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EU challenges require fundamental solutions with fiscal, energy unity

Mature economies need more trade in services; 'China threat' may reflect their own problems

by Takashi Kitazume

Staff Writer

The ultimate solution to the debt crisis in the European Union will not only need a banking union but also have to involve some element of a fiscal union and a major shift of power from the national level to the European level. On the other hand, the EU budget to finance the union’s key common needs is dysfunctional today as much of it remains controlled by national and sectoral interests.

Future growth of advanced economies will depend much on increased productivity in the services sector and greater trade in services. Meanwhile, the “China threat” theory often heard in mature economies can in fact be a mere reflection of their own problems.

These were among the topics discussed by experts from European think tanks who spoke at a symposium organized Oct. 26 by the Keizai Koho Center in Tokyo to discuss economic challenges confronting industrialized nations.

Of the continuing debt woes in Europe, Guntram Wolff, deputy director of the Brussels-based think tank Bruegel, said the EU has so far achieved a Greek debt restructuring, a mechanism put in place to help finance the countries in difficulties and significant governance reforms on the fiscal and structural side.

The major issue on the agenda now is the banking union among EU member states, and for a banking union to be successful “requires some degree of fiscal union,” Wolff said.

A banking union “essentially tries to restore, reinstall and re-establish the integrity of the eurozone financial system,” he said. What was observed in the years since the onset of the crisis is “a very serious fragmentation of the financial system in the euro area” and “very prohibitive credit conditions for non-financial firms,” he noted.

“The financial disintegration is leading to a real economic divergence and real economic fragmentation of the eurozone. If that continues for many years, then at some stage the euro is not sustainable,” he said.

To make a banking union successful, it has to be comprehensive, he said.

“A true banking union must involve three elements — a common supervision, resolution authority and a common fiscal backstop,” Wolff said. “Having one element missing or poorly designed would undermine the whole construction,” he said.

“You have to plan for the worst” in designing a banking union,” and a big banking crisis can require massive fiscal costs, he said. If that cost is to be borne solely by the taxpayers of the country where the crisis originated, “this country will have a problem servicing all this debt and will go down in a downward spiral,” he noted.

“If you really want to do the banking union seriously, you need to agree ex-ante on how you would share the burden” among EU members in case a crisis occurs, he said.

The banking union plan currently on the table is just about common supervision and is “therefore yet incomplete,” Wolff said.

A banking union is “also a political project and cannot be separated from political integration,” he noted. It will be a major political step to have a single supervisor who is able to close any bank in the entire eurozone, and it’s a “major shift of power from the national level to the European level,” he said. “That needs to be done well. You need more political integration and more parliamentary control,” he noted.

While responses to these crises require deeper integration, the EU budget as it is today is under pressure for cuts despite the massive fiscal needs to pay for common policies, said Jorge Nunez Ferrer, an associate research fellow with the Center for European Policy Studies (CEPS), also based in Brussels.

The EU budget funded by contributions from member states “is an instrument to finance treaty obligations and common policies” of the union, and even though it’s often perceived and disputed by politicians as an enormous machine, it accounts for 1 percent of the EU gross domestic product and 2 percent of its public expenditure, he said.

Of the expenditures, around 45 percent is distributed to common agricultural policy and related programs and another 35 percent is used for “cohesion” policies to help the development of the poorer regions in the EU.

“In other words, you have 80 percent of the budget in one way or another managed by and pre-allocated to member states” which are often worried about the money allocated to them than the policies and do not want to give it away, Ferrer said. “If you combine this with the fact that common agricultural policy is very much influenced by the agricultural lobby, it makes changes in EU common expenditures very difficult.”

While key needs of the EU include construction of trans-European infrastructures on energy, transportation and communication, the reality today is that “less than 10 percent of the budget can be mobilized” to fund these projects, Ferrer said. “We have funding needs that are more than 100 times the contribution from the EU budget,” and in the budget negotiations “member states, instead of wanting to help achieve the objectives that they themselves have approved, say they are in a crisis and want to cut the budget,” he said.

So the EU budget, which is meant to solve common problems, is “completely taken and controlled by national, regional and sectoral lobbies. It is really paralyzed and dysfunctional,” he said.

One solution that will become increasingly important, Ferrer said, is mobilizing funds from the private banking sector to finance those EU programs, with the limited funds from the EU budget used as a multiplier or guarantee to attract other financiers to pay for the project.

Energy is among the key areas where a common regional approach is increasingly required, and investments are needed to create a single market for electricity and gas among all the 27 EU members, said Arno Behrens, a research fellow and head of energy of the CEPS.

While individual member states have a diverse energy mix and conditions, the EU as a whole shares the same problem with Japan in its high dependence on imported fuels, particularly in oil and natural gas, he said.

The production of fossil fuels within the EU have peaked, and the outlook for shale gas exploration seems bleak. Meanwhile, countries on which the EU depends for its fuel imports “are not often characterized by political stability” and some member states are convinced that Russia, the biggest fossil fuel exporter to the EU, uses its fuel exports as a political weapon, he said.

The high dependency on imports, as well as rising energy demands in fast-growing economies like China and India, is often perceived as the major risk to the security of supply. But in Europe, a bigger risk to supply disruptions and outages in recent years has been aging infrastructures, which will require new investments, Behrens said.

A more important energy agenda, he said, will be the creation of a common market of electricity and gas. “This basically means not only to integrate the markets in terms of infrastructure and cross-border infrastructure, but also to induce more competitiveness into the market — to liberalize the market and reduce the power of the former state-owned energy companies and to allow smaller and other energy generators to the market,” he said.

It will aim to ensure a fair network access by different energy generators, including those for renewable sources, “and on the external side, to get a better bargaining power toward major exporters like Russia,” Behrens said.

Other participants in the symposium discussed broader issues concerning common challenges for mature economies.

The greatest potential for growth in mature industrialized countries lies in the services sector — and in liberalizing international trade in services, said Iana Dreyer, economy and Europe analyst for the French think tank Institut Montaigne.

“The services sector accounts for roughly three quarters of the gross domestic product and jobs of advanced economies. World trade in services is much lower — just below 23 percent of world trade,” she said.

Data among OECD member countries point to a sharp divergence in productivity performance over the past several years between some industrialized countries such as the U.S. and Britain on one hand, and core EU economies like France, Italy and Germany on the other, she said. While the U.S. and Britain have had relatively high productivity growth, the key European economies have had very low or even declining productivity increase, and “a lot of this has to do with low productivity growth in the services sector,” Dreyer said.

Trade in services, either through direct investments in another country or takeover of a foreign firm, is key to raising productivity because it raises competition, Dreyer said. This is important because, she noted, debate on export competitiveness of advanced economies focuses too much on industrial production.

Emphasis on manufacturing to boost export competitiveness “is confusing when industries account for 20-25 percent of GDP” of the mature economies and could end up “overemphasizing something that is very small,” she said. It could also lead people to miss fundamental changes in industrial sectors in recent years — that manufacturing sectors rely more and more on services, ranging from research and development and marketing to maintenance, she added.

Today, barriers to cross-border trade in services are much higher and more complicated than the barriers to trade in goods, she noted. While border tariffs and quotas on import goods have come down to minimal levels in most advanced economies, barriers to services trade come in a variety of forms, including restrictions on investments, movement of personnel or certain professionals, monopolistic industry structures in certain sectors, Dreyer said.

Statistics suggest that many of the core “old” advanced economies such as France, Italy and to a certain extent Germany that tend to keep tight restrictions on services trade “are also those economies with lowest productivity growth,” she said, adding that Japan resembles the profiles of such economies in terms of restrictions on foreign investments.

Noting that services were hardly given any serious discussions at the deadlocked Doha round of the World Trade Organization trade liberalization talks, Dreyer said it would be a good step in principle to take up services trade in bilateral or regional free trade negotiations.

The problem with bilateral or regional FTA talks, she pointed out, is that the negotiations could be overshadowed by geopolitical considerations, and that strong lobbies “that do not necessarily represent the interests of the entire economy can hijack these negotiations.” The services sector in economies that have not been very competitive will likely resist liberalization, she said.

Most advanced economies have faced the brunt of tightening competition with emerging powers, including China in particular. But what is often referred to as the “China threat” can in fact be the reflection of problems on the part of the mature economies, said Francoise Nicolas, a senior research fellow and director of the Center for Asian Studies at The French Institute of International Relations (IFRI), citing the case of France.

France’s widening trade deficit with China is frequently attributed in the French press to surging imports as a result of unfair competition, dumping or exchange rate manipulation, while the perception remains strong that access to the Chinese market is difficult due to hidden and regulatory barriers, she said.

But hard economic data do not show any substantial correlation between the evolution of the euro-yuan exchange rate and that of the French-China trade balance, Nicolas pointed out.

More disturbing for France, she said, is that Germany maintains a trade surplus with China just as the French deficit widened. “If the euro were responsible for the evolution, then there will actually be no reason why Germany and France should behave differently,” she noted.

What may explain the difference between France and Germany, Nicolas said, is the composition of their exports to China. Germany, whose passenger cars account for a major portion of its exports to China, is “apparently quite good at taking advantage of the rising demand for consumer goods particularly luxury cars,” she said. “Germany is in the right segment of the market and France is apparently not.”

Another major component of German exports to China — capital goods such as machine tools — is evidence that “again Germany was good at taking advantage of the fact that China was industrializing, and France was not,” Nicolas said.

Given that there’s no major difference in the structure of Chinese exports to either France or Germany, Nicolas said a major explanation for the French deficit is “the mismatch between supply and demand — between the supply on the French side and the demand on the Chinese side.”

“It is more a French problem than a Chinese problem,” she said. “Altogether, I think there is definitely a problem of competitiveness in France.”

While there can be a variety of possible explanations, “the major problem in France has been the weakening and the shrinking of the industrial sector,” she said. However, the need to “re-industrialize” France should not be misinterpreted — as politicians may be tempted to — as turning back the clock to protect industries that are no longer competitive, she said. “The right approach is to find new niches, new segments, new industries, innovate more.”