Showdown between France and Commission set to test EU’s budget rules

It has been widely reported over the weekend that the European Commission (EC) is seriously considering rejecting France’s new budget proposal which will see it run a deficit of 4.3% next year rather than the EC target of 3%.

As the graph above shows, France has strayed significantly from the path originally agreed with the EC, even after it requested and was granted additional time to meet its deficit targets just last year.

Importantly, this is the first time a country has flagrantly flouted the budget rules. Other countries have missed their targets or asked for extensions, but with the presumption of good faith and serious efforts being made to meet said targets. However, with its latest budget France has rejected the previously agreed cuts (worth 0.8% of GDP) and offered just 0.2% of GDP in savings. In other words it has flat out chosen to ignore the rules.

This may seem like semantics but it puts the EC and the EU more broadly in a tough position. With much of peripheral Europe failing to meet the fiscal rules agreed under the Stability and Growth Pact (SGP), the Fiscal compact and the European Semester, many have already been questioning the effectiveness of these tools. Ultimately, the EC risks replaying one of the key features of the previous crisis – letting a big country break the SGP and then being unable to effectively enforce it for other countries, helping to facilitate the large build-up of sovereign debt.

This is therefore a key test of the viability of the new rules and whether this time will really be any different. Combined with the renewed bank stress tests and bail-in rules, the coming months are an important testing ground for the new financial architecture which the Eurozone has put in place.

Sadly, as Reuters highlights, another fudge looks to be on the cards. While the EC will probably reprimand France to the fullest extent before getting to outright fines, it will also work up a new looser programme which gives it more time. This helps all sides save face and avoids the risk of further weakening French President Francois Hollande to the benefit of the Front Nationale (something which the EU wants to avoid).

As for what happens now, the EC will provide a verdict on the budget by the end of the month in what will be one of the last acts of the Barroso Commission. This is of course all complicated by the hand-over of the EC and the wrangling over who will actually be in charge of enforcing the budget agreements. When all is said and done another muddle through is likely, but with the Eurozone facing economic stagnation investors may be less than convinced by such moves.

Is Merkel gearing up for a scrap over EU Treaty change?

The big EU related story of the day (our bumper report on EU regulations notwithstanding) is Der Spiegel's splash that German Chancellor Angela Merkel set out her proposals for giving the EU greater powers over eurozone members’ national budgets to EU Council President Herman Van Rompuy last week, a move which would require EU Treaty change. Merkel will reportedly insist on legally enforceable contracts between the Commission and individual member states, setting out their obligations for maintaining budgetary discipline and improved competitiveness. In return, Germany could agree to a eurozone budget which would amount to tens of billions. Finally, the President of the Eurogroup would become a “Euro Finance Minister” of sorts.

In one form or another, these ideas have been around for a while but many politicians and commentators asserted that the German government had no interest in opening up the EU treaties. However, as we noted in our pre-election briefing:

"German politicians and the general public are both keen on stronger central eurozone control over taxation and spending as a prerequisite for any further financial aid... Such beefed-up supervision and enforcement could well require EU treaty change in some form. A Merkel-led government may well push for a formalised 'competitiveness pact' after the elections."

This is only one Spiegel report, but it could well be that Merkel is looking to make a concerted push after all. She will have significant opposition to overcome in the form of the SPD, who will almost certainly be her coalition partners by December. The party remains opposed to any treaty change that could trigger referenda in individual member states (although the debt-redemption fund proposed by the German Council of Economic Experts, a policy broadly backed by the SPD, could have the same effect). Likewise other member states (chiefly France) and the EU institutions are far from keen on Treaty change. However, if Merkel has set her sights on something, we would not bet against her, not least because this move would be very popular back home.

This could be the opening that David Cameron has been looking for to force through EU reforms but at the very least will present another stage for a clearer definition on the separation between eurozone and non-euro countries and the necessary safeguards. That said, he too will have to contend with the SPD who have made it clear today that they oppose the return of powers to member states, as party of a new treaty deal specifically designed to fix the Eurozone.

'Budget Deadline Day' in Europe

As you may have noticed, yesterday saw numerous governments across Europe unveiling their latest budgets for the coming year. Rather than just being a coincidence, this is down to the fact that yesterday was the deadline for eurozone governments to submit their budget plans to the European Commission – 'Budget Deadline Day', if you will.

As part of the ‘Six-pack’ set of rules, eurozone governments must have their budgets endorsed by the Commission, although the ability to actually force changes to the budget plans is limited for those countries which are not missing their targets already (except for significant peer pressure).

As with football’s transfer deadline day, there were some frantic negotiations, albeit without the minute to minute media coverage. Below, we take a look at the budgets of the Italian, Irish and Portuguese governments.

Italy
Italy yesterday unveiled its new ‘Stability Law’ – the budget guidelines for 2014-16. There’s some encouraging stuff in there, notably a package of tax cuts for businesses and workers worth €10.6bn over three years (of which €2.5bn to be cut in 2014). Nothing massive, but it's a start. The money to cover for these cuts is due to come from a number of public spending cuts. However, the draft budget will now have to be adopted by the Italian parliament, and some of the measures may change.

Prime Minister Enrico Letta has confirmed Italy aims to bring its deficit down to 2.5% of GDP by the end of next year. That said, the problem for Italy remains its weak growth – which in turn threatens its fiscal targets. Last week, for instance, the Italian government had to adopt a set of urgent measures to find a further €1.6bn and make sure the deficit stays below 3% of GDP this year. Unlike other countries, the budget may hold less importance for Italy’s economic future with the focus now on much needed political reform and improvement in the business environment.

Ireland
Debate over the Irish budget has been going on for some time, and the government managed to secure a lower level of headline cuts than expected ahead of time - €2.5bn compared to €3.1bn. However, the budget remains controversial with the Irish Independent running the front page headline, "Unkindest cuts", because they fall on pensions, healthcare and unemployment benefits for young people.

For the most part, although this budget was about tinkering around the edges rather than making the huge cuts we have seen before, the government focused on adjusting lesser known taxes to reap numerous small savings. Interestingly, the government also committed to reducing tax evasion and tackling the view of the country as a ‘corporate tax haven’. It will be key to see if this impacts the number of multinationals locating in Ireland and if it has any knock-on impact on economic growth.

Portugal
Of the three, this is probably the most concerning budget. Following a difficult summer for Portugal, politically at least, the government has once again been forced to find a further €3.2bn in cuts. However, the government has once again taken the same approach by heaping the cuts of public sector workers pay (up to 12% in parts) and on pensions. Action on these areas is needed. However, it has also been repeatedly struck down by the Constitutional Court. This might be setting the scene for another showdown.

This has evoked concerns from within the Commission, and it will be interesting to see whether a full endorsement is forthcoming. Portugal also confirmed it will miss this year’s deficit target and the continuing push to ease next year’s target suggests little confidence that it will meet that one either. The good news is that Portugal’s borrowing costs remain well below their peak, and some market access once it exits its bailout next year seems likely. That said, unless it can get a hold of the public sector reform needed, some additional aid still looks likely.

Overall then, a bit of a mixed bag. Few marquee measures, but some positive moves in terms of focusing cuts on spending rather than tax hikes.

Testing the EU's budget discipline

The Netherlands, considered one of the eurozone's fiscal hawks, has become the latest country to test the EU's new instruments for imposing budget discipline (now composed of the Fiscal Compact, Six-pack, Two-pack and European Semester).

The Dutch government yesterday agreed to postpone €4.3 billion in budget cuts for 2014 in a deal with social partners (trade unions, employers groups etc.), counting on economic growth to keep the budget deficit below the EU-mandated ceiling next year. In the autumn, it will reconsider whether to implement the cuts.

The measures for 2014, now postponed, had been promised to EU Economic and Monetary Affairs Commissioner Olli Rehn only last month in return for leniency regarding the Dutch government's 3.3% budget deficit in 2013, which is in breach of EU targets. The country has been in the EU's "excessive deficit procedure" since 2009, and in 2012 the government collapsed over the failure to stick within EU budget limits.

Predictions for the 2014 budget deficit range from 3.4% (The Dutch Bureau for Economic Policy Analysis CPB) to 3.6% (Commission). If the economic growth the Dutch government is hoping for doesn't materialise, the 2014 deficit threatens to be even bigger. The European Commission will reportedly only respond when it gets to see the full package of measures.

Earlier this week, Finance Minister Jeroen Dijsselbloem vowed to respect the EU's 3% budget deficit rule in 2014, so this is being billed by some in the Dutch press as a U-turn by Prime Minister Mark Rutte. Today's headline of the largest Dutch daily, De Telegraaf, reads: "Rutte backs down" (picture) while the newspaper also complains that "important labour market reforms have been watered down and postponed to 2016."

The Dutch economy is currently going through a large-scale correction after a housing boom went bust, partly as a result of the Dutch government's reduction of generous fiscal incentives to buy a house. Last year, Moody's expressed doubts about whether the Netherlands could keep its triple-A rating.

And, in the background, is Geert Wilders' anti-EU PVV party, which is again polling as the country's most popular political party. 

Initial thoughts on Spain's latest austerity budget

We’re still waiting for the full breakdown and figures behind the Spanish budget (which we will analyse and post in due course) but in the meantime here are our initial thoughts:

• The decision to tap the pension/social security reserve fund for €3bn was surprising. Generally this is a fairly last resort approach, but why Spain felt the need to do this to get its hands on only €3bn isn’t clear, especially with short term borrowing costs still low. Could Spain’s liquidity problems be greater than thought?
•  The interest Spain will have to pay on its debt will go up by €9.7bn, compared to a total package of cuts of €40bn (undoing almost a quarter of them). For a country the size of Spain even seemingly substantial cuts can easily be offset by the massive debt burden.
• The majority of the savings (58%) will come from spending cuts rather than tax increases – there is an on-going debate over which is more effective but in the short term spending cuts are likely to harm economic growth (especially given the reliance on the state as an economic driver in Spain).
• Tax revenue is expected to go up by 3.8% - given that growth is likely to falter this seems incredibly optimistic, even with some tax increases.
• The basic macroeconomic forecasts for the budget haven’t changed – this suggests that the overly optimistic growth forecasts are likely still in place, despite most investors and international agencies reducing their forecasts.
• Unemployment is predicted to have topped out this year – again this seems hopelessly optimistic given that structural labour market reforms are yet to take full effect (and there are still more to come) while internal devaluation will need to continue at a rapid pace (see our recent briefing here for more info on this).

So, plenty of issues already, with what seems to be a fairly unconvincing budget given the state of the Spanish economy. 

One final point to note is that Spanish Economy Minister Luis De Guindos kept insisting that the measures were all in line with recommendations from the EU/IMF/ECB troika or in some cases even went further. This looks to be leading into a Spanish reform programme as part of a bailout/bond buying scheme, hinting that Spain may be preparing that request after all.

ECB's own budgetary discipline not inspiring confidence

With budgetary discipline the only game in town in the eurozone, it must have been a bit of an awkward moment at the ECB when they realised that the bank's new Frankfurt headquarters (pictured), currently under construction and due to be completed in 2014, will come in significantly over budget.

Executive board member Jörg Asmussen let the cat out of the bag in his welcome address at today's 'topping-out' ceremony, revealing in his welcome address that:

We are monitoring the construction progress, costs and price developments very closely, adjusting and adapting where necessary. As a public institution, we are committed to using our resources responsibly. This is essential. So far the ECB has spent approximately €530 million in construction and other costs, including the purchase of the site. In 2005 the overall investment cost was estimated at €850 million at 2005 constant prices. It is anticipated that increases in the price of construction materials and construction activities from 2005 until the completion of the project in 2014 will lead to a €200 million increase in the overall investment cost. 

In addition, there have been a number of unforeseen challenges that needed to be dealt with. The two major challenges unforeseen in 2005 were, first, that the original tender for a general contractor did not yield a satisfactory result and the ECB had to change to a different contractor model, and second, that the Grossmarkthalle – a large industrial heritage building from 1928 – presented a number of challenges that were not detected in the initial examination conducted prior to the acquisition:

• the foundations turned out to be insufficient and required additional support; 

• the roof coverage was found to be contaminated and therefore could not be disposed of as envisaged; 

• and parts of the concrete construction had insufficient steel support.

These factors are likely to account for additional costs of about €100-150 million, or a 10-14% increase in the overall investment cost. The resulting delay in the construction works on the Grossmarkthalle, as well as the entrance building, has been incorporated into the existing time schedule.

So overall the total cost is likely to come in at around €1.2bn, a tidy sum of money, even at a time of multi-billion euro bailout funds. We estimate that the cost of the new building amounts to around half of the outstanding cuts the Greek coalition still has to make in its latest austerity package.

DPA notes that the new building will hold 2,300 personnel, seemingly large enough for a central bank. Although when you consider that the ECB is currently looking to take over the supervision of 6000 financial institutions - a job which national supervisors currently employ tens of thousands of people to do - one does wonder whether another new building could be needed in the near future. 

We can't say the ECB is setting a great example for austerity, especially given that is now a precondition for accessing its new bond-buying programme.