Has the ECB backed German ‘reform contracts’ for the eurozone?

In a speech in London yesterday, ECB President Mario Draghi issued a call for new eurozone rules on structural reform. He discussed it at length in the speech, but the ECB’s summary captures the key points:

The governance of structural reforms deserves as much attention as enforcing fiscal rules and should be done at the euro area level.

Structural reforms need strong domestic ownership since they reach deeply into societal arrangements. But at the same time, the example of the International Monetary Fund shows that there is a convincing case to be made for a supranational body that makes it easier to frame national debates on reform. This can shift the debate from whether to how to implement reforms, Mr Draghi argues.

The outcome of structural reforms – a higher level of productivity and competitiveness – is not merely in a country’s own interest, but in the interest of the monetary union as a whole. 

In the euro area, there is therefore a case for establishing rules on structural reform at the EU-level. While a lack of reform can threaten cohesion of the union, the recovery shows us how decisive reform can strengthen it.

Despite the lack of specific details, this has rightly evoked comparisons to the German proposals for ‘reform contracts’, which were strongly pushed last autumn and which we discussed in detail here. There are lots of overlapping ideas, including the concept that eurozone rules will help encourage ownership of reforms rather than discourage it, and that this is a logical supplement to the existing European Semester.

We have always expected the reform contracts to make a comeback in some form or another, not least given Germany's strong support for the concept, and there are other reasons to think that they may gain some further traction this time around.

While the peripheral countries have previously objected to such sovereignty transfers, Italian Prime Minister Matteo Renzi has been vocally touting the idea that countries should be directly rewarded for reform efforts. The details might differ, but conceptually he has moved closer to the Germans on this point.

There is no doubt the reform contracts will remain a hard political sell, but with the ECB’s backing and the growing desire for a proper negotiation and discussion around the eurozone's fiscal rules, as well as the broader approach to economic reform, now could be the time for the idea to make a comeback in one form or another.

When it rains, it pours – EU legal opinion puts UK on backfoot over revamped Liikanen rules

It’s not shaping up to be a great month for the UK government with respect to the EU – a pretty poor showing at the European elections, a looming defeat over the Spitzenkandidaten process and now, just to top it off, a troublesome legal opinion from the European Council legal service.

The FT and Reuters overnight reported on a leaked legal opinion from the European Council legal service which looks at the new rules on proprietary trading and the structural reform of the European banking sector published in January.

As a reminder, these proposals are the offspring of the Liikanen report and we covered them in detail here.

The wider political importance of these reforms relates once again to how much control the UK can retain over how to structure, regulate and, by extension, supervise its own banking sector (which, lets not forget, it continues to backstop alone) in light of further eurozone integration, which it cannot be part of. And whether the EU can be flexible enough to accommodate this.


The legal opinion, which Open Europe has seen, is a blow to the UK because it focuses on the specific article of the legislation which allows the UK and other member states which already have reforms aimed at overhauling or ring fencing their banking sector in place (such as the Vickers reforms).  The opinion notes that:

“The derogation mechanism established in Article 21 of the proposed Regulation is not compatible with the legal basis of the proposal, with the nature of the proposed instrument as defined in the TFEU and with the general institutional principles established in the Treaties.”

There are a number of justifications for this judgement given (these are the arguments of the council legal service not OE):

• Firstly, any derogation under the single market article (Art 114) should be “temporary” according to the treaty. Since the derogation seems to be permanent it falls foul of the treaty here.
• Secondly, allowing for exemptions here breaks Article 288 of the EU treaties because it stops the “general application” of a regulation across all member states. It also falls foul of the “uniform application” of regulations across member states.
• Thirdly, the legal service does not buy into the justification for the derogation, suggesting that the costs of changing legislation to meet EU rules would not be prohibitively high. This sets it apart from previous instances where objective justification has been given. Furthermore, the use of the derogation is reliant on member states making an application and does not rely solely on the Commission.
• Fourthly, the derogation only applies to countries where similar legislation has been passed before 29/01/14 – the opinion stresses that no justification is given for such a date and calls for more explanation. This cut-off date also means the exemption applies differently to certain countries which happen to already have passed their own legislation. On top of this, it only applies to certain credit institutions.
• Finally, since the exemption essentially allows national law to take precedence, it questions the primacy of EU law.

The legal services suggest a number of remedies including: allowing the derogation for a specific temporary time period, clearer justification for the cut-off date, adopting the legislation as a directive rather than regulation (allowing for greater national flexibility) or dumping the derogation altogether.

As we noted previously, the target adoption date for these rules is January 2016 and there are plenty of negotiations still to come, as such this opinion, while a blow to the UK, is the not the end of the discussion by any stretch. As the remedies suggest, there are options open to the UK and others for adjusting these rules.

Furthermore, there are plenty of other controversies in the rules, such as how to properly define proprietary trading and how all the technical standards are defined. This one will run for some time still.

What’s wrong with Finland? Part 2

Since our last post on this issue things seem to have only got worse for Finland.

The European Commission’s latest economic forecast (see table below, click to enlarge) made pretty dire reading with Finland expected to be one of the worst performers in terms of economic growth over the next two years.

Furthermore, it seems that the credit rating agency S&P has finally caught up with our analysis of Finland, putting its AAA rating on negative outlook, suggesting that it may lose it in the next couple of years. Similar to our concerns about the rebalancing of the Finnish economy, the demographic problems and a stubborn lack of competitiveness, S&P noted:

“Finland’s persistent subpar growth rate reflects deep structural demographic and economic imbalances that hamper the government’s efforts to achieve fiscal consolidation. We consider that there are downside risks to growth and policy implementation.”

“We believe that the economy remains vulnerable to any slowdown of economic activity in the euro area or among other major trading partners, such as Russia.”

As the second part of the quote suggests, the situation in Ukraine and the potential sanctions on Russia are also likely to worsen the outlook for Finland.

The graphs above (data from Bank of Finland) highlight that Russia accounts for a decent chunk of Finnish trade and given the dwindling sources of growth any hit to this could certainly hamper the rebalancing of the economy and the reform/recovery process.

Furthermore, as we have flagged up before, Finland is one of the many countries heavily reliant on Russia for gas and energy more generally. With Putin’s threat to cut off gas to Ukraine the situation has potentially escalated another step, at least in economic terms, Finland is one (of the many countries, including Russia) which is on the front line.

Once again, all this is not to say that Finland is an economic basket case, far from it, but that even the healthy economies in Europe are undergoing some serious overhauls and reforms, further complicating the crisis response and, now, dealing with issues such as the Ukraine-Russia crisis.

What’s wrong with Finland?

That seems a strange question to ask. The country is a paid-up member of the eurozone core and is one of the few countries in the world to have a triple A credit rating from all three top agencies (S&P, Moody's & Fitch) and a stable outlook from all.

However, as the chart to the left shows (taken from the most recent Finnish Central Bank Macroeconomic bulletin) and today’s GDP data confirm (the Finnish economy contracted by 0.8% in Q4 2013) suggests all might not be well.

GDP growth has stagnated and is now teetering on the edge of slipping into its third recession in six years. But what has been causing this? The chart below on the right provides some insight.

The first point to note is the collapse in the electrical and electronics industry. This has been largely down to the struggles of Nokia. Formerly a dominant player in the telecoms market the firm has failed to adapt to the changing nature of the market, in particular the smart phone phenomenon, and has seen its market share, profits and share value eroded. The sector has also suffered knock on effects of the reduced global demand in the wake of the financial crisis, the threat of low cost emerging markets and the struggling domestic demand due to falling confidence.

Similarly the large metals industry has also been hit by the global downturn and has struggled with price competitiveness. In particular the ship building industry would have been doubly hit by the struggles in global trade and is yet to truly recover.

It was previously said that Finland lived off its forests. This is no longer true, or at least it is no longer able to fully. The forest industry and the related wood, textiles and paper industry have struggled with changing technologies. Demand for paper and related products has fallen substantially as digital replacements grow and environmental concerns take hold. Again cheap emerging market products may also threaten in this area.

The combination of all this has been falling employment and an accompanied fall in domestic demand, keeping downward pressure on the economy. At the same time Finland is also beginning to run into the same demographic problem facing much of the developed world – the decline of the working age population and the increase in the number of dependants.

It’s clear that Finland remains a very strong and healthy economy. However, it is clearly undergoing some serious structural changes and may continue to post low growth figures for some time to come. Fortunately, public debt remains low at around 59% of GDP, while the deficit continues to be under control at 2.4% of GDP, and unemployment remains at just 8.1% despite recent increases. This should give the country plenty of space to conduct the structural changes needed.

That said, the case of Finland provides further evidence (as we have pointed out for Germany) that the peripheral eurozone countries aren’t the only ones undergoing significant changes.

The long lost Liikanen report returns – but it looks pretty different

Has the Liikanen report become the Barnier plan?

Update 30/01/14 11:45:

Some eagle eyed HM Treasury officials have flagged up that the recitals of the proposal (the preamble points before the articles of the regulation) do allow for the derogation to apply to secondary legislation as long as the key primary legislation has been passed. As we note below, this is the case with Vickers and the UK therefore certainly counts for the derogation. It is a bit strange that this isn't also spelt out in the article of the proposal but its inclusion is likely to be more that sufficient for the UK.

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Okay, maybe long lost is an exaggeration, but it’s certainly been off the front line agenda for some time.

The time away from the spotlight has been used to significantly overhaul the European Commission’s flagship proposal on reforming the banking sector in the aftermath of the crisis.

Here’s the full proposal, out this morning, while here are the press release and Q&A.

While the proposal was always expected to be the offspring of the Liikanen report, in this case the apple has fallen quite far from the tree. The proposal is quite a change from the original report and as expected focuses more on a Volcker-style rule on proprietary trading rather than a significant separation of large banks. That said, the focus remains on separating off risky trading activities, meaning the main impact is a lessening of scope. We outline our thoughts below.

A reform overtaken by events?
While this was originally flagged as a key proposal, it has been a long time coming. In the meantime, a new single supervisor has been created, new plans on capital requirements, a new macro prudential framework, new plans on bank bail-ins and a new bank resolution scheme have all been substantially developed. The new framework for the financial sector has largely grown up without this proposal, and how exactly it will fit in – both in terms of timeline and structure – remains unclear.

An EU Volcker rule – the Barnier rule?
The key part of the new proposal is a ban on “proprietary trading in financial instruments and commodities, i.e. trading on own account for the sole purpose of making profit for the bank.” While this is well intentioned, it does come with some complications:

• It has proved very difficult to identify what exactly classifies as proprietary trading, compared to necessary trading to manage risk and to act as a market-maker.
• The current definition in the proposal is fairly narrow, and refers to activities specifically dedicated to making a profit for the bank itself. In other words, it looks as if it could be fairly easily side-stepped. It also exempts trading of government bonds and money market instruments for cash management.

Separation power – moving away from national control?
As we have noted before, the prospect of a supranational body ordering the break-up of a flagship national bank has the potential to be incredibly explosive. The banking union has brought this closer, but final decision on how to resolve a bank remains mostly national. This proposal would allow such a decision to be taken not just to resolve a bank, but also if its non-retail activity was impacting financial stability. However, it seems that the final say will now rest with the ‘competent authority’ (a definition which is never spelled out), which in the case of large eurozone banks would likely be the ECB as the SSM (Single Supervisory Mechanism).

Has the UK secured a derogation?
As expected, a clause has been included on a general derogation (not specific and only applying to the separation rule not the prop trading ban) which allows for the rules on separation to be superseded by any national rules which aim to achieve the same goals. While Vickers would certainly qualify on this front, the text specifies that the derogation can only apply to legislation adopted before 29/01/2014. Currently, all legislation relating to Vickers is not expected to be adopted in the UK until mid-2015. However, the key banking reform act (which includes the ring-fencing plans) was made into law in December.

For the most part then, it seems the UK has secured a derogation, which can be put down as a small but important win for the government. Plenty of other states have also secured scope for their national plans.There is clear encouragement in the wording for states who are yet to put a comprehensive system in place, to adopt the EU framework. That said, with lots of different national plans in place, one has to question how effective this system will really be.

A long way to go
As the points above suggest, this remains a controversial proposal and negotiations will be tricky. Little should happen this year, due to the European Parliament elections and the new Commission entering office. Assuming the next Commission picks up the same proposal (which is not guaranteed) the aim is to have the necessary legislative acts approved by January 2016, with the prop trading ban coming into force at the start of 2017 and the separation powers in mid-2018. As with some of the other regulations, it seems the EU response to the financial crisis will only be in place a decade after the crisis hit.

These are just some of the key points of contention upon first reading. There is much more to go in this process with the input of member states and the European Parliament likely to be very different, and sometimes even adversarial. There is also a lot of scope for the rules to be altered using delegated acts and technical standards – these will ultimately determine how the prop trading ban and separation rule work in practice.

So far, a large part of the banking sector (mostly smaller banks) will probably be happy. Larger banks will see it as an improvement, but will likely push for a further watering down. Questions can still be raised over whether costs will be passed onto consumers and whether it will really help limit risky activity, which can often be related to mundane retail bank activity. But then the idea is that other parts of the framework will also help limit this effects.  

In any case, the proposal is likely to once again fall away from the frontline and it could yet come back with a different face once again.

Eurozone reform contracts take shape - and they include "fiscal transfers"

As we have predicted numerous times - as recently as in our previous blog post - ‘reform contracts’ in the eurozone could well become the next thing. As a recap, these are agreements where one country commits to a series of structural reforms in exchange for low cost loans, or other form of help, to aid its economy. As we argued back in September - when it was unclear whether the idea would make a comeback - it's one of the  politically more feasible options for Germany as it involves more control and less cash.

@michaelsteen Tricky one. Merkel seems to float reform contracts in this recent interview: http://t.co/rToOm65l9a @SpiegelPeter
— Mats Persson (@matsJpersson) September 16, 2013

@michaelsteen @SpiegelPeter In theory more politically feasible for Berlin than other options, as it involves more control and less cash
— Mats Persson (@matsJpersson) September 16, 2013

Well, Reuters have now got their hands on the latest draft of the plans for these contracts and have published them in full here. The idea now seems to be firmly on the agenda, which is not the same to say it'll actually happen.

Below are the key points of the plans:

• The contracts are seen as a supplementary part of the ‘European Semester’ – the new system of economic governance. They will build on tools such as the macroeconomic surveillance and budgetary oversight, which we have already covered in detail. The contracts are targeted at those countries not making adjustments under the other procedures.

• They are designed to promote “ownership” of reform and “home grown” policies (which lines up with Merkel's comments from yesterday). There is, of course, a tension here, given that by definition they are part of a system of increasing economic oversight and some would say a loss of control of economic policy. As Eurogroup Chief Jeroen Dijsselbloem suggested yesterday, if these countries aren’t pushing these reforms, slightly cheaper loans are unlikely to be the deciding factors in pushing them to do so.

• Further to the above point, the text does stress that the policies will be drawn up by the domestic authorities and will be renegotiable (unlike the bailouts or other parts of the governance system which are more set in stone).That said, they will come with significant “monitoring” – which, to us, evokes the feeling of the EU/IMF/ECB Troika trips to bailout countries.

• The loans will involve “limited fiscal transfers across countries”, the large majority of which would come through the lower interest rate on loans compared to the borrowing countries usual market rate. The open admittance of fiscal transfers has slipped into the draft, this sort of open admission is rare in the eurozone crisis, but given that the contracts are an explicit trade off, it is not entirely surprising (again, as we've argued).

• “The specific amount of financing would not be linked to the direct cost of reforms”. Instead it will be used more generally as an incentive to reform and aid any parts of the economy that need it or to help relieve funding pressure generally. This makes some sense since simply ‘paying’ for reforms seems rather circular and dictatorial. However, making sure the level of reform demanded matches up to the loan size will be very tricky.

So this is something that could fly with the Germans, politically, but how much difference will that make in practice? There are already numerous platforms for reform – bailout programmes, precautionary credit lines, macroeconomic surveillance and budgetary oversight (as well as good old political pressure).

In the end it all comes down to the money. How much will be available and at what price? These questions are yet to be answered, but as with much in the crisis, the likelihood of a muddy compromise looms large.

A hint as to what a eurozone grand bargain could look like?

German coalition talks are dragging on, but we may have got a hint as to what a grand bargain between the eurozone north and south might look like, with German Chancellor Angela Merkel again appearing to open up for an EU Treaty change.

She told a Süddeutsche Zeitung leadership conference,

"Germany is ready to develop the treaties still further. At the very least we have to be ready to improve the euro protocol of the Lisbon Treaty – which only applies to euro states – to allow an institutional co-operation via the so-called community method and not to only be active at intergovernmental level."

She proposed a "new co-operation" between the European Commission and member states, with the policy recommendations being the result of negotiations.

She added,

"In this way we create a sense of ownership, a sense of responsibility is created among member states to implement necessary change. That's what I understand by economic co-ordination."

As we've argued before, it's easy to get sustained whiplash injuries from tracking the German position on EU treaty change, but this (again) sounds like 'reform contracts' or 'competitiveness pacts' to us - which we have long argued would come back on the agenda - with the European Commission acting as the 'structural reform police'.

Meanwhile, in an interview with Les Echos and other European papers, Eurogroup Chairman Jeroen Dijsselbloem also had some interesting things to say: 

"If a country is not persuaded that it’s in its own interest to reform and modernise, it cannot be motivated from outside. It doesn’t seem wise to me to propose a ‘reward’ in return for a reform. Instead, I think one should link the concession of additional time to correct budget deficits to stricter conditions in terms of reform. I give you more time if you speed [reforms] up. The European Commission may, if a country fails to do so, demand more on budget [adjustment]."

A lot to play for...