long as Putin or others with similar views are in power in Russia, there will be a military and political threat to Russia’s neighbours.

In the 1997 NATO-Russia Founding Act, NATO stated that “in the current and foreseeable security environment”, it would carry out its missions without “additional permanent stationing of substantial combat forces”. Both sides agreed to respect the “sovereignty, independence and territorial integrity of all states and their inherent right to choose the means to ensure their own security”. NATO should announce that it is revisiting its policy in view of the changed situation. It would be imprudent for the alliance to abide by an agreement that Russia has abandoned.

NATO should review its relations with Georgia and Ukraine. Obama was clearly trying to reassure Putin when he said after the EU-US Summit in Brussels on March 26th that Georgia and Ukraine were “not currently on a path to NATO membership”; but he was ignoring the fact that successive NATO summits since 2008 have said that the two countries “will” become NATO members. NATO could withdraw that commitment, but that would merely reinforce Putin’s sense that former Soviet states are his to deal with as he wishes.

Georgia has consistently backed NATO membership and has been a major contributor to ISAF in Afghanistan; it should be rewarded at the NATO Summit in September with a Membership Action Plan (MAP) and a clear and short pathway to full NATO membership. There has never been a popular majority in Ukraine for joining the alliance, but after the Presidential election in Ukraine, once a new government is in place, NATO should discuss with Kyiv how the NATO/Ukraine relationship should develop. At least one recent opinion poll in Ukraine shows a sharp increase in support for NATO membership since the Russian intervention in Crimea, but at this stage membership remains a divisive issue and an unnecessary distraction from solving pressing economic and political problems.

The threats to Europe’s neighbourhood are not only or even primarily military. The prospects of all the EU’s Eastern Partners (Armenia, Azerbaijan, Belarus, Georgia, Moldova and Ukraine) have been blighted by corruption, poor governance and economic mismanagement. Ukraine would not have been so vulnerable either to internal instability or Russian meddling if it had been better governed and economically stronger. Moldova, though less corrupt than Ukraine, is still in 102nd position in Transparency International’s annual ‘Corruption Perceptions Index’. Georgia has done considerably better, but the rule of law is still weak there. And all three countries, lacking Russia’s mineral wealth, remain relatively poor.

Ukraine will need massive international assistance simply to meet its obligations this year; but financial aid should come with strict conditions, and with hands-on technical help. The priorities are to make state finances transparent and limit the opportunities for corruption; to establish courts that decide cases on the basis of laws, not in favour of the highest bidder; and to sort out Ukraine’s energy sector.

Ukraine’s gas industry has been a notoriously corrupt sector in a notoriously corrupt country. Energy inefficiency reduces competitiveness and increases dependence on Russia. Before the overthrow of President Viktor Yanukovych, the Ukrainian government had signed contracts with a number of Western oil majors to explore for both conventional and shale gas. Over time, these will enable Ukraine to buy less Russian gas; but reducing wasteful consumption will bring benefits more quickly and at lower cost. EU member-states like Denmark and Sweden have already identified energy efficiency as a priority area for investment.

A number of EU countries, particularly in Central and Northern Europe, are even more dependent than Ukraine on Russian gas. Reducing this dependence will take time, but is vital if the potential for Russia to use gas as a geopolitical tool is to be reduced. In a forthcoming CER insight Stephen Tindale will set out the options in detail. Europe needs more LNG terminals, and freer access to LNG, including from the US (which, thanks to shale gas, now has a surplus of gas). It needs more interconnectors, both for gas and electricity, particularly between the countries of Central Europe. These countries rely on pipelines from Russia but are largely isolated from each other and from other sources of gas and electricity. Interconnectors would support diversification, increasing both security of supply and competition. Europe needs more pipelines from the Caspian Sea and Iraqi Kurdistan. And it needs to overcome its fear of fracking and of nuclear power.

Europe is also losing the propaganda battle with Russia, not only in Ukraine but in some EU member-states. Russia has a number of means to get its messages across. Many Western articles on events in Ukraine are influenced by Russian reporting on the supposedly deep linguistic and ethnic divide between Eastern and Western Ukraine – a divide which Ukrainian census data shows is very blurred. Because Russian leaders constantly repeat that the Crimean ‘referendum’ reflected the will of the people, most Western media are now uncritically reporting this line without commenting on the shortcomings in the process. Outlets like RT, the Kremlin-controlled English language TV channel, though ridiculed by experts for their misinformation, still get quoted in social media; their views are given the same value as more objective journalism. And Western populists and anti-Europeans, including Nigel Farage of the UK Independence Party and Lord Tebbit of the Conservative Party, are promoting the Russian narrative that EU ‘expansionism’ has created the problems in Ukraine.

Western media should not stoop to propaganda, but Western governments should be more active in ensuring that objective information is available – including through direct engagement on social media. The US embassy in Kyiv has done a better job than most of trying to counter propaganda directed at Ukraine; the EU Delegation there could do a lot more. If Russia’s version of the story is allowed to dominate, it will foment division not only in Ukraine but also in Latvia and Estonia, where Russian TV is widely watched; and Western publics will be less likely to back strong action if Russia continues to expand into its ‘historical’ territories.

A return to some form of implicit containment and East-West competition may be the most likely short- to medium-term scenario, albeit this would (and should) fall far short of a comprehensive ‘Cold War’. But much better in the long term, both for the West and Russia, would be a constructive, win-win relationship. This seems out of reach as long as Putin is in power, or the oligarchic concentration of political and economic power around the Kremlin and the securocrats continues. Putin has been paranoid about attempts by the West to engineer a revolution against him. Perhaps it is time the EU gave up trying to reassure him, and instead worked on a long-term programme to support democratic change in Russia. Elements of this might include:

* Strong enforcement of the international ‘rules of the game’, including in the WTO. EU member-states should also make full use of existing anti-corruption and anti-money laundering legislation, and publicise examples of those in Putin’s circle who have grown rich in suspicious circumstances (the explanation by the US Treasury of the links between Putin and some of those sanctioned by the Americans in relation to the annexation of Crimea provides an excellent model).

* Investment in the next generation of Russians through scholarship schemes and increased links between universities. The more that ordinary Russians are exposed to the realities of life in the West – and particularly in former Communist countries which have benefited from economic and political reform – the harder it will be to mislead them with propaganda, and the more they will understand how free societies work.

* Support for small and medium enterprises (SMEs) in Russia. SMEs suffer from weak rule of law in the current system; entrepreneurs have a strong interest in change. There is funding available for help to SMEs in the framework of the EU-Russia ‘Partnership for Modernisation’, but there should be more.

* Support to civil society organisations – not necessarily political ones, but those working in areas such as protecting the environment, aiding vulnerable groups or identifying and combating corruption. This would be deeply unpopular with the Russian government, which has tried to brand NGOs that work with international donors as ‘foreign agents’, but it should be left to the NGOs themselves to decide whether to run the risk of taking Western funding or advice.

* Long-term political and economic engagement with Russia’s neighbours. If the EU can help the countries of the Eastern Partnership move from basket-cases to success stories, that will show that post-Soviet countries, including Russia, have alternatives to the way they have done things for the last 20 years, and undermine Putin’s argument for the system he has created.

* Consistent messaging to Russian society that it was not democracy and the free market that left Russia chaotic and impoverished in the 1990s, but the legacy of autocracy and communism, the worst elements of which Putin is now perpetuating with his imperial adventures.

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