Updated: Commission silent as foundation for increased EU budget contributions remains unclear

Update 24/10/14 17.05:
Outgoing Commission President Jose Manuel Barroso has just given his press conference which frankly did not clear much up. Barroso insisted, as the Dutch position below does, that this payment demand is part of an annual adjustment which is based off of the revised figures for annual GNI (which are produced by national statistics agencies and then verified by eurostat).

Essentially, he is suggesting that the final figures for the UK in 2013 proved to be so far ahead  of expectations that they altered the UK's share of the budget significantly.

This is not a completely implausible scenario but it leaves some glaring gaps. Firstly, its hard to imagine the economy outperformed so much and other EU economies underperfomed so significantly that the UK has to stump up another €2.1bn. Secondly, this doesn't fit with the leaked doc from the FT. As discussed below, the figures clearly seem to relate to a longer term assessment based off the ESA changes to the way GNI is calculated.

All that said, its becoming increasingly clear that the positions of the Commission, UK and others are not quite compatible so something will have to give in a negotiation.

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Currently, there is still no clear explanation for where the demand for increased contributions to the EU budget came from or exactly how it was calculated - see our comprehensive analysis here. While the Dutch and the Brits are both concerned about being asked to contribute more, they are actually putting slightly different versions of events forward. These two split the prevailing theories about how this has come about.

The first version of events, pushed by the Dutch, suggests that this is not as surprising has been made out since it is actually down to the regular assessment of the four cycle of VAT receipts and tax returns related to GDP of countries. When asked by Dutch BNR radio ‘Does this revision have anything to do with the new accounting method?’, Dutch Finance Minister Jeroen Dijsselbloem responded,

“No, this seems to come from a [annual] source revision which is something different from the statistical method that is used to calculate [the GDP].” 

The point that surprised the Dutch was that the demand came out at almost double what they had forecast and there is no clear explanation of why this is.

The other version of events ties into the document leaked by the FT. Judging by this document it is hard not to see this cost as a result of a calculation based off the introduction of the new European System of Accounts 2010. The UK is suggesting it was unaware of such a significant overhaul to the EU budget calculations and has not been included in the discussion around the changes. The document clearly looks to alter the budget contributions over the period between the introduction of the previous system of accounts and the end of 2013. The total figures also line up with the reports and are yet to be rejected or even disputed by anyone. The fact the figures are so large also fits more with this version of events than the regular adjustment - in this sense something will have to give (size of demand primarily) for the first version of events to be true.

What do they agree on?

• There is clear agreement that this has been handled poorly by the Commission, who is still yet to provide any clarity into the debate or explain exactly how much they are asking for and why.
• Furthermore, the demand for payment immediately also seems to be a miscalculation by the Commission which caught some unawares at least in terms of the size, if not the timing.

While this may seem trivial it is vitally important that the Commission makes clear and gets to the bottom of what is going on here. Ultimately, Cameron’s options will be very different depending on whether the demand is driven by a unique one off event (such as long terms GDP changes) or part of a regular assessment of the EU budget. In any case, whatever the source serious questions need to be asked about how a bill of €2.1bn can materialise with little or no political discussion.

Why is the UK being asked to pay in more to the EU budget and what can it do about it?

There are a number of headlines today around the EU’s request for a further €2.1bn from the UK in terms of its contribution to the EU’s budget.

Below we breakdown exactly how and why this has happened and what options the UK has now.

How has this happened?

• The European Commission has launched a review of EU budget shares (based of VAT receipts and Gross National Income [GNI]) going back to 1995.
• This is tied in with the introduction of the new European System of Accounts (ESA) 2010 which came into force in September. This is a new approach to assess the true value of a country’s economy (its GDP) by counting some activities which are often missed. Many of you will have read the countless headlines about how GDP will now try to quantify the value of prostitution and the drug trade. However, the new calculations also give more weight to research & development and other softer types of investment. The Commission has estimated that these adjustments will push most member states GDP up, albeit by varying degrees.
• Essentially, since 1995 the UK has performed better than expected and better than many of the other EU member states. As such its economy is larger than originally thought. Under the review this means that its share of the EU budget – which is calculated off the back of GDP and population as a share of overall EU GDP and population – has increased.
• The EU is also in the process of producing an amendment to the annual budget which we discussed here. At some point, very recently, the EU has decided to almost combine the two issues possibly causing a speed up in the payment date for this €2.1bn lump sum.

Why has everyone been caught off guard?

• While the annual amendments to the budget are expected and usual (though often unnecessary and far too high as we have pointed out numerous times) this adjustment on GDP terms is unprecedented and seems to be largely a one off – as such it has caught most people off guard.
• It also seems that the release has been kept under wraps for some time. While the amending budget has been known and discussed for some time, with the final details circulated to member states a week ago in preparation for the current EU summit, the details of this were only released to member states a day ago. Essentially it was somewhat sprung on them ahead of the summit.
• This is exacerbated by the fact that this is clearly an extensive long term process and that the ESA 2010 adjustment has been running for years. To say the release and interaction with member states on this issue has been poorly handled would be a massive understatement.

What are the UK’s options now?

• First, it’s clear the UK is not alone in its outrage. The Netherlands has been asked to pay in a further €640m, while Italy has been asked for €340m. Dutch Prime Minister Mark Rutte has called this “an unpleasant surprise which raises a lot of questions”, adding, “when I say go to the bottom of this, it means to look at all aspects, including legal ones. It is still too early to run ahead on this.”
• The first option is to get an agreement to deduct any payments from future budget contributions. This would avoid having to pay in a lump sum now and also mean that it on net the UK does not pay any extra.
• The second option would be to secure a political or legal agree to ignore these uprated GDP shares and stick with the originals. This should be doable through a vote in the European Council. That said, because some members are getting a rebate – France and Germany in particular – this could prove a very tricky agreement to strike.
• As Rutte has already pointed out, countries may have legal recourse. Exactly what form this could take is unknown but the retroactive nature of the cost and its lack of discussion and warning could provide some grounds.
• Lastly, the UK (and the Netherlands) could simply refuse to pay. As large net contributors to the EU budget, there is little that others can do to force them to pay. Obviously the EU could launch its own legal action in terms of infraction proceedings; however, the maximum fine for the UK is around €225m on an annual basis – much less than it is being asked to stump up here. This could also be combined with the point above, with the UK refusing to pay until the legal proceedings have run their course. ***see update below***

Open Europe’s take
While this does not necessarily seem to be a political stitch up from the EU there is no doubt that it is unreasonable and politically irresponsible. Retroactively taxing someone over 20 years is fundamentally unfair. The fact that the UK and Netherlands are being punished for doing better than expected and better than others almost encapsulates everything that is wrong with the EU’s approach – particularly when the Eurozone economy is struggling to find any growth.

Once again the EU has failed to learn any lessons from the previous budget negotiations and has helped to feed those who want to leave the EU, possibly ultimately shooting itself in the foot. Still, what's interesting is that in a debate marred by splits, the UK political class is almost entirely united in its outrage against this move. It is ironic that in the week when one poll found British support for EU membership at its highest since 1991, the Commission has managed to unite everyone from Lib Dem MEPs to UKIP in outrage. If Cameron manages to resist the demand somehow, he would be able to score a massive victory.

Update 24/10/14 12:05:
One point to add regarding the refusing to pay option and the potential fines. On top of the potential fine from infraction proceedings mentioned above, the amount of €2.1bn will be charged 2.5% interest (standard 2% above the Bank of England base rate currently 0.5%), which increases by 0.25% for every additional month which the outstanding amount is not paid off. Such interest could clearly mount up very quickly and become very expensive. If the UK is eventually forced to accept £2.1bn figure, then it could clearly turn out to be very costly. Ultimately, though, if the UK is prepared to play hard ball, it would lead to a stand-off that will would need to be resolved by a political negotiation. Such disputes rarely reach such escalated levels and resolutions are normally found before costs mount up. 

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.

ECB stands firm but looks to wider measures

Over on his new Forbes blog, Open Europe’s Head of Economic Research Raoul Ruparel lays out his take on why the ECB decided to stand firm despite the apparent deflation threat,

“My feeling is that there are two broad reasons. The first being that the flow of data is mostly positive, and the second, more important factor, being that none of its tools are economically, politically or legally suited to tackling the low inflation environment in the eurozone.”

He concludes,

“All in all then, the tools at the ECB’s disposal are far from suited to helping push up inflation in the struggling countries and boosting lending to the real economy to help economic growth. This is not to say the ECB would never use them, but that are better suited to a deeper more acute crisis (such as a break-up threat) than the chronic long term malaise which the eurozone currently finds itself in.”

These are themes we’ve explored plenty of times on this blog so won’t rehash here.

But there were a couple of other interesting points to come out of ECB President Mario Draghi’s press conference though.

The first being his mention of a new dataset which the ECB is looking at, specifically the “the high degree of unutilised capacity” in the eurozone economy. This refers to the ‘output gap’, i.e. the amount by which GDP in the eurozone has fallen below potential GDP. As you might imagine, estimating such a gap is fraught with difficulty and estimates are notoriously revised retrospectively (for example before the crisis few economies were seen performing above potential despite huge financial, real estate and debt bubbles).

Why is this important? Well, it could be the first step towards a more firm GDP target on the part of the ECB. Admittedly, it’s a small step and a full GDP target is unlikely but it could be an interesting shift for the ECB which has traditionally focused more on inflation, money market and private sector survey data (such as the PMIs). As Draghi himself said, it also shows that monetary policy will stay looser for longer, even if the data improves, due to the large gap between actual and potential GDP. It will be interesting to watch how this one develops over the next few meetings and whether the ECB decides to put any more emphasis on this measure.

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.

Where will Cypriot growth come from?

This is now emerging as the key question for Cyprus following the severe mishandling of its bailout. The financial services sector, along with real estate and related businesses, which accounted for around 30% of Gross Value Added in the economy is now essentially gone as a source of growth.

Cyprus’ main trading partners, Greece in particular, remain mired in recession. Its two largest banks – key employers – will be restructured and unemployment will undoubtedly rise. Meanwhile, the government will be cutting spending and raising taxes, laying off public sector workers and embarking on some strict labour and product market reforms – as part of the standard Troika bailout package. Many of these reforms are needed but as we have seen across Europe, when combined with other impacts mentioned above, a downward spiral can be created.

The key hope for growth remains tourism. However, with the euro remaining strong and the prospect for political and social unrest in Cyprus still high, it is difficult to see a huge boost in this area. It will continue to truck along but is unlikely to fill the gap left by other areas of the economy shrinking. As we have discussed before, the prospect of growth from large gas revenues remains a pipe dream for now.

With all of this in mind we have put together a comparison of some of the previous growth estimates, along with the implicit ones included in the latest troika report and some of OE’s initial (optimistic) projections (click to enlarge).

All of this remains uncertain, depending on when capital controls are removed and how investors respond but it does not make pretty reading. All previous hopes for the economy are off the table and expectations need to be severely adjusted. The Troika's estimates are very optimistic, particularly in terms of returning to rapid growth in 2015 and 2016. Furthermore, if the growth estimates included in the bailout prove to be overly optimistic it means Cyprus will, just as Greece did, require further financial assistance.