The European Union and the Challenges of the New Global Context [1 ed.] 9781443882019, 9781443878357

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The European Union and the Challenges of the New Global Context

The European Union and the Challenges of the New Global Context Edited by

Ileana Tache

The European Union and the Challenges of the New Global Context Edited by Ileana Tache This book first published 2015 Cambridge Scholars Publishing Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Copyright © 2015 by Ileana Tache and contributors All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-4438-7835-9 ISBN (13): 978-1-4438-7835-7

TABLE OF CONTENTS

List of Tables ............................................................................................. vii List of Figures........................................................................................... viii List of Boxes ............................................................................................... x Foreword .................................................................................................... xi Chapter One ................................................................................................. 1 Challenges of EU’s Foreign and Security Policy in a Rapidly Changing World Ileana Tache Chapter Two .............................................................................................. 26 EU Development-Aid Policy and the Rise of Competitive Emerging Donors Ileana Tache Chapter Three ............................................................................................ 52 EU Sanctions in the Post-Soviet Space Dirk Lehmkuhl and Mariia Shagina Chapter Four .............................................................................................. 86 Importance of Preferential Trade Agreements (PTA’s) for the EU and its Partners: The Case of the DCFTA with Georgia Elzbieta Kawecka-Wyrzykowska Chapter Five ............................................................................................ 109 Reconfiguration of External Relations of the European Union Nicolae Marinescu

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Chapter Six .............................................................................................. 133 The Monetary Policy of the European Central Bank during the International Crisis Vicente Esteve and Maria A. Prats Chapter Seven.......................................................................................... 177 Capital Flows and Boom-Bust Cycle in Emerging Europe: Responses to the Volatile Financial Global Context Jean-Pierre Allegret and Audrey Sallenave Chapter Eight ........................................................................................... 208 Macroeconomic Linkages in the European Union Oscar Bajo-Rubio and Carmen Diaz-Roldan List of Abbreviations and Acronyms ....................................................... 234 Bibliography ............................................................................................ 238 List of Contributors ................................................................................. 261 Index ........................................................................................................ 262

LIST OF TABLES

Table 2-1: EU member states Institutions and Agencies for development Table 2-2: Ranking of the EU member states and EU donor institutions in 2013 ATI Table 2-3: The ACP countries Table 2-4: Number of EIB operations by region in 2013 Table 2-5: Top Official Development Assistance (ODA) donors in the world (in percentage) – Year 2012 Table 2-6: DAC members Table 2-7: Imports and Exports of the EC from AAS (1953–1975) Table 2-8: LDC share of EU imports (%) Table 3-1: EU – Belarus Table 3-2: EU – Moldova (Transnistria) Table 3-3: EU – Uzbekistan Table 3- 4: EU – Ukraine/Russia Table 4-1: Main agreements on free trade areas, and association, concluded and still negotiated by the EU (as of the middle of 2014) Table 5.1: Top merchandise traders in the world, $ bn (2013) Table 5.2: Bilateral trade of the EU with selected partners, $ bn (2013) Table 5.3: Shifting positions in world merchandise exports, $ bn Table 6-1: Phases of the international crisis Table 6-2: Countries and territories with exchange rate regimes linked to the Euro Table 6-3: The share of the Euro in the currency composition of foreign exchange reserves for selected countries Table 7-1: Foreign bank assets among total bank assets, in % Table 7-2: Output gap from 2004 to 2008 Table 7-3: Variance Decomposition of the Real Exchange Rate: Ratio of NEER Shocks to REER Variations 2004M1-2010M12, in % Table 7-4: Variance Decomposition of the Real Exchange Rate: The Ratio of price shocks to REER Variations 2004M1-2010M12 Table 8-1: A macroeconomic model of a monetary union Table 8-2: Effects of shocks on endogenous variables in the model of the monetary union

LIST OF FIGURES

Figure 6-1: Systemic Stress Composite Indicator, Index Figure 6-2: Central Banks interest rates Figure 6-3: Central Banks balance sheet Figure 6-4: Liquidity providing operations: MRO and LTRO Figure 6-5: Securities Market Programme Figure 6-6: Long term interest rate Figure 6-7: Main ECB rates and EONIA rate Figure 6-8: ECB balance sheet projection Figure 6-9: Euro money market Figure 6-10: Main ECB rates and EONIA rate (left) Spreads Figure 6-11: Central Bank’s loans to credit institutions Figure 6-12: Deposit facility and excess reserves Figure 6-13: TARGET 2 BALANCES Figure 6-14: Lending margins of MFI’S Figure 6-15: Exchange rate EUR/USD Figure 6-16: The Euros’ share as an invoicing/settlement currency in extra-Euro area transactions of Euro area countries Figure 6-17: Currency composition of global foreign exchange reserves Figure 6-18: Currency composition of global foreign exchange reserves Figure 7-1: Composition of external liabilities, stock, in % of GDP Figure 7-2: External positions of reporting banks vis-à-vis all sectors, March 2007 = 100 Figure 7-3: Capital flows and credit expansion Figure 7-4: Ratio of Foreign Liabilities to Money in several emerging countries*, in % Figure 7-5: Growth differentials between credit and GDP, percentage points Figure 7-6: Changes in deposit and credit to GDP, 2002-2007, in percentage points Figure 7-7: Inflation rates in fixed and floating exchange rate regimes Figure 7-8: Output gap from 2007 to 2013 in fixed and floating exchange rate regimes Figure 7-9: Indicators of sovereign risk in emerging countries Figure 7-10: Tensions on interbank funding markets

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Figure 7-11: Changes in external positions of reporting banks vis-à-vis all sectors, in terms of 2013 GDP in fixed and floating exchange rate regimes Figure 7-12: Changes in the ratio domestic credit to the private sector / GDP, year on year change Figure 7-13: Short-term real interest rates in fixed and floating exchange rate regimes Figure 7-14: Nominal effective exchange rates in fixed and floating exchange rate regimes, 100 = 2010 Figure 7-15: Real effective exchange rates in fixed and floating exchange rate regimes, 2010 = 100 Figure 7-16: Nominal effective exchange rates and core inflation Figure 7-17: Unemployment rates in fixed and floating exchange rate regimes Figure 8-1: A country-specific decrease in the risk premium in the model of the monetary union Figure 8-2: A country-specific expansionary shock in the model of the monetary union Figure 8-3: A country-specific supply shock that lowers the inflation rate premium in the model of the monetary union

LIST OF BOXES

Box 1-1: Maastricht Treaty’s objectives of CFSP Box 1-2: Policy instruments of the Amsterdam Treaty for CFSP Box 1-3: Chronology of a Common EU Foreign, Security and Defense Policy Box 1-4: The Main “Euroforces” acknowledged by the Treaty of Lisbon Box 2-1: Second revision of the Cotonou Agreement – adaptation to the new global context Box 2-2: European Development Fund Box 2-3: The five pillars of Paris Declaration (2005) and their fundamental principles

FOREWORD

The book investigates the new challenges confronted by the EU as an international actor in the context of the latest economic and political developments, with particular attention to common foreign and security policy; development-aid policy; EU sanctions in the post-Soviet space; preferential trade agreements; external relations of the EU; international aspects of the monetary policy of the ECB; capital flows and the boombust cycle in the emerging Europe; and macroeconomic modeling of the relationship between the EU and the rest of the world. To the existing literature in the field of the EU’s foreign and security policy - now at the top of the EU’s agenda - the book intends to add a thorough up-to-dateness to include all the recent tense evolutions. The respective chapter offers an historical survey of the main stages of the construction of a foreign and security policy and of the developments of the ESDP and then of the CSDP, showing the EU’s efforts to assert its role and identity on the international scene. The same chapter intends an attentive analysis of the EU’s response to recent security challenges: the popular revolt in Tunisia; Egypt’s political turbulences; crises in Libya; the Syria civil war; Iran’s nuclear program; and the Ukraine crisis, as the greatest test for the EU’s common foreign and security policy. As regards the development-aid policy, besides providing a synthetic chronology of this policy and an appraisal of the EU development cooperation effectiveness, the allocated chapter shows how globalization has brought opportunities but also threats that transcend frontiers; it presents an aspect not fully considered in relevant literature – that of the new global competitive context in which emergent donors like China, India, and Brazil, challenge the traditional Western donors. The chapter “EU sanctions in the post-Soviet space” analyzes thoroughly the harder instruments that complement the toolbox of the EU “soft power” polity, including a specific typology of restrictive and coercive measures. Keeping the post-Soviet region as a focus point, preferential trade agreements - as a key element of the EU external trade policy - are analyzed in the next chapter, using the Deep and Comprehensive Free Trade Agreement (DCFTA), with Georgia as a case study and emphasizing not only its benefits but also its costs.

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The reconfiguration of external relations of the EU is also seen in our book in the light of the following current events: the last waves of the EU enlargement and potential enlargement in the near future; shifts in transatlantic negotiations in the post-crisis period; and responses to the uprising in Arab countries and to the Ukrainian conflict. The EU responses to the new global context are also examined through a detailed description of the non-standard monetary policy measures, adopted by the ECB, in the context of the financial and sovereign debt crisis, along with the associated international use of the Euro. The penultimate chapter of the book investigates monetary policy responses in a volatile financial global context, and in respect of the massive capital inflows and outflows in emerging Europe over the period 2000-2013, paying a special attention to the exchange rate regimes adopted in these countries. Our approach is concluded by proposing a macroeconomic model in which the EU constitutes a block “against” the rest of the world, but also creates a two country model by itself, made up of Eurozone and nonEurozone members. Thus far, there are no macroeconomic models describing such a situation. This book was realized with the collaborative scholarly effort of researchers from five European countries (Romania, Switzerland, Poland, Spain and France), and is a publication included in the Ad Personam Jean Monnet Chair Project (EACEA Decision n. 2012-2825/001-001), coordinated by the book editor Ileana Tache. Vicente Esteve acknowledges the financial support from the Generalitat Valenciana (Project PROMETEOII/2014/053). Vicente Esteve and Maria Prats acknowledge also the financial support from the MINECO (Ministerio de Economía y Competitividad), through the projects ECO2011-30260-CO3-01 (Vicente Esteve), and ECO2012-36685 (Maria A. Prats). Finally, the above authors acknowledge the financial support received from the government of the Región de Murcia, through the project 15363/PHCS/10.

CHAPTER ONE CHALLENGES OF EU’S FOREIGN AND SECURITY POLICY IN A RAPIDLY CHANGING WORLD ILEANA TACHE

Summary This chapter examines a field of external EU policies which, unlike other areas such as trade, enlargement, neighborhood policy, development assistance, and humanitarian aid, is not yet a deeply integrated process. Through an explorative policy analysis of the main stages of the construction of a European Common Foreign and Security Policy (CFSP), and of the recent developments of European Security and the Defense Policy (ESDP) as an integrant part of CFSP, the chapter aims at identifying the shortcomings in reaching entire consensus among the member states and the reasons for the limited global impact of this policy. The EU’s priorities, instruments, partnerships and strategies - linked to security and defense - are scrutinized, highlighting some of the key issues raised in contemporary literature. The emerging security issues are also analyzed with a perspective on their intractability and challenges for the relevance of the pacifist principles promoted by the EU. The EU’s efforts to adapt to the fluid, evolving security agenda of recent years, and the mixed record in confronting the Arab Spring, Iran’s nuclear ambitions and the Ukrainian crisis, will be attentively considered.

Introduction: The main stages of the construction of a European foreign and security policy The founding Treaty of Rome of the European Community does not mention the idea of a common foreign and security policy, and makes no

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reference to a military dimension. The beginnings of the European integration took place under the Marshall Plan and US sponsorship, so that consultations on foreign and security policy developed under NATO’s larger framework. The Marshall Plan shaped the future of Europe, even if the economic recovery was already under way; it contributed to impeding the spread of communism in Western Europe, and the stabilizing of the international order, to favor development of political democracies and free market economies. NATO offered a solid structure for opposing the Warsaw Pact, signed on 14 May 1955 by the Soviet Union, Czechoslovakia, Poland, Bulgaria, Romania, Albania and East Germany. Even the Schuman Plan for the European Coal and Steel Community – the greatest gesture toward French-German rapprochement - was launched in 1950 as a response to the US insistence, in order to assure a supranational umbrella for resources used in the arms production. At almost the same time, a plan for the European Defense Community (EDC) was proposed by the French Prime Minister René Pleven, following the American call for the rearmament of West Germany. The EDC was to include West Germany, France, Italy and the Benelux countries, but it never came into effect, failing to obtain ratification in the French Parliament. The Gaullists opposed the plan - considering the EDC as a threat to France’s national sovereignty, and the Communists as well because of the tying of France to the capitalist US. Meanwhile, the death of Joseph Stalin, and the end of Korean War, faded the concerns about a potential conflict. The foreign policy cooperation went on under President de Gaulle’s challenges both to the US hegemony and to the supranational ambitions of the EEC. The Fouchet Plan, proposed by de Gaulle in 1961, was conceived by Christian Fouchet - France’s ambassador to Denmark - and was intended to create an intergovernmental alternative to the European Communities. This attempt to keep a balance of power in France’s favor was never implemented, being received with a lack of enthusiasm from the other Community states. In the context of the British application to joining the EEC, and the Atlantic partnership called by President Kennedy, the Fouchet plan was undoubtedly a challenge to the US leadership and was an attempt to subvert NATO’s power. In the Hague summit of 1969, the European leaders decided to look more closely at foreign policy and in 1970 agreed to promote European political cooperation (EPC) for coordinating foreign policy stances. However, no laws were adopted on foreign policy; each country acting independently, and the voting rule for most decisions being unanimity. The EPC had a strictly intergovernmental character and was overseen by

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foreign ministers within the Council of Ministers. It was to receive formal recognition much later, in 1986, with the Single European Act. After de Gaulle’s departure in 1969, foreign policy consultations among EEC members (organized separately from NATO’s framework) represented a concession to the French, who wanted a more autonomous European foreign policy. The creation of the European Council in 1974 helped coordination in the field of foreign policies. But policy cooperation was marked by divergent reactions of the Western European states, such as in the case of the Arab-Israeli War of October 1973, escalating into a new FrancoAmerican confrontation. Cooperation in the field of foreign and security policy was very often spurred by external events, which revealed shortcomings and inadequacies. The most suggestive examples are indeed the Middle East problems; always a subject for transatlantic dispute. The 1970s and 1980s witnessed a Western Europe of “civilian power”. According to Duchêne (1973) - one of the most famous scholars of civilian power in Europe - the EEC should continue to remain as a civilian group, long on economic power and relatively short on armed forces. This idea corresponds to the general orientation of the early 1970’s, when the significance of military power was diminishing at the same pace as economics were growing. Twitchett (1976) also argued that the European Community impact on the international arena had been via diplomatic influence and trade, rather than via military power. This is the reason why security and defense issues could not be put on the European agenda, Western Europe emphasizing diplomatic, rather than coercive, instruments during this period. However, some external events renewed efforts to promote cooperation in the field of foreign policy. The Iranian revolution of 1979 caused ripples well beyond the Middle East as the new regime began alienating once close Western allies. In the Khomeini era, the US foreign policy toward Iran would shift from one of total commitment to one on the defense, embedded in Iran’s rampant anti-Americanism (Pauwels, 2011). Then, the Polish crisis of 1980-1981, associated with the emergence of the Solidarity mass movement, created a drift of the US foreign policy and caused serious European concerns. During the same period there was the Soviet invasion of Afghanistan, a watershed event of the Cold War, marking the only time the Soviet Union had a military intervention outside the Eastern bloc. The Soviet move determined a sharp US and Western Europe criticism, accompanied by numerous measures to compel Moscow to withdraw.

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The foreign and security policy restated again its importance, with the German unification and the anti-communist revolutions in Central and Eastern Europe in 1989, and other international developments. The EU enlargement became then one of the most significant and difficult challenges facing Europe in the post-cold war interval. Not only did enlargement threaten to disturb the internal order of the EU, but the newly resulted external borders might create new divisions on the European continent. This was to be followed by a radical transformation of the EU strategic priorities. At almost the same period, in 1990-1991, Iraq’s invasion of Kuwait revealed quite different positions of the European Community members. France and the UK largely contributed with troops and warplanes; Germany kept its stance in rejecting “power politics”; other states like Spain, Portugal and Belgium had small military contributions; while Ireland stayed neutral. It was precisely on that occasion that Belgium’s foreign minister, Mark Eyskens, famously stated that the European Union is “an economic giant, a political dwarf, and a military worm”1. Even though this depiction fails to acknowledge the EU’s structural power, and the more subtle ways in which it exerts power in the international realm (Bossuyt, 2007), it stressed once again - and recognized the need - to formulate a common foreign and security policy. Additionally, the European responses were at odds with one another during the prolonged Yugoslavian crisis (1990-1998). A key development in the EU efforts - to realize its own defense capability and peace-making operations - is represented by the “Petersberg Declaration”, adopted at the Ministerial Council of the Western European Union in June 1992. On that occasion, the Western member states expressed their readiness to make available to the EU, and NATO, military units from the whole spectrum of their conventional armed forces. The Petersberg tasks were designed to avoid any confusion between the defense roles of individual EU states, NATO, and the EU acting as a single entity. They cover humanitarian and rescue operations, peacekeeping operations, and tasks of combat forces in crisis management, including peacemaking. This spectrum was to be expanded by the European Security Strategy in 2003. The remit of the EU’s fledging rapid reaction is based on the Petersberg tasks. The Maastricht Treaty (signed on 7 February 1992 and entered into force on 1 November 1993) finally established the Common Foreign and Security Policy (CFSP) as a replacement for the EPC. Unlike the EPC, the CFSP brings for the first time an explicit political and military-defense 1

The New York Times, 25 January 1991.

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component of the European project. The CFSP became one of the three pillars of the EU, the other two being the European Community and Justice and Home Affairs. Of course, this pillar was a shared competence with the member states, but the mere re-affirmation of the broken initiative of the EDC is much more significant than its inter-governmental character. The main objectives of the CFSP, as set out by the Maastricht Treaty, are presented in Box 1-1. The two new instruments introduced by the Maastricht Treaty, in order to implement the CFSP, were: -

common positions to establish systematic cooperation on a day-today basis and, joint actions to allow member states to act together in concrete ways based on a Council decision as to the specific scope of such actions; the EU’s objectives in carrying them out; and (if necessary) the duration, means, and procedures, for their implementation.

Box 1-1: Maastricht Treaty’s objectives of the CFSP x To safeguard the common values, fundamental interests and independence of the European Union; x To strengthen the security of the Union and its member states x To preserve peace and strengthen international security in accordance with the provisions of the United Nations Charter and the Helsinki Act (which created the Conference on Security and Cooperation in Europe; a forum for all the nations of Europe as well as the United States and Canada) x To promote international cooperation x To develop and consolidate democracy and the rule of law, and respect for human rights and fundamental freedoms. The EU achievements of the CFSP in the early 1990s are obvious, as emphasized by Ginsberg (1997) and Holland (1995), but given that the CFSP represented an intergovernmental pillar, there was no way of enforcing member state compliance with these provisions. The European Commission’s Opinion (1996) “Reinforcing Political Union and Preparing for Enlargement” recognized that, unlike other areas such as trade policy, economic assistance, development aid and humanitarian action - where there is already a coherent single policy toward the outside world - the CFSP is still at an early stage in its

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development. The objective of a clearer identity on the world scene was formulated and meant to be achieved through: -

-

bringing together the various strands comprising foreign relations into a single effective whole, with structures and procedures designed to enhance consistency and continuity; improving the common foreign and security policy at all stages of its operation; establishing a proper European identity with regard to security and defense, as a constitutive part of the EU common foreign and security policy.

The Maastricht Treaty’s provisions in the field of the CFSP failed during the Bosnia-Herzegovina war, with its terrible massacre of Srebrenica in 1995. Since then, European leaders realized the necessity of sometimes using military force while promoting a pacifist system of international relations. However, in the words of Dinan (2005), the lessons of the Yugoslav debacle were not sufficient to weaken the ramparts of national sovereignty in the foreign policy field, nor did member states interpret them uniformly. Bradford (2000) even speaks about Europe’s failure to devise and implement collective security measures during the dissolution of Yugoslavia, and concludes that the Western EU is not a realistic alternative to NATO in the “post-post-Cold War era”. The same author states that the Dayton Agreement on Bosnia-Herzegovina (considered a “dishonorable peace”) illustrated that the Western European ability to formulate and implement a CFSP still was far too meager in the absence of the American leadership. As a consequence, the Amsterdam Treaty, signed on 2 October 1997 and entered into force on 1 May 1999, identified four policy instruments for improving the CFSP (see Box 1-2). Box 1-2: Policy instruments of the Amsterdam Treaty for the CFSP x Principles and guidelines (adopted by the European Council) to provide general political direction; x Common strategies (adopted by the European Council) to provide an umbrella under which the Council could adopt joint actions and common positions by qualified majority voting (except those with military and defense implications). Common strategies would set out “the objectives, duration, and the means to be made available by the Union and the member states” in areas of mutual interest;

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x Joint actions (adopted by the Council) were refined to address specific situations requiring “operational action”, including a revised list of their possible contents. The Council could request that the Commission submit proposals to ensure the proper implementation of joint actions. x Common positions (adopted by the Council) were also refined to “define the approach of the Union to a particular matter of a geographical or thematic nature” A distinctive feature of the Amsterdam Treaty was the introduction of the position of High Representative for Common Foreign and Security Policy, which was occupied by Javier Solana for ten years - given his experience as secretary-general of NATO and Spain foreign minister. The Treaty of Nice signed in 2001 also significantly enhanced the importance of CFSP as a pillar of support for future European Union development. The European Security Strategy (ESS), entitled “A Secure Europe in a Better World” - adopted by the European Council of 12-13 December 2003 - provides the conceptual framework for the CFSP. The split between EU countries over the US-led invasion of Iraq in 2003 highlighted the need for a common strategic vision to enhance internal cohesion at the Community level. The five key threats identified by the ESS are: terrorism, proliferation of weapons of mass destruction, regional conflicts, state failure and organized crime. The ESS, which is the first ever declaration by EU member states of their strategic goals, also calls for preventive engagement to avoid new conflicts or crises, a priority being the security in the EU’s neighborhood – the Balkans, Southern Caucasus and the Mediterranean. When, in early 1999, the Serbian president Slobodan Miloševiü placed his forces in Kosovo, EU leaders realized the necessity to stop another humanitarian disaster. In June 1999, the European Council - held in Cologne, Germany - decided to give the EU the means and capabilities to assume its responsibilities regarding common European policy on security and defense. So the European Security and Defense Policy (ESDP) was born, as a “sui generis” security concept, distinguishing itself by two specific characteristics: a) a comprehensive understanding of security policy in reference to its available tools, and b) a comparatively narrowly defined political mandate focusing on international crisis and conflict management. The UK and France were the leaders of the ESDP implementation; being the only countries prepared to send military forces beyond Europe for more than United Nations’ peace keeping interventions.

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The ESDP is actually an integral part of the CFSP, consisting mainly of a 60,000 member rapid Reaction Force that could be deployed at 60 days’ notice and sustained for at least one year. This force was conceived to complement, rather than compete, with NATO and could only act when NATO had decided not to be involved in a crisis. The EU enlargement with the Central and Eastern post-communist countries brought greater diversity and limited capabilities on the agenda of the CFSP. Undoubtedly, the enlargement contributed to a more stable situation on the European continent and was a significant achievement in the field of the CFSP (as thoroughly described by Keukeleire and MacNaughten, 2008), but the foreign policy priorities of the CEEC’s were still determined by their immediate neighborhood; these countries being less interested in global affairs. Two examples illustrate quite different positions of some CEEC’s. In the Iraq crisis of 20032, which undermined the credibility of the EU as an international actor, the EU showed three points of view: 1) supporters of the US (the UK, Denmark, Italy, the Netherlands, Spain and the CEEC’s); 2) opponents of the US intervention (Austria, Belgium, France, Germany and Greece); and 3) countries with a neutral position (Finland, Ireland, Portugal and Sweden). The CEEC’s attitude in this regard – with the support of a US led intervention - contributed to strengthening the tension between European integration and Atlantic solidarity (Maracz, 2008). Another example is the Kosovo conflict, when Romania3 and Slovakia did not agree with Kosovo’s independence4; probably to avoid a precedent for separatist tendencies among their Hungarian minorities. For the whole Union, the above examples even made some authors like Chari and Cavatorta (2003) to wonder if the Iraq war was killing the dreams of a united EU, while Gordon and Shapiro (2004) - after a detailed dissection of the rift between the US and Europe - demonstrated that a new transatlantic partnership is both necessary and possible for the common security. In recognizing Kosovo’s independence some weaknesses of the 2

Iraq war was provoked by the concern at the ambitions of Saddam Hussein and at the possibility that Iraq was concealing aspects of its weapons mass destruction program from UN inspection teams. 3 In Romania’s case, a mention has to be made: in April 2013, following a resolution of the EP which urged all EU members that had not recognized Kosovo to do so, Romania’s Prime Minister Victor Ponta stated that his country must follow the EU’s lead. 4 Kosovo’s independence was not recognized by Cyprus, Greece and Spain as well, in the latter case due to concerns about perceived implications regarding the own issues with independence movements in the Basque Country and Catalonia.

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EU were revealed; one of the greatest strengths of the EU, that should not be forgotten, is its historical role in exorcising the demons of nationalism in Europe. Trying to emphasize the implications of enlargement for the wider European periphery, the European Commission advanced proposals for a broader European neighborhood policy, which materialized in a framework of cooperation for the states around the EU’s Eastern borders. As expressed by Giegerich and Wallace (2010), this was in effect a common foreign policy, but defined and managed through civilian instruments. The Treaty of Lisbon had important implications for the CFSP/ESPD. A key innovation was the replacement of the “Union Minister for Foreign Affairs” by a new “High Representative for Foreign Affairs and Security Policy”, who will be double-hatted as a Vice-President of the European Commission, and will be supported by a European External Action Service. In the institutional setting, a further novelty is created by the new permanent President of the Council who will chair the European Council and ensure the external representation of the Union in issues concerning its common and security policy, without prejudice to the powers of the High Representative of the Union for Foreign Affairs and Security Policy. Another notable change is the introduction of a mutual assistance article which reads like a mutual defense clause, in that it states “if a Member State is the victim of armed aggression on its territory, the other Member States shall have towards it an obligation of aid and assistance by all the means in their power”. There is also a mutual solidarity clause introduced, following the terrorist attack in Madrid. The above historical survey can be completed with the synthetic chronology of the EU Common Foreign, Security and Defense Policy supplied by Box 1-3. Box 1-3: Chronology of a Common EU Foreign, Security and Defense Policy March 1948: Belgium, France, Luxembourg, the Netherlands, and the UK sign the Brussels Treaty of mutual defense. April 1949: The US, Canada and ten West European countries sign the North Atlantic Treaty. May 1952: The European Defense Community Treaty is agreed by the six ECSC member states. It would have created a common European army, and permitted West Germany’s rearmament. In August 1954, the French National Assembly rejects the Treaty.

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October 1954: The Western European Union (WEU) is created on the basis of the Brussels Treaty, and expands to include Italy and West Germany. West Germany joins NATO. October 1981: Measures approved in the London Report include the crisis consultation mechanism: any three foreign ministers can convene an emergency EPC meeting within 48 hours. In meetings with third country representatives, the presidency can be accompanied by the preceding and succeeding presidencies (the troika). October 1984: The WEU is reactivated, as WEU foreign and defense ministers agree to meet regularly. February 1986: The Single European Act (SEA) is signed, and contains Title III on the EPC. The EPC can discuss the “political and economic aspects of security”. February 1992: The Maastricht Treaty is signed, replacing the EPC with Common Foreign and Security Policy. The Council of foreign ministers will decide Common Positions and Joint Actions, and the QMV can be used to implement the latter. June 1992: The Petersberg Declaration states that the WEU will engage in humanitarian and rescue tasks, peacekeeping, and crisis management tasks, including peacemaking (“Petersberg Tasks”). January 1994: The NATO summit agrees that the NATO assets can be used by the WEU and endorses the concept of “Combined Joint Task Forces”. October 1997: The Amsterdam Treaty is signed, and contains several reforms of the CFSP pillar. QMV is to be used to implement the European Council Strategies, and member states can abstain from decisions. A high Representative for the CFSP is created. December 1998: Franco-British declaration on EU military capability at St. Malo. June 1999: The Cologne European Council agrees that the EU should be able to undertake the Petersberg Tasks, replacing the WEU. December 1999: The Helsinki European Council sets the headline goal for the common European security and defense policy. July 2001: European Union Satellite Centre is established, in order to support early warning and crisis monitoring functions of the CFSP and the CSDP. The Centre becomes operational on 1 January 2002. March 2002 – June 2003: Convention on the Future of Europe drafts a constitutional Treaty creating a European foreign minister; a European external action service (EEAS); a European armaments, research and military capabilities agency.

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November 2003: EU foreign ministers reach agreement on permanent structured cooperation in defense (battle groups); a mutual assistance clause; creation of an EU civil and military planning cell within the EU military staff. June 2004: The provisions agreed since 2002 are incorporated in the draft constitutional Treaty, and many are implemented without Treaty ratification (excepting the foreign minister and the EEAS). June 2007: The European Council agrees a negotiating mandate for a new reform Treaty, which retains the constitutional Treaty’s provisions on foreign relations (the post of foreign minister being renamed High Representative of the Union for Foreign Affairs and Security Policy. December 2009: The Lisbon Treaty enters into force. March 2012: For the first time, the Foreign Affairs Council activates the EU Operations Centre to coordinate the on-going CSDP missions in the Horn of Africa.

Current developments of the ESDP The expansion of the EU policies, in the security and defense aspects, have so far had limited impact on global security, but the EU’s potential to respond to crises anywhere in the world shows an increasing tendency. The evolution of the ESDP was spurred on by the Kosovo conflict in 1999, which starkly demonstrated that European governments still lacked the military wherewithal to provide security in their own region (Payne, 2003). The military operations of 2003, in the Former Yugoslav Republic of Macedonia (CONCORDIA Mission), marked the effective beginning of the ESDP. The core aim of CONCORDIA was, at the explicit request of FYROM government, to contribute to a stable and secure environment. Under the framework of the ESDP, the EU supported the Democratic Republic of Congo (DRC)5 in its security sector reform and thus contributed to the promotion of peace and stability in Africa. One of the main drivers of conflict in the DRC was its plethora of valuable minerals and resources; the Congolese government being unable to control the entirety of its territory. The EU’s military operations in the Congo (developed in 2003 and 2006) contributed indeed to putting an end to the escalation of conflict, but some cleavages appeared between France and 5

The underlying acts of this mission were Council Joint Action 2005/355/CFSP of 2 May 2005 (EUSEC DR Congo) and Council Joint Action CFSP of 12 June 2007 (EUPOL DR Congo).

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Germany. While France was willing to deploy its military forces in 2003, for Germany it was difficult to adopt this unequivocal position in 2006, as it was always constrained by its past and was responsive to a public extremely critical about military actions. The German-led operation in the Congo was successfully conducted, but it provoked a clash and sharp exchanges between Javier Solana and the German Minister of Defense Franz Josef Jung, so that the Franco-German engine looked ill-suited to carry on with the EDSP. Brummer (2006) identifies a similar gap between France and the UK: France emphasizes a strategic approach whereas the UK pursues a more tactical/pragmatic approach, which stresses best value for money - not to mention the differences between the two countries concerning the role of the US and NATO. All these different views continued to throw-up barriers for the satisfactory function of the ESDP. Nevertheless, the intervention in 2003, in the Congo (ARTEMIS), was the EU’s first ESDP operation to be deployed outside Europe and was carried out without NATO assistance. As described by Giegerich and Wallace (2004), the EU participation in the military operations of the Congo and Macedonia showed that the EU was “not such a soft power”. In the Lebanon war of 2006, between Israel and Hezbollah, the EU took the decision to decline a military operation; on this occasion it was a commonly agreed position. There were two determining factors leading to this stance. The first one was the unwillingness of France, the UK, or Germany to act as a lead nation, and the second consisted of the potential for the mission to escalate into open hostility. While in the Congo the EU peacekeepers were kept away from the most violent areas, however the Lebanon mission called for the deployment of the EU peacekeepers to the most violent areas, but no EU country had the political capital to support such a high-risk military operation. Even though the EU missed an opportunity to enhance its credibility as a security provider, the EU governments created this time an interesting and unprecedented mechanism for control (Gowan, 2007). A special strategic cell was created at the UN headquarters to direct the operation. This cell ultimately reports to the US Secretary-General, but nineteen of the twenty seven officers in the cell were initially seconded from member states of the EU, allowing thus significant control to the respective European governments. The evolution of the ESDP was indeed accompanied by cooperation with the UN. Gowan (2009) illustrates a close relationship with some examples. Of the 23 ESDP missions launched between 2003 and 2009, 15 have been deployed in countries where the UN has a peace-keeping or peace-building mission. All EU missions in Africa have involved direct or indirect cooperation with the UN - ranging from military support (as in the

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Democratic Republic of the Congo) to parallel efforts to sustain the African Union (AU) in Darfur. The EU naval operation off the coast of Somalia (Atalanta) has taken place in parallel with the UN support to the AU peacekeepers in Mogadishu, and has protected the UN aid shipments. The EU-UN cooperation has also taken on unexpectedly complex forms in Kosovo and Georgia. A novel aspect of the ESDP and the EU’s role, in conflict resolution, was brought about by the Russia-Georgian war of August 2008. With the accession of Bulgaria and Romania in 2007, and the associated extension of the EU’s borders to the Black Sea, stability in Georgia became extremely important for the Union’s interests. Georgia’s disputed territoriality mirrored major risks for European security. The EU failed to impede the outbreak of the conflict, but its role in conflict resolution in Georgia has been paradoxically enhanced in the aftermath of this event. As Bardakçi (2010) observes, the pullout of the OSCE monitors from South Ossetia on December 31, 2008 and the UN Observation Mission (UNOMIG) from Abkhazia on July 15, 2009 - due to the veto exercised by Russia on the grounds of the refusal of these organizations to recognize the breakaway regions - resulted in the EU becoming the only international body, with observers, in Georgia. This was indeed a positive development in the EU’s role in conflict resolution. However, an increasingly confident Russia and the lack of a coherent strategy for the Eastern Neighborhood was a barrier on the way to promoting solid EU visibility in the region. In general lines, the Georgian case demonstrates, once again, that the ESDP development was realized through various exogenous shocks. The ESDP was replaced by the CSDP (Common Security and Defense Policy) - a name change introduced by the Treaty of Lisbon - which represents a cornerstone in the development of this policy field, bringing both continuity and innovation. Dedicating a new section in the founding Treaties to this policy, the Treaty of Lisbon emphasizes the specific nature of the CSDP, which still forms an integral part of the CFSP. Under the CSDP framework, the following new tasks were added to those that already existed6: ƒ joint disarmament operations ƒ military advice and assistance tasks ƒ tasks in post-conflict stabilization. 6

Humanitarian and rescue tasks, conflict prevention and peace-keeping tasks and tasks of combat forces in crisis management.

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In the CSDP implementation, the Treaty of Lisbon acknowledges the potential intervention of multinational forces, which are the result of the military alliance between certain EU member states and their decision to combine capacities, equipment, and personal strength. The main “Euroforces” are presented in Box 1-4. Box 1-4: The main “Euroforces” acknowledged by the Treaty of Lisbon x Eurofor, regrouping land forces between Spain, France, Italy and Portugal x Eurocorps, regrouping land forces between Germany, Belgium, Spain, France and Luxembourg x Euromarfor, regrouping maritime forces between Spain, France, Italy and Portugal x The European Air Group, regrouping air forces between Germany, Belgium, Spain, France, Italy, the Netherlands and the United Kingdom. The Treaty of Lisbon extends the Petersberg tasks and introduces the new concept of a collective defense obligation. The establishment of a Permanent Structured Cooperation, and of the European Defense Agency, strengthens the EU’s capacity as a military actor. In addition, the so-called “group of the willing clause” removes the possibility of a veto because, according to this clause, if some member states intend to participate in a mission they may be tasked by the Council with the protection of the Union’s values and interests. Despite all these innovations, which aim to gradually establish a common European defense, the CSDP remains a fundamentally intergovernmental issue, and the financial means for external missions are provided by the EU member states. Defense still remains a national, rather than a European, undertaking. The relative ineffectiveness of the CSDP lingers in the reluctance of the EU member states to give up control over national defense issues. The voting system in the CSDP is unanimity, meaning that the agreement of all the states is necessary for the launching of a mission. The EU military missions have been limited in scope, and the failure of the EU to compensate for the increasing national incapacity (coupled with the austerity of recent crisis context) constitutes a “defense deficit” for the European security interests. Solutions exist for all these weaknesses, as suggested by Menon (2013). In his opinion, what will be required is a willingness to submit

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national defense policies to European authority more increasingly than ever before. Depriving member states of the veto, right in the military interventions area, would accelerate defense decision-making. European level procurement would ensure interoperability and foster economies of the scale and creation of a common European Defense Equipment Market. So the most efficient way to solve the “defense deficit” would be the communitarisation of armaments, with national agencies replaced by supranational institutions. A window of opportunity can also be brought forward by the institutional decisions made in 2014; with the European Parliament elections; the establishment of a new European Commission; and a new EU’s High Representative for Foreign Affairs and Security Policy.

The EU response to some recent security challenges This section deals with the latest security issues - analyzed from a policy perspective - and discusses feasible interventions. Each case requires, not only reexamining current EU strategy, but also identifying alternative strategies for assuring European security.

Popular revolt in Tunisia Tunisia displayed an illusionary stability until the 2010 events. The popular revolt goal was in ending the authoritarian rule and in the overthrowing of President Ben Ali, which was achieved on 14 January 2011. Events in Tunisia triggered all the Arab unrest across North Africa and the Middle East. The viability of the present Tunisian government is questioned by the opposition because reform processes are slow, and the general feeling of uncertainty remains high. As regards security, there is little trust in the Police Force, because it has a bad reputation linked to its previous loyalty to President Ben Ali. Security issues have in some circumstances become a matter for religious communities; in that religious activists are being called on to maintain security (Eriksson and Zetterlund, 2013). While the large and spontaneous mobilization of Tunisians has achieved success in ending Ben Ali reign, it remains unclear whether the near future will bring genuine political reforms essential for stability, or whether continuing instability will affect other countries in the region. A radical rethinking of EU policies towards the region is called for; the bottom line of which should be to halt lenient EU policies towards countries that are not implementing serious political reform, despite their

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proven willingness to cooperate in the fight against terrorism, illegal migration and broader geostrategic objectives (Ayadi et al., 2011). The EU moved swiftly to support the transition in Tunisia. Political support is illustrated through regular visits, Council Conclusions, and High Representative Declarations. An EU-Tunisia Task Force meeting was held in September 2011 and produced an impressive list of assistance projects. The “EU’s response to the Arab Spring: The State-of-Play after Two Years”7 reaffirms that EU-Tunisia relations are based on three interrelated “M’s”: money, market and mobility. Mobility is especially problematic due to its interrelatedness with justice, security and defense issues. With the increasing violence in many other North African countries, the EU is not expected to take quick steps towards easing the entry to the EU of Tunisian residents and those in transit. Discussions with a view to a “Partnership for Mobility” on migration and security are ongoing.

Egypt’s political turbulences Inspired by the popular revolt in Tunisia, massive protests erupted in Egypt in early 2011. The social, economic and political situation in Egypt produced a significant impact on neighboring countries. The revolution in Egypt had indeed a broad spillover in the Arab countries. In terms of regional security, Egypt remains a pivotal state in the Middle East and North Africa, enjoying good relations with Israel and close collaboration with the United States. The euphoria which emerged from the Arab spring, and the collapse of the Hosni Mubarak regime on 11 February 2011, has been replaced with a period of political and social polarization; increasing violence and economic stagnation. The stability in Egypt is part of the comprehensive EU security strategy in its immediate neighborhood. The Southern Mediterranean region is an area that the EU sees as essential for its security and prosperity. In the wake of the Arab Spring of 2011, the EU re-launched its ENP to express its solidarity with those calling for democracy. An EUEgypt Task Force was launched in November 20128. This crisis revealed some challenges confronted by the EU. In Egypt’s highly debated situation it was the US that played a central role, while there was a lack of independent European policy. The fall of Mohammed 7

See www.eu-un.europa.eu/articles/en/article_13134_en.htm This is similar with the EU-Tunisia Task Force, which is in place to coordinate European and international support intended to help Tunisia as it makes the transition to democracy and restarts its economy.

8

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Morsi in July 2013 was a development strongly supported by the US, and President Barack Obama. Referring to Egypt’s unsustainable crackdown, Dworkin and Michou (2014) emphasize a long-term vision for European policy. In this sense, the temptation for the EU to accept Egyptian authorities’ actions at face value should be avoided, because they are not likely to lead to stable politics or an improvement in security. In the Egypt situation, the EU also faces competition from other outside powers. While the European countries are eager to continue cooperation with Egypt on security and other areas, the Gulf States, and Russia, stand ready to provide alternative sources of financial and diplomatic support, as well as security cooperation and the export of weapons. Another problem is that the political groups that best represent the vision that Europe would like to advance are too weak to play a major role in the near future.

The crisis in Libya Libya’s armed conflict of 2011, between forces loyal to colonel Muammar Gaddafi and those seeking to oust his government, offered a mixed picture in which European countries (France and the UK) were at the head of military actions; but Europe was not - due to a lack of member states will, fear, and restrictions from the UNSC Resolution 19739. During the vote of this Resolution, the noticeable German abstention (attributable either to German reluctance to use force, or to the lack of political will from northern member states to invest in the Mediterranean), emphasized a division within the EU over a security issue. The EU did not distinguish itself among the intervention leaders, although Libya is one of the close neighbors, and Mediterranean and Arab countries represent an important region for Europe’s stability. Libya’s case, where only French and British leadership assumed action, demonstrates once again that the EU is leaning less towards a body of coherent security response and more towards a return to bilateral action. The EU took indeed several measures to prevent an escalation in the crisis, such as humanitarian effort and the opening of an EU office in Benghazi, which brought more efficiency to EU actions and represented a de facto recognition of the Libyan National Transitional Council (NTC). However, Libya’s crisis provides three key strategic lessons for Europe (Biscop, 2011): 1. The EU’s challenge to carry out its own vital interests, 9

This Resolution formed the legal basis for military intervention in the Libyan civil war, demanding “an immediate ceasefire” and authorizing the international community to establish a no-fly zone and to use all necessary means to protect civilians.

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because nobody else will protect them; 2. the necessity of thinking and acting strategically, meaning to prioritize the regions where EU interests are essential and act accordingly; and 3. achieving the right capabilities, because - in the military realm - European capabilities remain deficient. The Libyan conflict proved indeed that the EU might be required to take military action if no other means can work, but of course this does not mean a militarization of the relationship with the Arab Mediterranean countries. It can be part of a comprehensive approach to the Mediterranean, including: assistance; economic and technical cooperation; fair trade; and trade access opportunities. All these measures can help North African states to rebuild their economies, put them on a sustainable path, and create more security in the region.

Civil war in Syria One of the most pressing challenges in the EU immediate neighborhood is Syrian civil war. In this particular country, over the past three years, more than 100,000 Syrians have lost their lives in the escalating conflict between forces loyal to President Bashar al-Assad, and those opposed to his rule. The bloody internal fighting has destroyed whole neighborhoods and has forced more than nine million people to abandon their homes. What began as another event of the Arab Spring uprising against an autocratic ruler, has mushroomed into a brutal proxy war that has drawn in regional and world powers. Since violence and repression broke out in Syria in March 2011, the EU has not only called repeatedly for an end to attacks, but has also suspended other agreements intended to forge a closer relationship with Damascus. Following the EU sanctions in November 2011, the EIB stopped all disbursements for loans and technical assistance contracts with the Syrian state. The regional crisis in Syria proved again, that in comparison with other fields of European politics, the EU’s defense and security policy is highly susceptible to differences among the member states. The EU opposed sending arms to Syria, but the heads of the European states could not reach an agreement on the revocation of the arms ban against the opposition. France and the UK announced that they would consider a unilateral abrogation of the agreement by sending arms to the Syrian rebels. On the other hand, an unexpected consequence for Europe’s foreign policy was highlighted. Major European states’ (like France and Germany) opposition to the US-led Iraq war, of 2003, was replaced by the most explicit European support to the US policy towards Damascus. François Hollande

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and Angela Merkel’s positions were quite different from those of their predecessors Jacques Chirac and Gerhard Shröder in 2003. However, taking into account the rejection by the UK’s Parliament of a military intervention - and the uncertain backing of the Assemblée Nationale for France’s President and Germany’s cautious approach and insistence for UN action - the Syrian civil war reflected the Europeans’ overwhelming preference for the EU to act as a world power but without the military force that this entails. In all uprisings that swept North Africa and the Middle East, which radically changed the international and regional landscape,10 the citizenled spirit of reform and unity is now shadowed by polarization and tensions between secular liberals and Islamists; different Islamic groups and government and civil society. As Youngs (2014) notices, what Western observers initially saw as a process in which reformist civil society pitted itself against authoritarian regimes, today seems to be primarily about managing myriad levels of polarization within societies. In this context, the EU has increased the emphasis on consensus building in its diplomatic efforts, and develops funding initiatives in the Middle East. It also tries to balance conflict mediation and reform promotion in these countries.

Iran nuclear program Iran’s interest in nuclear technology dates to the 1950’s, when the Shah began receiving assistance through the US Atoms for Peace program. Iran signed the Treaty of the Non-Proliferation of Nuclear Weapons as a nonnuclear weapon state in 1968 and ratified it in 1970, but the Shah’s nuclear weapons ambitions did not cease. The expansion of the nuclear program was stopped by the Iranian Revolution of 1979 and the Iran-Iraq war, but the 1990’s witnessed Iran beginning to pursue an indigenous nuclear fuel cycle capability. In August 2002, the National Council of Resistance of Iran - an opposition group established in Paris - revealed the existence of undeclared nuclear facilities in Iran, which provoked a diplomatic impasse with the international community, and sanctions, which were aimed at Iran’s nuclear-related investments. The EU efforts to solve the conflict over Iran’s nuclear program began under particular circumstances determined by the US-led invasion of Iraq 10

Prior to 2010, for the EU, the situation in its southern neighborhood represented stability without democracy and the EU at no stage did call for regime change.

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in 2003, which divided EU member states and damaged transatlantic relations. In these conditions, the stakes for international security were high. A nuclear armed Iran could have major consequences for regional and global security. On 14 June 2008, Javier Solana - the EU’s High Representative for Common Foreign and Security Policy - met in Tehran, with the Iranian Foreign Minister, in order to freeze Iran’s enrichment of uranium efforts, but Ayatollah Khamenei continued the path of nuclear development. The EU recognizes Iran’s right to use nuclear energy for peaceful purposes, but these rights are conditional on compliance with the obligation of not building nuclear weapons. Despite the EU’s best efforts, Iran did not respect the requirements of the International Atomic Energy Agency (IAEA), and there was no guarantee that the nuclear program is dedicated to peaceful purposes. The unresolved stalemate over Iranian nuclear ambitions is indicative of the limitations of European diplomacy. Nonetheless, the participation in the Geneva Interim Agreement11 (November 2013) constitutes a major accomplishment of the EU High Representative, Catherine Ashton. She served as chair and spokesperson of the P5+1 group12 to implement a strategy designed in Washington. Her ability in fulfilling this task contributed to the interim agreement success. With a remarkable constancy of engagement, the EU tries at present to find a diplomatic solution to the dispute over Iran’s nuclear activities. It focuses on maximizing tactical advantages in direct negotiations with Iran. As Meier (2013) shows, the EU should try to capitalize on new opportunities to discover ways out of the stalemate over Iran’s nuclear ambitions by defining what a final deadlock could look like and outlining steps toward such an agreement. While the conflict remains unsolved thus far, the coherence of European diplomatic efforts could have promising chances of success.

11

Geneva Interim Agreement, officially titled the Joint Plan of Action, was signed on 24 November 2013 and consists of a short-term freeze of portions of Iran’s nuclear program in exchange of decreased economic sanctions on Iran, as the countries work towards a long-term agreement. 12 P5+1 group is made up of the six world powers which in 2006 joined the diplomatic efforts with Iran regarding to its nuclear program. The term refers to the P5 or five permanent members of the UN Security Council, namely United States, Russia, China, United Kingdom and France, plus Germany

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The Ukraine crisis as the greatest test for the EU’s common foreign and security policy A severe threat to European security is addressed by Ukraine facing, undoubtedly, the most prolonged crisis since its post-Soviet independence. The crisis unfolded as a result of the government dropping plans to sign the EU Association Agreement, under pressure from Russia. The proRussian president Yanukovich’s motivations were regarding concerns about damage to Ukrainian industry because of harsh European competition. Since the dissolution of the Soviet Union in 1991, Ukraine struggled to solve its internal divisions; to implement economic reforms; and to fight the increasing control of oligarchs over the economy. The Orange Revolution of 2004 masked the divide between the European-oriented, western, and central Ukraine and the Russian-oriented, southern and eastern Ukraine. Ukraine was included in the EU Eastern Partnership - established in 2009 - which was negatively perceived by Russia, taking into account its proposed Eurasian Economic Union; a customs union that came into being on 2nd January 2015 and whose likely members were Ukraine, Kazakhstan, Belarus and Armenia. Ukraine pulled out from this project and continued unabated in its struggle against Russia. The EU’s project to expand eastward to Ukraine through the association agreement is regarded as a security threat by Russia, and as a possible stepping stone to NATO’s membership. Actually, Russia has come to view the Eastern Partnership as a zero-sum game and an infringement on its perceived regional sphere of influence (Nichol, 2014). In February 2014 the Crimean Peninsula overwhelmingly opted, in a referendum, for union with Russia. The EU’s position in this regard is that the referendum violates both Ukraine’s constitution and international principles, and condemned Russia for its military intervention. As a response to the developments in Crimea, the EU announced $15 billion of financial aid over the next years, conditioned on a Ukraine agreement with the IMF and an adoption of reforms, such as the ending of gas subsidies. Along with the US, Japan and Canada, the EU imposed sanctions (travel bans and the freezing of assets) on Russian and Ukrainian officials linked to the escalation of tensions. For the common EU foreign and security policy, Russia’s annexation of Crimea has triggered a major reappraisal of the EU-Russia relationship. While, in recent years, the EU has developed a strategic partnership with Russia, the recent events made the European policy makers confront the prospect of Russia as a potential adversary rather than as a partner. The

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Europeans were convinced that they had entered a new “postmodern” era where soft power replaced hard power. Now this assumption needs to be questioned, because Russia’s attitude shows that the old-style power politics are back. The EU conveniently delegated questions of hard power and strategy to the US, but at present the Europeans must take a more active role in transatlantic security and shoulder more of the burden of their own security (Speck, 2014). The EU policy makers must rethink the bloc’s allure as a soft power. The Ukrainian crisis starkly reminded us all of the fragile status of stability and peace on the European continent. The troubling relations between the EU and Russia may affect all cooperation channels, calling also for a reconfiguration of the European Neighborhood Policy. After some hesitation, Europeans have finally put forward a common front and have adopted credible sanctions towards Russia. The recent pressures of the Ukrainian crisis, and turmoil in the Middle East and North Africa, have placed the foreign and security policy at the top of the EU’s agenda. The evolutions described above show that, at present, the EU is unequipped to address all challenges and to develop an effective external action. It seems that neither the European Neighborhood Policy, nor the EU’s instruments of diplomatic, civilian and military crisis management, is sufficient to allow the union to play a genuine and sustainable stabilizing role in its surrounding regions (Lehne, 2014). The developments in North Africa and the Middle East raise a major challenge for the EU foreign policy, pressing the members to re-analyze the overall concept of the future role of the EU in this region as a constructive partner, and to decide whether it is able to provide assistance in the creation of a stable democratic system and in the laying down of the foundations of civil society and free media. An enhanced economic cooperation will also be one of the main generators of stability in the region. In the security field, there are three key areas of the new EU attitude towards the Southern neighbors: energy security, migration issues, and countering international terrorism. As regards the energy security, the relations were, in general, developed bilaterally between member states and the Arab countries. A common approach aimed at the establishment of an Energy Union in the Mediterranean region becomes necessary. Then, migration issues, closely related to development policies, should be included in a viable common strategy for combating illegal migration. The growing cross-Mediterranean migration to the EU has, unfortunately, scarcely been tackled in policy terms; the EU still lacking a clear approach to migration across its southern flank. The joint fight against terrorism is

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not effective and has limited results because of bilateral action plans. To step up the efforts in combating terrorism, the EU must strengthen the monitoring of counter terrorism policies, and must better tackle the root causes of terrorism and improve dialogue with partners.

Conclusions The historical survey of the construction of an EU common foreign and security policy shows that, even if the European Union is an increasingly important global actor - in the realm of security and peace - it still fails to exert its influence. It cannot speak with a single voice on international crises, and the difficulty to agree on joint interventions in conflict zones is evident. First of all, there are differences in member states approaches depending on diverse defense priorities and national political cultures, which are sometimes distinct from the EU stance as a global player. Member states hesitate to give up issues of the mobilization of national resources for defense; the inter-governmentalism remaining the fundamental policy mode in this field. Then, the dependence on the USA for hard security and leadership in managing international security threats is obvious. One of the reasons why the output did not measure up to the input of activity - in the field of foreign and security policy - is the lack of obligation for EU members to implement agreements made. All too often, member governments have signed up to policies in Brussels that they have neither reported back to their parliaments nor implemented (Giegerich and Wallace, 2010). Even the creation of a High Representative did not alter the situation in any meaningful way as long as the ultimate authority rested with the member states; all of them having the veto right in making decisions related to military forces. The EU has indeed created institutional structures for developing a common foreign and security policy and, gradually, the EU member states have coordinated their foreign policies to a remarkable degree on many aspects. These efforts have allowed the EU to assert its role on the international scene and to add an important new layer to its identity. As the institutions introduced by the Treaty of Lisbon mature, the EU will concentrate on developing and ‘fleshing out’ the substance of the common foreign and security policy, and of the common security and defense policy; confronting the great challenges that lie ahead in the new global context.

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However, the recent pressures of the Ukrainian crisis and the diminished strategic partner Russia, and also the turmoil in the Middle East and North Africa, require a deep reconsideration of the EU’s soft power attitude (betraying too idealist points of view); a radical shift to a more active role in the global arena; and a reassessment of the EU strategic situation and security toolbox. The above events also highlight that protecting European security often requires helping others countries improve theirs. The latest evolutions in the Middle East and North Africa call for a paradigm shift: from the EU endlessly reiterating the responsibility it has to help MENA reforms, to a more-headed look at how Europe needs to reposition itself geo-strategically in light of changes in the region (Youngs, 2011). At the same time - by tackling the security threats represented by the chaos of the ever-smoldering Middle East region - the EU cannot neglect the very root causes that led to the destabilization in the first place (authoritarian governance and lack of economic opportunities) and should act accordingly, providing assistance and enhanced economic cooperation. European armed forces are at present in a malaise, due to the reserved approach to using military force and the constraints of the economic and financial crisis. As Rogers (2013) points out, these failings call for a conceptual reappraisal of the utility of European military power and a better understanding of both the active and passive uses of armed force. Of course, that is not an easy task for the EU; born as a project that replaced war with peace on the European continent and even won the Nobel Peace Prize in 2012. Military force becomes an option for the EU, of course never desirable, but useful eventually and legitimized when respect of the law should be imposed. In an increasingly unstable neighborhood and at a time of growing geopolitical stress across the world, the EU and its member states should take into account the lessons offered by the past divergent positions and be more engaged in a collective action; having a hard look at where they can make a difference together - thus recognizing the interconnected nature of all these global challenges. It seems that, at present, no member state can insulate itself from the security woes of others. In the tense and severe current international context, the simple cooperation in military affairs is not sufficient. The EU has to consider, or pursue, military integration with real moves to form a viable European defense community, and become a single military actor capable of asserting itself as a solid pole on the world arena.

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Great expectations are now directed to the new European Parliament and European Commission: taking office at a watershed moment for the EU, with questions that span the whole spectrum of international politics, the new leaders - especially the EU High Representative of the Union for Foreign Affairs and Security Policy - could be a pivot to Europe foreign and security issues.

CHAPTER TWO EU DEVELOPMENT-AID POLICY AND THE RISE OF COMPETITIVE EMERGING DONORS ILEANA TACHE

“As a continent that went from devastation to become one of the world’s strongest economies, with the most progressive social systems, being the world’s largest aid donor, we have a special responsibility to millions of people in need”. —José Manuel Barroso, Address at the Nobel Peace Prize ceremony, 2012.

Summary Development is at the heart of the EU’s external action, along with foreign, security and trade policies. The EU and its member states are the biggest donors of official development assistance (ODA). Together, in 2013, they provided aid to the tune of €56.5 billion, which amounted to 52% of the total global ODA donated during the year.1 But the EU is the world largest donor not only by the mere amount of its commitments, but also by its comprehensive development policy and its position of international agenda setter. The primary objective of the EU development policy is the eradication of poverty in the context of sustainable development, including the achievement of the eight Millennium Development Goals (1. Eradicate extreme poverty and hunger; 2. Achieve universal primary education; 3. Promote gender equality and empower women; 4. Reduce child mortality; 5. Improve maternal health; 6. Combat HIV/AIDS, malaria, and other diseases; 7. Ensure environmental sustainability and 8. Global partnership for development). Even though there is an on-going debate on the relevance and validity of these goals (see Sumner and Melamed, 2010),

1

According to European Commission (2014).

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they have provided recently the guidance for the prioritization of investments in the area of poverty reduction. The foundations of development cooperation are laid down in the Treaty on the Functioning of the European Union (Title III). The EU development policy was concerned at the outset with only the overseas countries and territories associated with the European Community - taking into account the long colonial history of some member states – and it was then extended to all developing countries of the world. This chapter intends first to offer a synthetic historical overview of the EU development-aid policy and of the key moments of the associated conventions and partnerships (Yaoundé and Lomé Conventions, Cotonou Agreement); to describe the institutional architecture of this policy, both at European and state level; and to assess the EU development-cooperation effectiveness and its contribution to the structural transformation of the less developed economies – stressing some barriers encountered in improving the development-cooperation results. Eventually, the major challenge of some emerging aid donors (Brazil, China, and India) will be discussed; helping to understand the changing context for a new global development framework, along with its implications for a rethinking and adjustment of the EU development-aid policies.

Introduction: Brief historical overview of the EU development-aid policy The beginnings of the EU development policy are marked by the Treaty of Rome signature in 1957; the first beneficiaries being the overseas countries and territories of the member states. The evolution of aid-development measures were then accompanied by Europe’s political concerns. The colonial history of some EU countries had a significant influence on the relationship between the EU and the developing world. During negotiation of the Treaty of Rome, France insisted on special treatment of its former colonies like Tunisia and Morocco; Italy asked concessions for Libya2. The long European colonialism left behind both a heritage of close economic and political ties with the poorer countries and a moral concern about their poverty, hunger and underdevelopment. As the overseas territories of the EEC member states became independent some years after the Treaty of Rome, a formal institutional 2

Libya, along with Eritrea, Somalia and the Dodecanese Islands had been annexed by Italy in the World War I.

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framework for their participation was necessary and this was created by the Yaoundé3 Conventions. The first Yaoundé Convention was signed in July 1963 and lasted till 1969. The Yaoundé II Convention marks the following period of 19701975. These two conventions allowed the participating countries (eighteen associated African states and Madagascar - AASM) to export the small amount of industrial goods they manufactured, usually duty free, into the EEC, but with much less preference for exports of agricultural products. These would have undermined the Common Agricultural Policy (CAP) in protecting the European farmers and their high food prices. In return for the preferential treatment for limited industrial exports to the EEC, the AASM countries had to accept comparable European exports. The Yaoundé Conventions, which mainly benefited the former French colonies, were replaced by the Lomé4 Convention, which was a response to the UK’s accession to the EEC and to its interests in preserving the British Commonwealth LDC trade preferences. The new agreement included the UK’s African territories but excluded Asian countries (India, Pakistan, Malaysia, Singapore, Hong Kong, and Indonesia). There have been four Lomé Conventions between 1975 and 1999, the first being signed in 1975. The last one, Lomé IV, offered dutyfree access for ACP exports of primary products and manufactures and most non-CAP agricultural products. It also tried to push the EU policy in a new direction by adding a structural adjustment to ACP aid: an encouragement of economic diversification in the ACP countries instead of simply aid providing. A General System of Preferences (GSP) offered to non ACP LDCs similar preferences to Lomé but on a narrower range of products. The Lomé Conventions were replaced during 2000 by the Cotonou5 Agreement, covering a period of twenty years and offering a more flexible structure, based on a series of interregional free trade agreements between groups of ACP countries and the EU; it also transferred accountability for development actions to the ACP countries. The Cotonou Agreement is the most comprehensive partnership agreement between the EU and the LDC (79 ACP countries). Its first revision was operated in 2001 and the second in 2010, when the partnership was adapted to the new challenges of climate change, food security, regional integration, state fragility and aid effectiveness. The main changes, which have taken place in the decade 2000-2010 (as an 3

Capital of Cameroon Capital of Togo 5 Capital of Benin 4

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adaptation to the new global context) and which were incorporated in the second revision of the Cotonou Agreement, are summarised in Box 2-1. Box 2-1: Second revision of the Cotonou Agreement – adaptation to the new global context - The growing importance of regional integration in the ACP countries and in the ACP-EU cooperation is reflected. - Security and fragility: no development can take place without a secure environment. The new agreement highlights the interdependence between security and development, and tackles security threats jointly. - Our ACP partners face major challenges if they are to meet the Millennium Development Goals, food security, HIV-AIDS and sustainability of fisheries. The importance of each of these areas for sustainable development, growth, and poverty reduction is underlined. - For the first time, the EU and the ACP recognize the global challenge of climate change as a major subject for their partnership. - The trade chapter of the Agreement reflects the new trade relationship and the expiry of preferences at the end of 2007. It reaffirms the role of the Economic Partnership Agreements to boost economic development and integration into the world economy. The revised Agreement highlights the challenges the ACP countries are facing to integrate better into the world economy; in particular the effects of preference erosion. - More actors in the partnership: the EU has been promoting a broad and inclusive partnership with ACP partners. The new agreement clearly recognizes the role of national parliaments, local authorities, civil society and the private sector. - More impact, more value for money: This second revision is instrumental in putting into practice the internationally agreed aid effectiveness principles; in particular donor coordination. It will also untie the EU aid to the ACP countries to reduce transaction costs. For the first time, the role of other EU policies for the development of the ACP countries is recognized, and the EU commits to enhance the coherence of those policies to this end. Despite all the trade concessions and aid supplied through different Conventions, it was not until the Maastricht Treaty of 1993 that development-cooperation became a shared European responsibility, offering a new explicit competence for the EU in initiating new policies and programmes and in elaborating strategies.

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The Lisbon Treaty, which entered into force on 1 December 2009, requires that the EU foreign policy does no harm to development objectives, while calling for development-cooperation to be conducted within the broader framework of external action. The Treaty entrenches development policy as a” shared competence” under the mandate of both High Representative for Common Foreign and Security Policy (CSFP) and Development Commissioner. The EU’s contribution to global development is marked by the search of greater policy coherence. Since the mid-2000, the European Consensus on Development6 has continuously stressed the necessity for greater policy coherence for development (PCD); the EU tries in this sense to better take into consideration what the development world needs in the five global challenges areas of the PCD programme: trade and finance, climate change, global food security, migration and security. Along with the OECD, the EU is at present a key promoter of the PCD on the global stage. Recently, the Horizon 2020 research projects launched by the European Commission include the topic “The European Union’s contribution to global development in search of greater policy coherence”. Research on the PCD is thus highly encouraged and expected to advance the understanding of the bases for the effective EU development policy and of the successful integration of development concerns into other EU policy areas. This research initiative could also bring a comprehensive perspective on the EU policies impact on developing countries. A notable fresh initiative of the European Commission, unanimously adopted by the European Parliament and the Council, was the launching of the European Year for Development 2015 (EYD 2015), dedicated to raising awareness, engaging Europeans everywhere in the EU’s development-cooperation and sparking debate around the motto “Our world, our dignity, our future”. As a year that promises to be hugely significant for development, with a vast array of stakeholders involved in crucial decision-making in development, environmental, and climate policies, 2015 represents also the target date for achieving the Millennium Development Goals.

6

European Consensus on Development 2005 is a policy statement that reflects the EU’s willingness to eradicate poverty and build a more stable and equitable world. It identifies shared values, goals, principles and commitments which the European Commission and EU member states will implement in their development policies.

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Institutional architecture of development-aid policy The development-aid policy, as a policy area where the EU can really make a difference as an international actor, is supported by a rich institutional system. The Lisbon Treaty marks a milestone in creating clearer institutional safeguards for the EU development policy. It entrenches development policy as a shared competence under the mandate of both the High Representative for Common Foreign and Security Policy and the Development Commissioner. The EU aid architecture comprises the 28 member states institutions; the European Commission (with a coordinating role, monitoring function and a high aid dimension); the European External Action Service (functionally autonomous from other EU bodies, which highly facilitates development policy coherence); and the European Investment Bank (acting as a lending institution). Member states and EU level institutions will be discussed separately, given that development policy within the European Union is a shared competence between each member state and the European Commission. Bilateral development policies co-exist with Community policies managed by the EC, each with its own agencies, administrations and institutions (Kitt, 2010).

EU member states institutions EU member states and agencies for development are provided by Table 2-1. Besides their Foreign Ministries, the majority of EU countries have more than one institution devoted to development-aid policy implementation. Table 2-1 refers only to top-level national organizations, but countries like Spain or Belgium, with a relatively high degree of decentralization, often are active at regional levels too, increasing thus the total number of donor agencies. On the other side, new EU countries from Central and Eastern Europe like Bulgaria, Croatia, Latvia, Estonia, Romania and Slovenia, do not have a separate implementation of the development policy; the only involved institution being their Foreign Ministry. An important issue of development-aid policies and institutions of the EU member states is related to the aid transparency, and is considered a key pillar of development – a necessary condition to enable effectiveness and accountability. Despite recent progress, in making their aid more transparent, the EU countries perform poorly, scoring an average of only 23%, compared to the average score of 31% for non EU-bilaterals. Only

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Table 2-1: EU member states Institutions and Agencies for Development EU member state Austria

Development policy Foreign Ministry

Belgium

Estonia Finland France

Development Cooperation (DGDC) Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry (DANIDA) Foreign Ministry Foreign Ministry Foreign Ministry

Germany

Development Ministry

Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal

Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry

Romania Slovakia Slovenia Spain

Foreign Ministry Foreign Ministry Foreign Ministry Foreign Ministry

Sweden

Foreign Ministry

Bulgaria Croatia Cyprus Czech Republic Denmark

United Kingdom

Department for International Development (DFID)

Separate implementation Austrian Development Agency (ADA) Belgian Development Agency (BTC)

Yes Czech Development Agency

Agence Française de Développement (AFD) Deutsche Gesellshaft für Internationale Zusammenarbeit (GIZ) Hellenic Aid Yes Irish Aid

Yes Lux Development

Polish Aid Portuguese Institute for Development Support Slovak Aid Spanish Agency for International Development Cooperation (AECID) Swedish International Development Cooperation Agency (Sida)

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five member states – the UK (DFID), Sweden (Sida), Denmark, the Netherlands and Germany received places in the top three categories (very good, good or fair) of the Aid Transparency Index (see Table 2-2). Brazil, which does not consider itself a donor country, ranks 56th; higher than 10 of the EU’s bilateral agencies7. In 2013, the net official development assistance (ODA) by the 28 EU member states was USD 71.2 billion, or 0.41% of their combined GNI, while net disbursements by EU institutions to developing countries and multilateral organizations were USD 15.9 billion8. The same year, the largest EU donors were Germany, France, Denmark, Luxemburg, Sweden, the UK and the Netherlands. While Denmark, Luxembourg and Sweden continued to exceed the 0.7% ODA/GNI target, the UK met it for the first time. The Netherlands fell below 0.7% for the first time since 1974. Table 2-2: Ranking of the EU member states and EU donor institutions in 2013 ATI Very good (scores of 80-100%) 3. UK, DFID (83.5%)

Fair (scores of 40-59%) 12. European Commission, ECHO (54.2%) 13. European Commission, DEVCO (52.1%) 14. European Commission, FPI (51.1%) 15. Denmark, MFA (50.7%) 16. Netherlands, MFA (49.4%) 17. European Commission, Enlargement (48.1%) 20. Germany, BMZ-GIZ (45.9%) 23. Germany, BMZ-KfW (43.7%) Notes: 1. The number denotes place in overall ranking of 67 donor organizations; 2. EC – European Commission. Source: Extracted and adapted from http://ati.publishwhatyoufund.org/wpcontent/uploads/2013/10/2013-EU-ATI-brief.pdf, p. 2.

7

Good (scores of 60-79%) 9. Sweden, Sida (60.4%)

All data regarding aid transparency of EU member states are extracted from 2013 Aid Transparency Index (ATI), available at: ati.publishwhatyoufund.org/wpcontent/uploads/2013/10/2013-Aid-Transparency-Index.pdf 8 According to OECD, http://www.oecd.org/newsroom/aid-to-developingcountries-rebounds-in-2013-to-reach-an-all-time-high.htm

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European Commission The European Commission administers aid to developing countries and offers a number of advantages over national bilateral aid programmes, such as administrative economies of scale, or coordination of EU aid-development programmes and harmonization of their administrative requirements. The development initiatives of the European Commission are also free of the commercial and political reasons that often guide national aid policies. The Commissioner in charge of International cooperation and Development is directly responsible for: x Ensuring the EU delivers on its commitments to the Millennium Development Goals to reduce poverty; x Setting out the Commission and EU positions for the negotiations on the United Nations Millennium Development Goals agenda after 2015; x Working with national governments to make the EU’s development more effective; x Launching negotiations on a revised Cotonou Agreement with the ACP group of states. In order to ensure that the EU development-aid policies are consistent with, and support, EU goals and priorities, the Commissioner for International Cooperation and Development has to work closely with the Commissioners responsible for other cross-cutting policies and, in particular for Migration and Home Affairs, Employment, Social Affairs, Skills and Labour Mobility, Agriculture and Rural Development, Climate Action and Energy, and Environment, Maritime Affairs and Fisheries. At present, the Directorates General, which deal with the developmentaid issues, are DG for International Cooperation and Development (DEVCO – EuropeAid), DG Enlargement, and DG ECHO – Humanitarian Aid and Civil Protection. DG DEVCO is responsible for designing EU development policies and delivering aid through programmes and projects across the world; it is in charge of development cooperation policy in a wider framework of international cooperation, adapting to the evolving needs of partner countries. It incorporates the former Development and EuropeAid DG’s. Having only one DG simplifies communication in the development field by acting as a "one stop shop" – providing a single contact point for stakeholders inside and outside the EU to deal with. DG DEVCO defines sectoral policies in the field of external aid in order to reduce poverty in the world; to ensure sustainable economic, social and environmental

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development; and to promote democracy, the rule of law, good governance and the respect of human rights. Its role consists also in coordinating the actions of the EU institutions; the EU member states; and other EU actors around the Union’s core values, objectives and common priorities. Within the European Commission, DEVCO-EuropeAid assures coherence between the EU’s development policy and its other internal and external policies. It bears responsibility for implementing the EU’s external aid instruments, which are financed by the European budget and the European Development Fund (see Box 2-2). Box 2-2: European Development Fund EDF was created by the Treaty of Rome (1957) and was first launched in 1959. It is the main instrument for providing aid in the ACP countries and OCTs. EDF supports actions in the following key areas for cooperation: - economic development - social and human development - regional cooperation and integration. Each EDF is concluded for a period of around five/six years. Since the conclusion of the first partnership convention in 1964, the EDF cycles have generally followed that of the Partnership agreements/conventions. • First EDF: 1959-1964 • Second EDF: 1964-1970 (Yaoundé I Convention) • Third EDF: 1970-1975 (Yaoundé II Convention) • Fourth EDF: 1975-1980 (Lomé I Convention) • Fifth EDF: 1980-1985 (Lomé II Convention) • Sixth EDF: 1985-1990 (Lomé III Convention) • Seventh EDF: 1990-1995 (Lomé IV Convention) • Eighth EDF: 1995-2000 (Lomé IV Convention and the revised Lomé IV) • Ninth EDF: 2000-2007 (Cotonou Agreement) • Tenth EDF: 2008-2013 (Cotonou Agreement) • Eleventh EDF: 2014-2020 (Cotonou Agreement) The 11th EDF has a budget of € 31589 million out of which € 29089 million has been allocated to the ACP countries. This amount for the ACP is divided as follows: - € 24365 million to the national and regional indicative programmes; - € 3590 million to intra-regional cooperation; - € 1134 million to Investment Facility. Source: compiled from Europe, Summaries of EU legislation, http://europa.eu/legislation summaries/index_en.htm

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DG Enlargement administers the Instrument for Pre-accession assistance (IPA), which supports reforms in the enlargement countries with financial and technical help. The IPA funds build up the capacities of the countries throughout the accession process, resulting in progressive, positive developments in the respective region. The budget of the 20072013 period was € 11.5 billion, increasing to € 11.7 billion for the 20142020 multi-annual perspective9. Funding and technical assistance is also monitored by DG Enlargement, including the following instruments: -

TAIEX, helping partner countries become acquainted with, apply, and enforce, EU law; Twinning, assuring cooperation between Public Administrations of EU member states and of beneficiary countries; Grants supporting projects or organizations, which further the interests of the EU or contribute to the implementation of an EU programme or policy.

The EU enlargement, which always proved the thesis that the European Union has a transformative power, does indeed have a great influence on the geographical and strategic focus of the EU development policy. Some authors like Rehbichler (2006) and Lightfoot (2008) even evaluate - when the new EU members included former recipients of EU financial assistance - to what extent they have been able to undertake the mental reorientation from a “receiver country” to a “donor country”. DG ECHO – Humanitarian Aid and Civil Protection provides humanitarian assistance based on the principles of humanity, neutrality and independence. ECHO’s humanitarian aid is distributed without regard for any political agendas, and without exception seeks to help those in the greatest need, irrespective of their nationality, religion, gender, ethnic origin or political affiliation. With regard to its civil protection mandate, DG ECHO encourages and facilitates the cooperation between the 31 states participating in the Civil Protection Mechanism and Financial Instrument (the 28 EU member states, Norway, Iceland and Lichtenstein) in order to improve the effectiveness of systems for the prevention and protection against natural, technological or man-made disasters. The Civil Protection Mechanism is operated by the Monitoring and Information Centre (MIC), which has been part of ECHO since early 2010 9

See http://ec.europa.eu/enlargement/index_en.htm

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- when the appointment of Kristalina Georgieva as the first European Commissioner for International Cooperation, Humanitarian Aid and Crisis Response reinforced the coherence of EU response operations. One of her priorities was to develop a European Emergency Response Centre based on the existing MIC, and the ECHO Crisis Room, for humanitarian crises. The new Centre, which was created in 2013, will further strengthen the EU disaster response capacity. The European Commission spends annually more than 1 billion euro on humanitarian assistance. Since 1992, it has financed and coordinated humanitarian operations in more than 100 countries outside the EU. However, institutionally, the European Commission’s task in the development field is complicated by the fact that its staff is too small for administering such a huge policy sector.

European External Action Service (EEAS) The EEAS was established by decision of the Council of Ministers on 26 July 2010, based on a proposal by High Representative Catherine Ashton. It was formally launched on 1 January 2011. With the establishment of the EEAS, Europe’s stance in the world was supposed to become more coherent, effective, and visible, finally leaving behind the long-standing divide of the foreign and security policy and the European Commission’s portfolios “development” and neighborhood” (Tannous, 2013). From a development perspective, the European External Action Service (EEAS) was designed to play a role in shaping strategy and in programming development-cooperation for all regions of the world. The stated intention was to improve the links between development and foreign policy and to combine the European Commission technical expertise with the Council’s political weight, thereby enhancing the EU’s global role (Faure, Gavas and Maxwell, 2013). The EEAS brought the opportunity to add development to the “tool box” of European foreign policy under a more comprehensive approach. Working closely with the member states, the new diplomatic service assured also more coherent links among diverging stances. Given that member states are generally reticent to allow the EU to coordinate or control their development policies, the EEAS assumed some strategic competencies by placing itself nearer to the member states. The first act of the external action service was the coordinated response to the 2010 Haiti earthquake.

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European Investment Bank The EIB, as the European Union’s long-term financing institution, is active both inside and outside the EU. Outside the EU, the EIB lending is governed by a series of mandates from the EU in support of development and cooperation policies in partner countries. The current external mandates of the EIB include: ƒ Southern and Eastern Europe10 ƒ Neighborhood policy - The Mediterranean neighborhood11 - Russia and Eastern neighborhood12 ƒ Development and cooperation countries - ACP13 (and OCT) - South Africa - Asia and Latin America The EIB financing facilities are complemented by technical assistance provided by a team of expert economists, engineers and specialists. The project-related technical assistance contributes to improving the quality of lending operations throughout the project cycle and enhancing their development impact. Recently, the EIB had to significantly step up its lending in order to address the economic and financial crisis in Europe, but it did not lose sight of its role in supporting EU external policies and developmentcooperation objectives. The EIB continued indeed to work around the world in supporting local private sector development; the formation of critical social and economic infrastructure; climate changes mitigation; and regional integration. In 2013, the lending volume for non-EU countries was EUR 7.6 bn for a total number of 102 projects.

10

EU candidate countries (FYROM, Iceland, Montenegro, Serbia, Turkey) and potential candidates (Albania, Bosnia-Herzegovina and Kosovo) 11 Algeria, Egypt, Gaza/West Bank, Israel, Jordan, Lebanon, Morocco, Syria, Tunisia, Libya 12 Ukraine, Moldova, Armenia, Azerbaijan, Georgia 13 Table 2-3 presents the 79 ACP countries.

EU Development-Aid Policy and the Rise of Emerging Donors

Table 2-3: The ACP countries AFRICA (48) Angola Benin Botswana Burkina Faso Burundi Cameroon Cape Verde Central African Republic Chad Comoros Congo (Brazzaville) Congo (Kinshasa) Djibouti Equatorial Guinea Eritrea Ethiopia Gabon Gambia Guinea Bissau Ivory Coast Kenya Lesotho

Liberia Madagascar Malawi Mali Mauritania Mauritius Mozambique Namibia Niger Nigeria Rwanda São Tomé and Principe Senegal Seychelles Sierra Leone Somalia South Africa Sudan Swaziland Tanzania Togo Uganda Zambia Zimbabwe

CARRIBEAN (16) Antigua and Barbuda Guyana Bahamas Haiti Barbados Jamaica Belize St. Kitts and Nevis Cuba St. Lucia Dominica St. Vincent and Grenadines Dominican Republic Suriname Grenada Trinidad and Tobago

Cook Islands Fiji Kiribati Marshall Islands Micronesia Nauru

PACIFIC (15) Niue Palau Papua New Guinea Samoa Solomon Islands Timor-Leste

Tonga Tuvalu

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40

The value and number of operations by region is presented below in Table 2-4, which shows that more than half of the operations signed were in the ACP and pre-accession regions. Some operations are multi-regional; hence the sum of projects by region is greater than 102. Amounts signed are pro-rated region. Figures in this table do not include the EFTA countries (inclusion brings total non-EU lending to EUR 7.7 bn). 2013 was the year when the EIB celebrated 50 years of fighting poverty and supporting development and economic growth in the ACP regions. Table 2-4: Number of EIB operations by region in 2013 Region ACP Pre-accession EAST ALA MED Total

Number of operations 30 26 20 16 16 102

Value in EUR 988 m 2958 m 1240 m 583 m 1805 m 7573 m

Source: Author’s processing, with data extracted from EIB (2013), http://www.eib.europa.eu/attachments/country/eib_rem_annual_report_2013_en.pdf, p.7.

Appraisal of EU development cooperation effectiveness The EU has always been a leader of the international community’s efforts to support the less developed countries, and it has been the most successful at fulfilling its commitments - notably in terms of market access and official development assistance (ODA). Table 2-5 illustrates that the EU DAC members14 represent the highest percentage in the world regarding development assistance. The EU is the world’s largest donor of ODA, collectively providing EUR 55.2 billion in 201215.

14

Table 2-6 presents the 29 DAC members. http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/EN/foraff/13 7320.pdf 15

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Table 2-5: Top Official Development Assistance (ODA) donors in the world (in percentage) - Year 2012 Region European Union United States Japan Canada Australia Others

% 51 24.2 8.4 4.5 4.3 7.6

Data source: Organization for Economic Cooperation and Development (OECD)

Table 2-6: DAC members Australia Austria Belgium Canada Czech Republic Denmark European Union Finland France Germany

Greece Iceland Ireland Italy Japan Korea Luxembourg The Netherlands New Zealand Norway

Poland Portugal Slovak Republic Slovenia Spain Sweden Switzerland United Kingdom United States

Source: OECD: http://www.oecd.org/dac/dacmembers.htm

However, the aid directed to the LDC is not always as effective as desired due to a lack of coordination, overly ambitious tasks, unrealistic budget constraints, or because of political reasons. There are some factors that undermine the effectiveness of the EU development-aid policy and are worthy of discussion. First of all, there is the persistence of separate member states’ development policies; given their unwillingness to surrender the policy instruments in the international sphere. Most member states want to maximize their own international influence while also benefiting from the European Union collective effort. In the case of development assistance in particular, most member states have specific preferences and agendas that are best pursued individually than collectively, according to Dinan’s (2005, p.549) remark, which is still valid. Even the last Cotonou Agreement is a “mixed” one, because the member states are also signatories of the agreement in their own right.

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The preferential treatment of the ACP countries under successive treaties contributed indeed to the diversification of ACP exports and in reducing their dependence on the colonial pattern of trade. Nevertheless, as Table 2-7 reveals, the share of the AAS (the former French Associates), while increasing slowly during 1958-1963, declined then steadily during Yaoundé I and Yaoundé II Conventions. Table 2-7: Imports and Exports of the EC from AAS (1953-1975) Periods

Duration

Colonial Rome Treaty Yaoundé I Yaoundé II

1953-1957 1958-1963 1964-1969 1970-1975

% of EC Imports from the AAS 71.90 71.30 66.30 60.30

% of EC Exports from the AAS 63.30 67.80 62.10 59.50

Source: IMF and Moss (1982)

The obvious decreasing tendency of AAS exports to the EC is explained in principle by the decolonization process, characterized by significant structural changes in the African countries export sectors and by permanent attempts to set up and develop their export industries and to diversify geographically their international trade. Then, the reduction of the EC Common External Tariff - CET (a consequence of EC compliance with successive GATT rounds on multilateral tariff negotiations) under the Yaoundé I Convention, and its eventual elimination under Yaoundé II, caused an increase in EC imports from other suppliers of competing commodities like the United States and Latin American countries – whose competitiveness in EC markets was hampered by the CET constraint (Sissoko, Osuji and Cheng, 1998). Over more than two decades of Lomé Conventions, the ACP countries witnessed a halving of their share of EU imports (see Table 2-8). The influence of the GSP upon non ACP LDCs was also very low (Langhammer and Sapir, 1987). It reflected a deterioration of the LDCs international competitiveness, determined by overvalued exchange rates; inadequate financial services; capital shortages; poor infrastructure; and human capital. The GSP scheme failed to attain its goals for being too complex and restrictive. At the same time, the inclusion of all the LDC countries in the scheme placed the ACP states in a disadvantaged competitive position.

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Table 2-8: LDC share of EU imports (%) Countries

1976

1980

1985

1990

1992

1994

2003

ACP Asia Latin America Mediterranean All LDCs

6.7 4.2 5.3

7.2 5.9 5.1

6.7 6.5 6.5

4.7 11 4.6

3.7 13.6 5.1

2.8 13.1 5.4

3.3 15.3 4.1

6.1 44.8

6.1 42.4

8.1 34.7

6.5 31.2

6.2 29.2

6.1 34.2

7.3

Source: Adapted from Eurostat

The EU’s relations with the heterogeneous and economically diverse ACP countries have never been easy. In addition, negotiations of Lomé Conventions were complicated in the recessionary 1970’s and economically uncertain 1980’s. By the end of the 1980’s, the increasing involvement of Brussels in Central and Eastern Europe led to a lower implication in the Third World. Meanwhile, with the Cold War over, EU member states began to demand democratization and good governance in Third World countries “instead of merely using such rhetoric to disguise support for authoritarian, anticommunist regimes” (Dinan, 2005, p. 551). At the same time, the process of liberalization and globalization rendered the trade aid assistance even less effective than in the past. The Youndé and Lomé Conventions contributed indeed to strengthening the commercial relations between the EU and ACP states, but as McCormick (2008) comments, there were many problems as well: few ACP countries saw economic growth (and in some, economic prospects actually worsened); imports to the EU from other parts of the world grew more quickly than those from ACP states; EDF funds took too long to be disbursed and were relatively small when divided up seventynine ways; too little attention was paid to the environmental implications of the focus on cash crops for export; and the program neither helped address the ACP debt crisis. A problem for the ACP countries was the fact that free trade was not allowed, regarding agricultural products competing with CAP, although tariffs were smaller than for similar products from non-ACP countries. Under Lomé I, a system known as STABEX was introduced, which compensated for loss of revenues of ACP countries' exports to the EU from their major products if greater than 2% of average earnings over the previous four years. A similar system was introduced for minerals known as SYSMIN under Lomé II. As prices have generally been rising the

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systems have not always had the effect desired by the ACP countries and the systems have discouraged diversification. The Cotonou Agreement lasts till 2020 when, theoretically, a renewal would not be necessary, but probably many of the LDCs will still need assistance. While the Cotonou Agreement is a more flexible structure than previous conventions, it was criticized as well (see Arts and Dickson, 2004), because it abandoned the preferential trade agreements and it is less innovative; the EU development-aid policy at present is less of the model it once was and has become more symbolic. It seems that, about fifty years after decolonization, most of the LDC remain exporters of primary products and importers of European manufactures, and dependence still characterizes the economic relationship between the LDC and the EU. The Yaoundé and Lomé Conventions benefited the European states by allowing them to have greater access to the ACP countries - as sources of raw materials - as well as market outlets for their manufactured products, but this obviously impeded the necessary structural transformation of the third world economies. A difficulty confronted at present by the EU budget support in developing countries, is their lack of public financial management and domestic accountability. A study of the Directorate-General for External Policies of the European Parliament (2010) - analyzing Ghana, Burkina Faso and the Dominican Republic - finds that the parliamentary budgetary oversight is weak and is not yet systematically integrated at policy level, receiving only limited EC support. The effectiveness of the European budget support would be considerably higher with the improvement of the national control mechanisms of the developing countries. At the same time, it seems that even donor agencies are not sufficiently adapted to developing countries’ systems of governance. Four notable international events were devoted to analyzing and improving the development cooperation: the High Level Forum on Aid effectiveness held in Rome (2003); Paris (2005); Accra (2008); and Busan (2011). The Paris Declaration on Aid Effectiveness (2005) is especially important because it sets up precise partnership commitments as regards five central pillars: alignment, harmonization, managing for results and mutual accountability. Box 3 contains the fundamental principles established by the Paris Declaration for making aid more effective. However, there is a gap between policy and practice, as different OECD Reports16 show when analyzing progress in implementing the Paris 16

For example, OECD (2012).

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Declaration. Even though the “Ownership” pillar promotes the aid recipients’ capacity to autonomously decide their policies, Europe is still involved in the policy process of aid recipients. Box 2-3: The five pillars of the Paris Declaration (2005) and their fundamental principles Ownership: Partner countries exercise effective leadership over their development policies, and strategies, and co-ordinate development actions. Alignment: Donors base their overall support on partner countries’ national development strategies, institutions, and procedures. Harmonization: Donors’ actions are more harmonized, transparent and collectively effective. Managing for results: Managing resources and improving decisionmaking for results. Mutual accountability: Donors and partners are accountable for development results. Then, the Accra Agenda for Action (2008) set the program for an accelerated advancement towards Paris targets, whereas the Fourth High Level Forum on Aid Effectiveness (Busan, 2011) marked a turning point in international discussions on aid and development, because it established for the first time an agreed framework for development cooperation, and embraced traditional donors, such as the South-South cooperators and the BRICS. The following section is dedicated to the emerging donors and their challenge for EU development aid policy.

The challenge of the emerging aid donors In recent years, as rapid economic growth by many major developing countries has led to a greater role in international affairs, the South-South Cooperation (SSC) - which is based on solidarity, shared experiences, and the self-reliance of the South (Yamoussoukro, 2008) - has become more prominent. Countries that were aid recipients until recently are emerging from the background of the development stage and are affirming themselves as new donors, or the so-called “non-DAC” development actors; countries such as India, Brazil, China or Saudi Arabia. These big developing states are promoting diverse approaches of developmentcooperation, and are shaking up the world of aid; challenging Europe’s leadership and global weight; and calling for a need to adjust and rethink the EU development-aid policies.

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India India was the largest recipient in history, receiving about $55 billion in foreign aid in the interval 1951-199217. Even at present, within the BRICS, this country is by far the leading receiver of ODA. India is now on the verge of setting up its own aid-giving body. The institutional framework of India’s development-aid and trade policy towards Africa was set up in Delhi in 2008, and then, the final declaration of the 2011 Africa-India Forum Summit established areas of cooperation in science, technology, R&D, social development, capacity building, health, culture, sports, infrastructure, energy-environment and media-communications.18 India’s structure of development aid implementation is rather confusing, as it has a number of different ministries and governmental institutions involved in executing foreign aid. The recent trends that coalesced to propel India into the donor category include: first, geopolitical reasons and India’s quest for regional power; the aim of permanent membership in a restructured UN Security Council; and India’s growing middle class and entrepreneurial abilities, which created an enormous appetite for energy sources. India’s aid allocation is motivated by commercial and political interests. Unlike the European traditional donors, India is less interested in the normative discourse, or the democratic process, of the needy countries and is more concerned with the gains of the relationship. Fuchs and Vadlamannati (2013) found out that the importance of political interests is significantly larger for India (as a state eager to assert its international position) than for all the DAC donors; moreover, countries that are geographically close are favored, and countries at a similar developmental stage are more likely to enter India’s aid program, proving that the SSC has a large intra-regional component. Figures about India’s development assistance are not easily available, since it does not report its aid flows to the DAC – ‘the donors’ club’, established within the OECD (taking into account that India does not belong to the OECD). Exact figures are also difficult to find because aid engagement is very often inter-twined with bilateral trade, and private sector involvement. At any rate, the Indian development assistance stretches from the Pacific islands to Central Asia and Southeast Asia. The countries receiving substantial amounts of aid include Senegal, Tajikistan, Ethiopia, Vietnam and Kampuchea. In 2004, India loaned more than US$ 400 million to Brazil, Indonesia and Burundi under the IMF Financial 17 18

According to The Economist, 13 August 2011. See http://www.au.int/en/summit/AfricaIndia

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Transaction Plan. In 2007-2008, India’s development assistance under the MEA19’s jurisdiction reached US$ 420 million; 20% higher than the previous year’s figure20. Some figures reflecting the trade between India and Africa are very suggestive for India’s growing economic ties with the less developed countries. The total trade with Africa increased from US$ 1 billion in 1990 to US$ 36 billion in 2007-2008, and the sum dropped to around US$ 32 billion in 2010-2011 on the background of the global economic crisis. As India has continued its rapid rhythm of economic growth, it has become one of the leading global consumers of energy, while Africa has become one of its main energy sources (Freitas and Mah, 2012). India’s role as a supplier of development assistance to other countries is far less known, but it is slowly becoming a significant donor and will possibly, in the following years, also become a net exporter of aid.

Brazil A country like Brazil, which is still contending with poverty at home especially in the rural north-east - knows the less developed states’ challenges first hand and can tailor support to rural needs. Brazil’s institution for international development is the “Agência Brasileira de Cooperação” (ABC), established in 1987; it is committed to organize both international cooperation and internal development with foreign policy approaches. The ABC is subordinated to the Ministry of Foreign Relations and is divided into several units. As in India’s case, the figures outlining the total amount of foreign aid are difficult to obtain. Estimates vary from US$ 362 million up to 1 billion per year (Directorate-General for External Policies, European Parliament, 2012). According to the Brazilian Institute for Applied Economic Research, overall, Brazilian foreign aid is about $ 1 billion per year. Even if Brazilian cooperation deals with far smaller sums of money than Western aid, what is certain is that Brazil’s total development budget has been constantly increasing in recent years. As one of the world’s biggest agricultural producers, Brazil’s aid focuses on in-kind food donations. Other areas of Brazil’s support for poor countries are health, and professional and vocational training. Most of Brazil’s development aid goes to Mozambique, East Timor, Guinea19

Ministry of External Affairs Special Report on South-South Cooperation 2010, available at http://www.realityofaid.org/wp-content/uploads/2013/02/ROA-SSDC-SpecialReport6.pdf 20

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Bissau and towards countries from Latin America and the Caribbean, including Haiti, Paraguay and Guatemala. 50% of the multilateral aid goes to the regional organization Mercosur (Argentina, Brazil, Paraguay, Uruguay, and Venezuela)21, and the Inter American Development Bank (World Bank 2011, p. 20). Here are some examples of Brazil’s initiatives: Bolsa Familia, a Brazilian welfare scheme financed with Brazilian government money, is a successful post-earthquake activity in Haiti; in Mali, cotton yields are soaring at an experimental farm run by Embrapa, a Brazilian research organisation; and Oderbrecht, a Brazilian firm, is building most of Angola’s water supply. Brazil also has strong political reasons for its strategy in becoming a donor country. A political objective is to increase Brazil’s influence in developing countries, particularly in Latin America and Africa. This is part of the consolidation of Brazil’s international leadership vis-à-vis nations of the so-called global South. Another objective is linked to its aspiration to achieve a permanent seat on the UN Security Council. Then, there are the commercial reasons, which could be demonstrated by the following example: Brazil is the world’s most efficient ethanol producer and intends to create a global market in this green fuel. But being the world’s unique real supplier, this objective is hard to be attained. If the ethanol technology is spread to poor countries, new providers will be created and the chance of a global market will be boosted, and business opportunities will appear for Brazilian firms. Brazil’s behavior in the development cooperation is not that of a donor, which implies a hierarchy; its cooperation is different, horizontal between partners and is based on a commitment to solidarity. Even though Brazil is generally considered to comply well with EU principles of democracy and human rights, its foreign development projects do not involve political conditionality. However, in the realm of development aid, Brazil is an example of how a new power is seeking to learn from the past, and do things differently.

China China’s external assistance includes grants; interest-free and preferential loans; cooperative and joint venture funds for aid projects; science and

21

Brazil is the largest stakeholder of Mercosur, generating 75.5 % of Mercosur’s GDP (IMF, Economic Outlook 2011).

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technology cooperation; medical assistance; and concessional loans provided by Eximbank (Export and Import Bank of China). Data about the volume of Chinese foreign aid are not easy to be accessed. China is not a DAC member, so it is not obliged to offer any statistics concerning its donor activities. Some figures can be found only in the budgetary governmental expenditures, or may be extrapolated from the recipient countries statistics. Various sources, such as De Haan and Warmerdam (2011), have put the volume of Chinese aid somewhere between US$ 1 billion and 3 billion annually, with aid to Africa at about one-third to one-half of that. China’s commitment to Africa is marked by the 2006 Forum on ChinaAfrica Cooperation (FOCAC). The Chinese foreign aid and trade policy towards Africa is implemented through the FOCAC. In this respect, there is a separation of attitude from the DAC countries, as the latter do not mix foreign aid with trade policy - considering that aid should not be driven by commercial interests. However, a well-documented empirical analysis undertaken by Dreher and Fuchs (2011) does not support the idea that China puts greater weight on giving aid to countries with strong commercial ties, nor to countries that are more abundant in natural resources, in comparison to other donors. Instead, political reasons could be identified for their donor activities. For example, countries that vote in line with China in the UN General assembly, and do not recognize Taiwan’s independence, receive larger aid shares. China’s aid policy is based on the belief that recipients’ development contributes to China’s development, and vice-versa. The aid is generally explained as benefiting both governments. China dismisses the concept of “charity”, stressing instead the idea of “friendship”. The challenges addressed by China in the global development cooperation are represented by: 1) motives and objectives of its development-aid activities; and 2) impact of China on the dominant development agenda. China’s provision of development aid is part of its articulation, and is a demonstration of its rising economic power. The global development dynamic is affected by China’s involvement, because it offers new opportunities for developing countries and determines the traditional Western donors to treat them on new terms, and not just as poor aid recipients.

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Conclusions Cooperation with the less developed countries goes all the way back to the beginnings of the European Community. After achieving their independence, the ex-colonies wished to retain access to their commodities on the European market and their financial assistance. The Yaoundé and Lomé Conventions, and the Cotonou Agreement, were partnership agreements granting trade preferences to developing countries. The European Community was always engaged in an effort to expand trade with its associates through preferential treatments under successive treaties, in order to diversify LDC exports and to reduce their dependence on the colonial pattern of trade. As regards the institutional architecture of aid, the majority of EU countries have more than one institution devoted to development-aid policy, and an increasing number of donor agencies. However, this aspect can pose a problem for the EU in fighting the fragmentation of assistance and the proliferation of donors at the country level - the success of this endeavor being dependent on strong political will. EU countries also perform poorly in making their aid more transparent. In the institutional setting of the EU development-aid, the European Commission DGs and European External Action Service contributed to the coordination and harmonization of the member state policies, having undoubtedly a comparative advantage over national programmes. The EIB as well, along with efforts to address the economic downturn in Europe, did not cease to support development objectives outside the EU. However, there are some weaknesses in the effectiveness of the EU development cooperation. First, the unwillingness of member states to surrender development policy instruments impedes the coherence of European aid programmes. Then, the economic rewards, expected from Yaoundé and Lomé Conventions and Cotonou Agreement, are somewhat disappointing given that the LDC remain exporters of primary products and importers of European manufactures. The EU budget support in developing countries also faces their lack of public financial management and domestic accountability. The rise of the emerging donors indeed helps to offset the slowdown in aid from traditional donors, but creates a more complex tapestry of interests in the field of development-cooperation, which is more and more permeated by competition. Even the emerging donors compete with each other for soft-power influence in the developing world. The new aid providers come with an international identity that is different from traditional Western donors and traverses the North-South divide.

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Some consequences of the new donors’ activities for the West are worth being stressed. Western countries governments consider that, if emerging markets are to become more influential, Brazil – stable, democratic, and at peace with its neighbours – looks more attractive and tractable than, say, China or Russia. It seems that Western donors worry less about Brazilian aid than they do over China’s, which they think fosters corrupt government and bad policy (The Economist, July 15th, 2010). In addition, China’s desire to avoid association with traditional donors leaves little room for significant collaboration. Benefiting from a new international division of labor and the liberalization of global trade and financial markets, developing countries like India, Brazil and China - animated by immediate commercial gains bring alternative models of development cooperation which challenge the aid regime. They adopt a non-interventionist approach regarding local political practices. The SSC is not guided by specific value sets and does not impose conditionality or political reforms. By contrast, the complexity of the EU aid system is prone to putting severe strains on the partner countries. In these conditions, the EU is confronted with the provocation of taming and downgrading the norms of conditionality created for the aid recipients. Its normative position is threatened by the business-oriented perspective of the emerging donors, which will undoubtedly trigger unmistakable strains, if not a scaling down of European ambitions and principles.

CHAPTER THREE EU SANCTIONS IN THE POST-SOVIET SPACE DIRK LEHMKUHL AND MARIA SHAGINA

Summary While for the longest time in its history the gap between the expectations towards the European Union (EU) - as a powerful player in the world economy - and the EU’s capability to enact a concomitantly strong role in world politics has been a marked feature in the EU’s existence, things have changed over the past decades. The EU has increasingly assigned more attention to its role in international politics. What is more, the EU has started to complement the toolbox of its “soft power” polity with harder instruments, including restrictive and coercive measures. Being part of a comprehensive policy approach involving political dialogue and complementary efforts, sanctions have become one of the EU's tools to foster the objectives of the Common Foreign and Security Policy (CFSP), that is peace, democracy and the respect for the rule of law, human rights and international law. With its reference to both democratic sanctions (that is sanctions meant to prevent backsliding of democracy and to encourage respect for liberal democratic governance practices) and security sanctions (that is either breaches of international law or, more general, practices that represent a risk for the EU and the international community), the EU utilizes this tool as a means to change the behavior in targeted countries. Overall, the EU sanctions policy goes consistently in line with the UN restrictive measures. However, as new emerging actor on the international arena, the EU tends to impose autonomous sanctions as well. Beyond the sanctioning instruments of the UN, the tools of the EU vary in the range of sanction types from arms embargoes, visa and travel bans, to assets freezing. Different types of EU sanctions and diverse scope are already in place – from comprehensive coercive measures for Belarus and Syria, to narrowly targeted sanctions for Egypt and Tunisia. Some sanctions, for

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example, such as arms embargoes or travel bans, are implemented directly by member states after the member states agree thereupon in the Council. Other sanctions, for instance, economic measures such as asset freezes or export bans, fall under the competence of the Union. With a separate implementing legislation in the form of a Council regulation they are directly binding on EU citizens and businesses. While for most of the time there had been no geographical focus of EU sanctions, the eastern enlargement of the EU in general, and both the new neighborhood policy and the eastern partnership in particular, have made countries in the EU’s direct neighborhood - and its near abroad - a more frequent target of sanctions. With the objective to gain a systematic understanding of the sanctioning policy towards countries in Eastern and Central Europe, this chapter provides an overview of the history and development of EU sanctions in general, and a typology of sanctions in particular. We then address three different stages in the process of sanctioning. In the first stage, we look more closely at the decision to sanction, and to the choice of measures. In the second stage, our focus is on the actual implementation of measure agreed upon by the member states, including attention to the costs of capacity-building for sanctioning. In the third stage, finally, we pay attention to the institutionalization of the means of monitoring of the effects of the EU’s sanctioning instruments. We claim that with a closer look on the design, implementation, and monitoring of sanctions we gain an encompassing picture of both the EU’s internal politics of sanctioning, and its relationship to its neighboring countries in Central and Eastern Europe.

Introduction It is analytically challenging to accommodate the well-described expectations-capabilities gap of the EU (Hill 1993, 1998), with the observation that sanctions have become the EU’s most favourite foreignpolicy tool (Gebert 2012). Why so? Because issuing and implementing sanctions in the European multilevel polity is a demanding enterprise as it implies to integrate the established interests, interdependencies, and policies of the Member States into a common European position that aims at changing the behavior of an identified target entity. But at least in the case of sanctions, in the context of the Ukrainian-Russian conflict, this is obviously what is happening. While for the longest time in its history the gap between the expectations towards the EU as a powerful player in the world economy

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and the EU’s capability to enact a concomitantly strong role in world politics had been a marked feature in the EU’s existence, things have changed over the past decades. Not only has the EU has increasingly assigned more attention to its role in international politics. What is more, the EU has started to complement the “soft power” toolbox with harder instruments, including restrictive and coercive measures. Being part of a comprehensive policy approach involving political dialogue and complementary efforts, sanctions have become one of the EU's tools to foster the objectives of the Common Foreign and Security Policy, that is peace, democracy and the respect for the rule of law, human rights and international law. With its reference to both democratic sanctions (that is sanctions meant to prevent backsliding of democracy and to encourage the respect for liberal democratic governance practices) and security sanctions (that is either breaches of international law or, more general, practices that represent a risk for the EU and the international community), the EU utilizes this tool as a means to change the behavior in targeted countries. However, the effectiveness of this “favourite foreign policy tool” has repeatedly been questioned (e.g. Lange 2012; Portela 2014 Schmitz 2009). Rather than reiterating the concerns about the effectiveness of the EU’s policies that dominate large portions of the literature, we opt for a different focus in the present context. Our interest relates to the aforementioned challenge, and addresses the question: what can the politics of sanctions tell us about the EU? Although we may well touch upon flaws and shortcomings across different sanctions regimes, the overall objective of this chapter is a different one. First of all, we want to provide an answer to the question of what we can learn about the EU itself. We therefore shift the perspective on EU sanctions policies, from the focus on effectiveness, to the dimension of EU internal politics. By studying its sanctions policies we seek to systematically identify cleavages between the Member States in the politics of sanctioning. In empirical terms, our focus is on sanctions regimes in post-Soviet countries. This choice is in accordance with the observation that in its sanction policies the EU is mainly concerned with its role as regional power (Kreuz 2005: 19). In particular the eastern enlargement of the EU in general, and both the new neighborhood policy and the Eastern Partnership in particular, have made countries in the EU’s direct neighborhood - and its near abroad - a more frequent target of sanctions. With the objective to gain a systematic understanding of the sanctioning policy towards countries in post-Soviet countries, this chapter proceeds as follows:

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After the development of some conceptual considerations on the analytical focus of our study, we address four cases (Belarus, Moldova/Transnistria, Uzbekistan and Ukraine/Russia). In each case, we present the general context, the sanction regime, and the position of the Member States. The objective is to take a closer look at the design, implementation, and monitoring of sanctions, in order to gain an encompassing picture of the EU’s relationship towards post-Soviet countries. What is more, we want to interpret the EU’s internal politics of sanctioning with regard to the question of the EU’s capacity to overcome fragmented interests between its member states. By so doing, we contribute to the discussion of how the EU, as a multilevel polity, does - or does not - entail the capacity to enact a credible foreign policy in a globalized world.

The European Union and its sanction policies What are sanctions? How are sanctions enacted in the EU? What can we learn from the politics of sanctions in the EU? These three questions guide our approach to understanding the EU sanctions regimes. We will ask the questions in turn within the following: Generally, sanctions may be defined as “politically motivated penalties imposed as a declared consequence of the target’s failure to observe international standards, or international obligations, by one or more international actors (senders) against one or more others (targets)” (Giumelli 2011: 16). This broad definition has a number of advantages: (i) it allows for the incorporation of the more recent shift in the design of sanctions - from blanket or general sanctions against entire countries, to targeted or smart sanctions that put pressure on political leaders or elites of a country; (ii) it enables different foci - be it on the design of sanctions or be it on their impact; and (iii) it indicates that not only targets, but also senders, might involve a variety of appearances, ranging from unilateral to multilateral. While issues especially related to the first two aspects have been substantially and extensively addressed1, we focus on the third aspect. This does not imply that senders, or the relationship between different senders, have not been analyzed (see for many others e.g. Kreuz 2005, Giumelli 1

See for instance Druláková et al. 2010; Portela 2010; Guimelli 2011; Lehne 2012, Esfandiary 2013, Biersteker and Eckert 2009, Kryvoi. 2007, Portela and Raube 2012, Eriksson 2010, Wouters and. Burnay 2013, de Vries 2002, de Vries and Hazelzet 2005.

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2011). In particular both the embeddedness of the EU sanctions into the framework of the UN sanctions, and the relationship between sanctions from the EU and the USA, has gained attention (see for many others e.g. Portela 2010, Esfandiary 2013). However, concerning the question ‘what can we learn from the sanction policy-making about the EU itself’ there is still some mileage to gain. So what is the EU’s ‘take’ on sanctions, and who is in charge? The EU interprets sanctions - very much in accordance with the above definition - as restrictive measures against third countries, entities or individuals. At best, restrictive measures should be integrated into a comprehensive EU foreign policy strategy promoting peace, democracy and the respect for the rule of law, human rights and international law. EU sanctions may either implement sanctions imposed by the UN or they may reinforce these by applying stricter and additional measures. Over the past decade, the EU increasingly imposed sanctions autonomously in accordance with Article 215 TFEU and Article 75 TFEU. In principle, there are two ways to enact sanctions. According to the first, the CFSP Council adopts decisions on EU restrictive measures with unanimity. While some decisions might require additional legislation to give full legal effect to the sanctions, others are directly binding on EU member states. This holds in particular for arms embargoes or travel bans that are implemented directly by Member States. The second modus to enact sanctions relates to those areas that fall under the competence of the Union. In particular with respect to economic measures, such as asset freezes or import and export bans, a separate Council regulation binds the EU citizens and businesses directly. According to Art 215 (1) the TFEU, Council decides with “qualified majority on a joint proposal from the High Representative of the Union for Foreign Affairs and Security Policy and the Commission, shall adopt the necessary measures. It shall inform the European Parliament thereof.” The regulation, adopted on the basis of a joint proposal from the EU High Representative for Foreign Affairs and Security Policy and the European Commission, contains the details on the precise scope of the measures decided upon by the Council and their implementation. While Article 215 TFEU refer Part V of the TFEU on the Union’s external action, Article 75 TFEU allows for the adoption of measures necessary to achieve the objectives of the Area of Freedom, Security and Justice (Elsuwege 2011: 493; also the Council of the European Union - Press Office. 2014, Missiroli 2010). Here, the Commission proposes a measure for a Council Regulation and the Council votes with a qualified majority. From an EU internal perspective, the EU legislation has some advantages in comparison to national legislation. For

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instance, the domestic room for interpretations is smaller, and so are the risks of distortions of competition in the common market (Druláková et al. 2010:110). This takes us to our third question on ‘what we can learn about the EU itself by addressing its sanction policies’. As has been mentioned, EU sanctions have been studied with quite a range of different interests, with the focus on their character, effects, and efficiency, certainly having the largest share. In this context, contextual external factors, such as the embeddedness of the EU sanctions into the UN sanctions - or the alignment of different international sanctions parties, especially the EU and the USA - have gained attention (see many of the aforementioned authors). For our purpose here, however, those studies that address the internal perspective are more relevant. For instance, Eckes identifies the treatment of sensitive information under the composite procedure that led to the adoption of the autonomous EU counter-terrorist sanctions becoming a critical issue. Composite administrative procedures combine decisions of national and EU administrative bodies into a binding decision. The risk is in these multilevel administrative procedures relate in particular to gaps in the protection of individual rights (Eckes 2012). Yet another set of findings that are of interest in our perspective relate to the relationship of different policy objectives. For instance, Del Biondo identified the interference of security, or economic interests, with the promotion of democracy as the main explanatory factor for EU inconsistency in democracy promotion (Del Biondo 2011: 382). This finding may be referred to what Nuttall labeled as “horizontal” consistency; as a consistency between the different policies of the EU. His typology comprises two further categories: “institutional” consistency, as a consistency between the two different bureaucratic apparatuses; and intergovernmental, Community, and “vertical” consistency, as a consistency between the EU and national policies (Nuttall 2001). In this context, two more recent contributions are of interest. With a focus on the institutional and horizontal dimension, Marangoni elaborates to the fact that the “Lisbon Treaty signals the importance attached to coherence: both the doublehatted position and its coherence mandate” (Marangoni 2012: 8). In contrast, Portela and Rabe address the vertical dimension and interpret the shift in the competences for sanctioning from national measures to Community legislation - since the post-Maastricht area - as an increase in vertical consistency and coherence. However, the persistent noncompliance of Member States remains the Achilles heel in this regard (Portela and Rabe 2012: 10pp).

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In what follows, we want to describe and analyse how a focus on the internal politics of the EU, as a multilevel polity, may help to understand the EU’s sanctioning policies towards countries in the post-Soviet space. As it is in this area, in its immediate neighbourhood, in which the EU has exercised its role as regional power quite extensively, we expect to find particular intriguing insights into the internal politics of vertical consistence, which is the position of the Member States, and how their respective interests play out in the design and implementation of EU sanctions.

EU sanctions policy towards post-Soviet countries In order to grasp the EU internal politics behind the design and implementation of the EU sanctions policies, we address four cases of EU sanctions towards post-soviet countries: Belarus, Moldova (Transnistria), Uzbekistan, and the ongoing sanctions in the Ukrainian-Russian conflict. Each case addresses three aspects. We start out by embedding the case into the historical and (geo) political context with the objective to report the premises for imposing a sanctions regime. We then scrutinize the design of the EU sanctions. As the sanctions regimes often evolve over time, we differentiate different episodes in the design of instruments in the respective country specific sanctions regime. In a third step, we address the EU internal politics and identify the positions of the EU member states. Our focus is on both the drafting and the implementation of the respective sanctions regimes.

Belarus Despite Belarus and the EU initially being engaged in cooperation negotiations after the recognition of Belarus as an independent state by the European Community in 1991, the relationship between Minsk and Brussels deteriorated after the rise to power of Alexander Lukashenko in 1994 – despite some noticeable areas of functional cooperation (see for contrasting assessments e.g. Korosteleva 2009; Bosse 2012). Since then, Belarus and the EU have experienced a longstanding history of sanctions regimes. Each regime was a reaction towards the curtailment of democratic rights and freedoms, and has been more stringent in its scope than the previous one.

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The sanctions regime The first package of sanctions was imposed in 1996, when in the wake of the new constitution president, Lukashenka, they were concentrated on large portions of the state authority around his position. As a reaction, the Council suspended the bilateral negotiations, for the Partnership and Cooperation Agreement, and withdrew its support from the country’s application for membership in the Council of Europe (Portela 2011: 9). The next round of sanctions followed after the diplomatic crisis over the Drozdy diplomatic residence. Due to renovations the embassies were cut off from water and electricity supplies, but the EU ambassadors claimed that it was an attempt to take over the whole diplomatic compound. After this incident, the EU accused the Belarusian government of being in violation of the Vienna Convention and imposed travel restrictions on members of the political elite. After Belarus fulfilled the Council’s demands, the sanctions were lifted (Kreuz 2005: 38). A third episode of EU sanctions started with the closure of the Advisory Monitoring Group (AMG) and of the Organization for Security and Co-operation in Europe (OSCE) in Minsk. In November 2002, the Belarusian authorities refused to prolong visas for the AMG members, which jeopardized the functioning of the OSCE representatives in the country. The EU imposed travel bans on the senior officials from the government. After the re-opening of the OSCE office in Minsk early in 2003, the sanctions were lifted. The next sanctions episode is bound to the 2004 fraudulent parliamentary elections and the disappearance of civil society activists. In 2006, the EU criticized the non-free and unfair presidential election and further expanded the list of travel bans and introduced asset freezes (Council Common Position, 2006/362/CFSP). In a Common Position, the EU condemned the arrest of peaceful demonstrators and adopted restrictive measures against president Lukashenka, and officials responsible for the violation of international election standards and international human rights law (Council Regulation 765/2006). In late 2006, in an attempt to invigorate the EU-Belarusian relationships, the EU presented a “non-paper” - i.e. an unofficial document, portraying the benefits of inclusion into the European Neighbourhood Policy (ENP) (Commission of the European Communities, 2006). The document detailed offers that the EU could provide to Belarus and listed conditions, which the Belarusian government should fulfill. Participation in the ENP opened up the perspective of visa liberalization; greater economic opportunities; and increased financial assistance - “as soon as the Belarusian government demonstrates respect for democratic values and for

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the basic rights of the Belarusian people” (Commission of the European Communities, 2006). The resilience of Belarus to comply with the EU demands was partly stipulated by Russia’s influence. Economically speaking, the population of Belarus was better off than the population in Ukraine or Moldova (Beichelt 2007). The country’s economy showed a steady increase in GDP and it profited from subsidized Russian gas. It made the regime resilient against the EU economic sanctions; the situation changed after the energy crisis in 2007. In order to impose more pressure on the Belarusian government to relinquish control over Beltransgaz, a gas transport company, Russia doubled the price of natural gas. As a result of deteriorated relations with Russia, Minsk turned back to the EU, underlining Belarus’ importance as a “transit country”. Soon after, “structured discussions” on energy were initiated by the European Commission. The Belarusian authorities were forced to make certain concessions: A European Commission Delegation in Minsk was opened, a privatisation programme was launched, and well-known political prisoners were released (Portela 2010). The 2008 parliamentary elections were monitored by a considerable number of OSCE observers. Although the OSCE election standards were not met, the EU continued its cooperation with the Belarusian government. Moreover, the Commission decided to suspend travel restrictions on blacklisted individuals for an initial period of three months, with the exception of the President of the Central Electoral Commission (Council Decision 2008). In March 2009, to encourage further dialogue, the Council extended the suspension of visa and travel bans until the end of the year. Despite lacking tangible progress, the EU was still ready to “deepen its relations with Belarus in the light of further developments in Belarus towards democracy, human rights and the rule of law” (Council of the European Union, 2009). The Council also welcomed the constructive participation of Belarus in the Eastern Partnership. However, the situation changed again after the severe crackdown of peaceful demonstrators during the 2010 presidential elections. The Belarusian authorities arrested about 600 individuals; seven presidential candidates were among them. Moreover, the OSCE mission was closed down after voicing its criticism towards non-compliance with international standards. As a consequence, the Council resumed travel restrictions and asset freezes on previously enlisted individuals, and added those who were responsible for electoral fraud and reprisal. During the same year, the Council significantly expanded the list. In June 2011, the Council imposed economic sanctions to 29 Belarusian companies and introduced arms

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embargos (Council Regulation (EU) No 588/2011). The enlisted companies were deprived from any access to the EU market and the EU companies were not allowed to purchase any military equipment from Belarusian producers. In February 2012, the Council introduced travel bans and asset freezes to another 21 individuals. In October 2013, the sanctions were reviewed again with further extensions due to the repression against the civil society and opposition (Council Implementing Regulation (EU) No 1054/2013). Last year, the restrictive measures were further extended until the next revision in October 2015 (Council Decision 2014/750/CFSP). Currently, 232 individuals, including Lukashenka and senior officials and 25 entities, are on the sanctions list. The position of the EU member states Inconsistent positions within the EU countries have been pronounced throughout different sanctions episodes. This holds for both the drafting and the implementation of the respective phases. Different positions of the EU member states became evident during the second episode of sanctions. Having launched the Eastern Partnership in 2008, the EU aimed to involve bordering Eastern countries in its new policy. Despite being exposed to the sanctions regime, Belarus was offered to participate in this initiative. This triggered talks on the loosening of the sanctions regime and opened dialogue with “the last dictatorship in Europe”. While some countries favoured further involvement with Belarus, others remained resistant as no progress in the human rights situation and/or in the release of oppositional leaders was achieved. "It's a moral dilemma. Nobody wants to let in people with blood on their hands but nobody wants to leave Belarus in a vacuum either," as an EU diplomat described the situation (EU Observer, 1 October 2008). Thus, Poland and Lithuania pushed for the re-opening of diplomatic ties with Belarus to prevent the country from further sliding into Russia’s influence. The Polish and Lithuanian diplomats preferred to see the relaxation of visa bans as a separate issue from the rigged elections and human rights situation. The new member states’ concerns were caused by Russia’s annexation of South Ossetia and Abkhazia. In their view, Belarus’ isolation could potentially lead to the recognition of Georgian enclaves as independent states by Minsk’s newly elected parliament (EU Observer, 30 September 2008). In contrast, while Germany held a neutral position, the Netherlands and Denmark strongly opposed any sanctions changes (EU Observer, 1 October 2008). The last sanctions episode might serve as an example of how the picture of different interests between the member states impacted on the

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actual design and substance of the sanctions. On the one hand, Germany, Poland, the UK, and Sweden, were the main initiators of more stringent sanctions after a number of failed dialogue rounds. Hungary’s foreign minister echoed the position of the Sweden foreign minister, Carl Bildt, saying that sanctions are “inevitable” (EU Observer, 7 January 2011). On the other hand, Slovenia, Latvia and Lithuania, amongst others, successfully scaled down the list of targeted companies. Initially, Slovenia voiced its strong opposition to the expansion of sanctions. Close economic ties with Belarus made the position of Slovenia so reluctant. One of the country’s large companies, the Riko Group, was deeply involved with a Belarusian tycoon, Yuri Chizh, who is close to the Lukashenka’s regime. The Riko Group had a contract to modernize the Belarusian electricity network (about € 54 million) and also to construct a new Kempinski hotel (about € 50 million) (Hyndle-Hussein and Klysinsky 2012). Afterwards, Latvia was trying to block newly designed sanctions as the country’s economy was heavily dependent on business with Belarusian companies. Lithuania also expressed its concerns but withdrew itself from direct blocking of the sanctions. Latvian and Lithuanian officials voiced their concerns too about the effectiveness of designed sanctions and future losses for the Baltic States. Due to Latvia’s lobbying, three petrochemical companies from the Triple Group, which belong to Yuri Chizh, were excluded from the sanctions list. For Lithuania, however, the EU made no exception; the country’s cement plant lost its Belarusian customers (Hyndle-Hussein and Klysinsky 2012). Italy also proved to be a supporter of the Belarusian regime in different sanctions episodes. In 2009, Rome was the only country offering Lukashenka an official visit with all diplomatic ceremonies. The same year, Silvio Berlusconi, visited Minsk as an official visit. Under his aegis, Italy opposed the EU trade tariffs imposed on the Belarusian regime (EU Observer, 7 January 2011). Also, Italy insisted on the permanent lifting of sanctions instead of its temporal suspension, in October 2011. Frequently, Italy was supported by Spain and Portugal. We find a similar pattern of opposing interests of the EU member states in the implementation of EU sanctions, too. In the early sanctions episode over the closure of the AMG, it first came to inconsistent position among EU member states. Portugal withdrew from the common EU policy against travel restrictions towards Belarus, undermining the effectiveness of the sanction regime as a whole (Eliseev 2012). Holding the OSCE chairmanship, Lisbon referred to the EU legislation that does not oblige a country to refuse entry into its territory if said country hosts an

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international or intergovernmental conference or meeting. Portugal’s exemption mitigated the strictness of EU sanctions; later, France used the same exemption to avoid the EU sanctions. In January 2012, the Interior Minister, Anatoly Kulyashou, was granted a visa entry to a conference at Interpol in Lyon. Even though he was on the blacklist, after violent crushes of peaceful demonstrations in 2011, neither the French government nor Interpol has explained the exemption (Gebert 2012: 3). A second example refers to sanctioned Belarusian companies that circumvented the ban from the EU market by re-registrating themselves in Latvia. It allowed them to avoid sanctions by concealing an original owner (The Guardian, 17 October 2013). Yet another example refers to inconsistencies written into the sanction regime due to the economic interests pushed by some member states. As case in this respect refers to the list of banned companies that did not comprise a core business on which the Belarusian regime hinged upon. Thus, Belneftegaz, a company specialised in trade of petrochemical products, was not sanctioned despite its large market share in the EU (the Netherlands mainly as the second largest importer from Belarus). Belarusian political activists demanded that firms that belonged to businessmen Nikolai Vorobey and Alexander Shakutin must be banned as well. By excluding them from the list, “the EU has given a huge lift to the Lukashenka regime, saving it from financial crisis much more effectively than Russian loans provided through EurAsEC Fund” (Report of the Working Group, May 2013: 19).

Moldova (Transnistria) After the dissolution of the Soviet Union, newly emerged republics went through a process of self-identification. So the Transnistrian region, a land strip of 10 km along the Nistru River, voiced its disagreement on the future unification with Romania and proclaimed the Dnestr Moldovan Republic. In 1990, fierce clashes took place between the Moldovan and Transnistrian Police Force for the control over municipal bodies in Dubasary. Intensified clashes renewed by 1992, where the Moldovan Police Force were trying to regain occupied municipal and administrative buildings, schools, police stations etc. During this stalemate between the Moldovan and Transnistrian forces, the 14th Soviet (de facto Russian) army entered the territory (Vahl and Emerson 2004: 6-7); it indicated a crucial moment for the entire military conflict. Several negotiation rounds on the conflict settlement took place, however, this proved to be rather unsuccessful. The agreement on the deployment of the international peacekeeping forces, under the auspices of the OSCE and the UN, were

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not reached due to Russia’s resistance. In July 1992, Presidents Snegur and Yeltsin signed an agreement on the allocation of Russian peacekeeping forces to restore law and order in the region (Portela 2010). From October 1994 onwards, there were many discussions on the withdrawal of the 14th army, but until now, Russia has been reluctant to withdraw its forces unconditionally. The created “frozen conflict” was further aggravated by a disagreement on fundamental issues between the Moldovan and Transnistrian leaderships. Numerous attempts to reconcile both positions over the constitutional settlement were undertaken. In February 2003, the Joint Constitutional Commission was launched to draft a new constitution co-authored together with Moldovan and Transnistrian leaders. However, due to fundamental differences over the constitutional settlement little progress has been made. Currently, the 14th army de facto controls the unrecognized Transnistrian territory. The sanctions regime Following the US, the EU decided to put more pressure on the Transnstrian leadership in solving the conflict. An adopted Common Position imposed restrictive measures on 17 leaders of the breakaway region. The introduction of travel bans proceeded after “the continued obstructionism of the leadership of the Transnistrian region” and aimed to encourage progress in the political settlement of the conflict (Council Common Position 2003/139/CFSP). In August 2004, additional sanctions were introduced due to the socalled “school crisis”. A closure of several Latin-script schools in the secessionist region and intimidation campaign against teachers, parents and students, triggered additional restrictive measures from the EU (Council Common Position, 2004). On the travel ban list, another ten individuals, responsible for the closure of Romanian-language schools, were targeted. By December 2005, the “school crisis” was solved and restrictions on travel were suspended. In February 2008, the Council imposed travel restrictions on the Transnistrian leadership (Common Position 2008/160/CFSP). Since September 2010, in order “to encourage progress in reaching a political settlement” (Council Decision 2010/573/CFSP) the Council has extended the sanctions but with temporal suspension. Being under constant examination, the Council possessed the right to re-impose the sanctions if required. In September 2012, the Council acknowledged the progress in the conflict settlement and removed sanctions against former President Smirnov, his sons, and ministers (Council Decision 2012/527/CFSP). In September 2013, the Council amended its previous decision by extending the sanctions and removing

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the suspension for a year (Council Decision 2013/477/CFSP). By the last Council Decision the restrictive measures were extended until October 2015 (Council Decision 2014/751/CFSP). In addition to the sanctions regime, the EU has implemented traderelated measures and has launched a series of confidence-building programmes. In September 2004, the EU introduced a double-checking system to establish the origin of steel production. As an effect, no steel production could be exported from Moldova to the EU without the Moldovan certificates. The introduction of this measure was meant to prevent steel export coming from the Transnistrian metal steel factory, Rybnitsa, without the supervision of the Moldovan authorities (Popescu 2006). Additionally, in November 2005, the EU Border Assistance Mission (BAM) was implemented to enhance security on the MoldovaUkraine border. The programme aimed to improve border control capacities and reduce illicit smuggling and trafficking. Enhanced border surveillance was also “expected to contribute to peaceful resolution of the Transnistrian conflict” (European Commission, October 2005). Generally speaking, the design and implementation of the sanctions regimes proved to be rather weak in achieving their goals. First of all, the imposition of travel bans on the Transnistrian leadership was very vague in formulation. The absence of conditionality for lifting restrictive measures imposed little pressure on the Transnistrian regime. Moreover, it was questionable to what extent the travel ban to the EU could influence Russian-oriented regime leaders. The sanction episode with the Latinscript schools was more effective as there were clear conditions formulated. Once the threat of intimidation was eradicated and the schools were reopened, the sanctions were lifted. Secondly, under the travel bans, key Transnistrian leaders were listed, including ex-president Smirnov and numerous ministers. However, the list was not exhaustive as it did not include key representatives of industries and business groups who supported the regime (Popescu 2005: 33). Thirdly, the credibility of sanctions was to a large extent influenced by the non-EU countries like Ukraine. The effectiveness of travel bans were diminished by the nonparticipation of Ukraine in these restrictive measures. At that time, Ukraine claimed to remain a neutral mediator in this conflict and did not comply with the EU sanctions regime. The position of the EU member states During the early 1990’s, the Transnistrian conflict kept a low-profile and did not raise any security concerns among the EU member states. Only in the run-up to the Eastern enlargement did the frozen conflict

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attract the EU’s attention. In July 2003, initiated by the OSCE, the EU started talks with NATO on sending a peacekeeping force (EU Observer, 15 July 2003). In fact, the Dutch foreign ministry was closely involved with the conflict settlement. Adriaan Jacobovits de Szeged, a Dutch diplomat, was appointed as the OSCE special representative on Transnistria and became an observer to the Joint Constitutional Commission (Popescu 2011, p. 44). Later, the EU launched negotiations with Russia on the subject of a subsequent withdrawal from the region. The EU diplomats warned against “long and difficult” negotiations (EU Observer, 16 July 2003). Therefore, even a partial withdrawal of Russian troops was considered to be a sufficient goal. The Italian presidency in the EU seemed to be a favourable platform for high-level talks with Russian diplomats (EU Observer, 16 July 2003). Nevertheless, Russia rejected this idea and the negotiations ended without any tangible success. Yet, a British diplomat acknowledged that “there is recognition within the EU of the need for greater engagement in Moldova” (European Security Committee, Eleventh Report, and Session 2004-2005). In March 2005, to strengthen its presence in the region, the EU appointed Jacobovits as the EU Special Representative on Moldova who strongly lobbied for a rearrangement of the peacekeeping format by pressing Russia. However, it met vehement opposition from Cyprus, Germany, Greece, Finland, France, Italy, Portugal, Spain, and Slovakia, joined by the then EU High Representative Javier Solana (Wilson and Popescu 2009, p. 326). As old members, such as France, Germany and the UK, showed no interest in challenging Russia directly in the Transnistrian conflict (Barbé and Kienzle 2007: 534), the idea of sending peacekeeping forces to the region was discarded altogether. In contrast, Jacobovits continued pushing the issue despite the wide opposition, which cost him a post (Popescu 2011, p. 117). In March 2007, a new EU Special Representative on Moldova, Kalman Miszei, was appointed who took a broader approach and focused on the EU-Moldova relations in general (Popescu 2011, p. 49). After Romania joined the EU, the secessionist region became the closest frozen conflict at the EU border. The region notoriously known for smuggling and trafficking emerged as a security problem in the EU neighbourhood as Moldovans – including those in Transnistria – were eligible for Romanian citizenship. Due to ineffective restrictive measures the emphasis was on negotiations and confidence-building programmes. In fact, Germany invested a lot of political capital in Moldova. In 2010, the foreign minister, Guido Westerwelle, visited Chisinau for the first time since its independence and in August 2012, Merkel’s visit to Moldova was

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perceived as an important foreign policy signal. Additionally, both the head of the EU Delegation to Moldova and the head of the EUBAM were German diplomats. Germany’s keen interest in solving the frozen conflict was to be understood in the context of its relationships with Russia (Rinnert and Parmentier 2013, p. 8). During 2009, Germany propelled the invigoration of the “5+2” talks under a new configuration. Under the socalled Meseberg process, Russia was considered to be involved with European security policymaking as a mediator together with Ukraine and the OSCE, whereas the EU and the US were involved as observers. For Germany, the motives were twofold: to diminish uncertainty on the EU border and to test Berlin’s new relationship with Russia (EurActiv, 27 August 2012). In this situation, Berlin triggered the shift from sanctions towards the dialogue on the EU level as well. During 2008, the Council renewably extended the sanctions but suspended their implementation. In all cases, the UK supported the Council’s decision. In 2009, Caroline Flint, the Minister for Europe at the Foreign and Commonwealth Office, reiterated her support for the sanctions’ renewal with its further suspension (European Scrutiny Committee, Third Report, Session 2010-2011, p. 95). Similarly, in February 2010, the Council’s decision was in line with the UK’s negotiating position. Chris Bryant, the UK Minister for Europe, favoured the removal of the three names “who no longer met the criteria for listing” (European Scrutiny Committee, Third Report, Session 20102011, p. 99). In 2011, although little progress was achieved, the UK supported the suspension of the sanctions’ renewal until March 2012. The Transnistrian “presidential” elections were considered to be a litmus test of the country’s developments. The surprise victory of Yevgeny Shevchuk, an alternative candidate, brought some positive steps towards the conflict settlement in Moldova. David Lidington, the UK’s Minister for Europe, also acknowledged further, but rather limited, progress of the “5+2” talks (European Scrutiny Committee, Sixties Report, Session 20102012, p. 38). Until now, the Meseberg process has failed to influence Russia’s position in the region. On the contrary, in March 2012, Russia appointed Dmitri Rogozin, a former ambassador to NATO, as a representative of Transnistria. This appointment has only increased the tensions during the “5+2” talks. In fact, the Russian position led to the maintenance of the status-quo – preserving the conflict, frozen and unsolved, while having a source of leverage on the Moldovan government (Popescu and Litra 2012: 2). In contrast, the combination of trade-related measures and confidencebuilding programmes imposed more pressure on the self-proclaimed

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regime; targeting the fragile Transnistrian economy proved to be more effective. The region’s economy is heavily dependent on the industrial plant - the JSC Moldova Steel Works in Rybnitsa - which constitutes about 60% of all Transnistrian export; the production of steelworks is mainly exported to Germany and Italy (Calus 2013). The introduction of a double-checking system obliged the steelworks to obtain the Moldovan certificates on export to the EU. This measure affected the region’s economy forcing the re-direction of the export to the East, and China in particular (Popescu 2005: 32). Yet, despite the introduction of this system, the measure still contained a loophole and was limited in its effect. Due to rampant corruption in Moldova, the Transnistrian firms could potentially bribe the Moldovan authorities to forge the origin of the steel production. A direct ban on steel production to the EU would hit the regime in a more targeted way. What is more, the breakaway region is non-immune to illicit smuggling and trafficking; this source of income could be undermined by better border control. For this purpose, on the Moldovan-Ukrainian border, the EU Border Assistance Mission was established. The Mission succeeded in the enhancement of border surveillance and information exchange, and the customs procedures on the border were improved in compliance with the EU level. Nevertheless, a limited number of experts in the mission, and their narrow authorities, constrained the programme’s success. On the lengthy border of 1200 km, there were employed less than 100 experts without any authorities to counteract against organized crime. Moreover, 95% of goods were transported by rail - making smuggling and trafficking still possible (International Crisis Group, Report, 2006). Finally, the Transnistrian regime is heavily dependent on subsidised Russian gas, which constitutes the main source of pressure on Moldova. Currently, Transnistria’s debt to Gazprom is estimated at $ 3.8 billion; gas deliveries to the region are operated through Moldova Gaz, a Gazprom-controlled company. Roughly, half of it is directed to Tiraspotransgaz, which distributes gas further into the conflict region. The gas prices in Transnistria are artificially lower than on the market, which generates enormous losses to the companies. Constantly growing debt is convenient for Russia as it constitutes an instrument of influence on the Moldovan government. As Moldova does not recognize Transnistria, officially the debt belongs to Moldova (Popescu and Litra 2012: 2). In the Transnistrian conflict, the EU attempted to combine a sanctions policy together with different confidence-building programmes. These programmes aimed to contribute to closer links between Moldova and Transnistria. Nevertheless, while substantial, but rather scattered, support

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was not embedded into any strategic EU approach to the region, the sanctions regime did not target the prime source of the conflict – the illegal presence of the Russian troops. As usual, core national interests of the EU member states and a Russian-oriented approach predominated in the EU sanctions policies. Dependency on the Russian energy supply constrained the EU’s room for maneuver in counteracting the presence of Russian troops in the region. The conflict remains deeply frozen between the EU’s economic interests and Russia’s geopolitical interests.

Uzbekistan In May 2005, anti-governmental protests took place in Andijan, triggered by economic impoverishment in the region. The Uzbek government violently responded towards peaceful protesters and at least 187 civilians were killed, and hundreds have been arrested. The government accused the Islamic Movement of Uzbekistan in organizing the unrest, but in fact, Karimov’s regime was anxious of the spread of colour revolution. The Uzbek government remained immune to condemnations from the Western countries, and refused to conduct an international investigation of the Andijan events. The sanctions regime In November 2005, the EU introduced restrictive measures, in the form of arms embargo and travel bans, towards the Uzbek leadership. The Council condemned “excessive, disproportionate and indiscriminate use of force by the Uzbek security forces” and a “failure of the Uzbek authorities to respond adequately to the United Nations’ call for an independent international inquiry” (Council Regulation No. 1859/2005). The EU imposed export bans on arms, military equipment, and equipment, which could be used for internal repressions. Additionally, 12 Uzbek highranking officials, who were directly responsible for the excessive use of force in Andijan, were banned from travelling to the EU. The sanctions were in place for an initial period of one year with a constant review of the human rights situation. From a technical point of view, the Common Position was wellelaborated and included explicit criteria for lifting the sanctions: “the outcome of the trials of individuals accused of participating in the disturbances”, “situation regarding the detention and harassment of those who have questioned the Uzbek authorities’ version of the events in Andijan”, and “the outcome of any independent, international inquiry” (Council Common Position 2005/792/CFSP).

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In November 2007, the Council renewed the restrictive measures dropping visa bans. In 2009, the restrictive measures were abandoned completely, together with the arms embargo. According to the new Common Position, the relationship between the EU and Uzbekistan has gained “a new scope and quality” (Council Common Position, October 2009). The Council acknowledged the progress with respect to human rights and fundamental freedoms: release of some human rights activists; the abolition of the death penalty; the introduction of habeas corpus; and the ratification of conventions against child labour. Yet, in general, the sanction regime was considered a failure. The position of the Uzbek government towards human rights and political freedoms did not change significantly. The EU was forced to return to “business as usual”, whilst having serious concerns (Council Common Position, October 2009). The ineffectiveness of restrictive measures towards Uzbekistan was stipulated by a poorly designed, and badly implemented, sanctions regime. From the beginning, the potential damage from sanctions inflicting the regime by introducing an arms embargo was questionable. Prior to the sanctions, there were few sales of military equipment to Uzbekistan. On the other hand, no interest was detected from the Uzbek government to purchase European military equipment afterwards (Portela 2010: 80). The position of the EU member states On the implementation stage, the sanctions regime proved to be porous as well. In October 2005, shortly after the introduction of visa bans, Germany allowed entry to the Uzbek Interior Minister, Zokirjon Almatov, for medical treatment (RadioFreeEurope, 27 October 2009). The noncompliance indicated an ambiguity within the EU towards the sanctions regime. Uzbekistan has been an important energy supplier in the region and a key partner for the Western military mission in Afghanistan. After the US criticised the human rights situation in the country, Uzbekistan terminated access to the Karshi Khanabad airbase for the US Forces. Germany remained the only NATO country allowed to stay at the military base at Temez, on the Afghan border. Additionally, the imposition of sanctions forced the Uzbek government to re-orientate itself towards Russia by signing the mutual defence agreement (Schmitz, November 2009). Due to this limited room for manoeuvre, certain EU member states found the restrictive measures detrimental to their security interests. In this situation, in the run-up to the EU foreign ministers meeting in May 2007, Germany pushed for relaxing the sanctions regime and lobbied for a “constructive engagement” with Tashkent. France, Spain, Italy and Poland

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supported Germany’s initiative. Berlin’s realistic approach excluded the isolation of Uzbekistan as an option in achieving tangible results. An EU Commission official, Rolf Timans, questioned the sanctions saying that “one should not expect that the Uzbek authorities will release such prisoners overnight. We have to discuss human rights first. Let’s not expect that the results will be forthcoming immediately” (EU Observer, 3 May 2007). However, the loosening of the sanctions coincided with the imprisonment of several human rights activists. Despite the worsening of the human rights situation, Germany lobbied the curtailment of sanctions to the arms embargo only. In Germany’s views, the EU achieved no political gain and moved Uzbekistan only closer to Russia. The EU Commission and the EU High Representative, Javier Solana, also backed Germany’s initiative for a dialogue and an engagement. In contrast, the UK and Sweden remained on the hard line; as a British diplomat explained, “it would be the wrong political signal at the wrong time” (EU Observer, 31 October 2006). The Netherlands, Denmark, the Czech Republic, Slovakia and Ireland opposed the German policy as well (The Guardian, May 2007). In Brussels, Frank-Walter Steinmeier, the German foreign minister, announced the plan to lift the sanctions due to the progress with the human rights situation. In the end, the sanctions were abandoned and in return, Uzbekistan agreed to organise human rights meetings annually and grant access for the UN, the OSCE and other NGOs to the country. Since 2011, the EU have returned back to a stance of “business as usual” with Uzbekistan. The EU Commission held a meeting with President Karimov on energy issues, although denied any official invitation (EU Observer, 21 January 2011). Due to its geopolitical location and energy resources, Uzbekistan used it as leverage towards the EU to block all the inquiries of the Andijan events (EU Observer, 21 January 2011). As the Uzbek government made little concessions to the EU demands, lifting the sanctions undermined the EU’s credibility and sent a wrong message to other Central Asian countries (Tynan, European Dialogue).

Ukraine/Russia On 15 March 2014, in the aftermath of the Euromaidan events and the failed Association Agreement between Ukraine and the EU, secessionist forces initiated a referendum on the matter of dissolution of the Crimea from Ukraine. Overshadowed by international protests, with respect to their legality, and by the boycott of many Crimean people - including the Crimean Tatars - a majority of those who voted put their cross in the box

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headed “Do you support Crimea's unification with Russia as a subject of the Russian Federation”. While the Russian government acknowledged Crimea as a part of the Russian territory, the USA and the EU officials called the referendum as illegal, illegitimate and not credible. According to international law standards, Crimea was de facto annexed by Russia. However, vetoed by Russia, the UN Security Council failed to adopt a draft resolution on the non-recognition of the Crimean referendum. The sanctions regime The Ukraine crisis has triggered the launch of a series of sanctions against Russian and Ukrainian officials. The aim was to set out a threestep process, with the pressure of sanctions steadily increasing if Russia did not respond by beginning to engage in mediation. In the wake of the Crimea’s annexation, the US initiated the introduction of travel bans and asset freezes towards those responsible for the crisis. The US banned the entry for seven top Russian government officials and four pro-Russian separatists. The US list included high profile officials, such as Dmitry Rogozin, a Russian deputy prime minister; Valentina Matviyenko, the head of the upper house of the Russian parliament; and Viktor Yanukovych, the former Ukrainian president. Later on, feeling pressure from the US, the EU sanctions then followed. On 17 March 2014, the EU introduced its own list of 21 targeted individuals “responsible for actions which undermine or threaten the territorial integrity, sovereignty and independence of Ukraine” (Council Decision 2014/145/CFSP). The EU list did not include high-profile Russian officials, but rather targeted against self-proclaimed Crimean “authorities” – Sergey Aksyonov, the acting prime-minister of Crimea; the speaker of Crimea’s parliament, Vladimir Konstantinov; the acting mayor of Sevastopol, and others. Later, Canada and Japan joined the EU sanctioning policy. Being unable to find a consensus among the countries, the EU undertook a series of rather symbolic actions: banning Russia’s application for membership in OECD and the International Energy Agency; excluding it from the G8 meeting; and suspending visa liberalisation talks with the EU. In an attempt to find a diplomatic solution, on 16 April 2014, the parties discussed the de-escalation process in Geneva. The main points of the so-called Geneva agreement included the ceasefire in eastern Ukraine; the disarmament of separatist groups; the return of seized buildings; and the release of detained protesters and monitors. During the talks, no mention of Crimea was made. Subsequently, it became clear that the agreements failed to obtain the ceasefire and that none of the conditions were properly held.

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As a next step, on 12 May 2014, the EU expanded the list of travel bans and asset freezes, adding another thirteen individuals as well as two Crimean oil and gas companies (Council Regulation 2014/265/CFSP). The next round of sanctions was triggered by another controversial referendum held on 11 May 2014, in eastern Ukraine. Pro-Russian separatists in the Donetsk and Luhansk regions gathered support for the establishment of self-rule in the regions. For the first time, the EU included individuals close to the Russian president – Vyacheslav Volodin, first deputy chief of staff, and Vladimir Shamanov, the commander of the Russian airborne troops, were among the sanctioned individuals. Surprisingly, Denis Pushilin, the self-appointed head of Donetsk People’s Republic, was not on the list. A Crimea-based gas company, Chernomorneftegaz, and a Crimean oil supplier, Feodosia, which were expropriated after the annexation, were on the sanctions list as well; no high-profile companies such as Gazprom were targeted. A new amendment to the EU sanctions list included low-profile Crimean companies, such as resort “Nizhnyaya Oreanda”, and wine producer “Massandra” (Council Regulation No 811/2014). The game change in the EU sanctioning policy came with the crash of the Malaysian airline MH17. On 17 July 2014, the civilian plane was shot down by separatists - using a Russian-made surface-to-air missile system when it was flying over the conflict zone in eastern Ukraine. Officially, the expansion of restrictive measures was connected to “Russia’s actions destabilizing the situation in Ukraine” (Council Regulation, 2014/512/CFSP). Additionally, the EU was under strong pressure from the US to take a hard line on Russia and employ coordinated economic sanctions. The US administration targeted Russia’s top energy firms and banks. Companies on the sanctions list included: Rosneft, Russia’s biggest oil firm, Novatek, second largest gas company; Gazprombank, a bank branch of Gazprom; and VEB, a bank that financed the Sochi Olympics. In addition, the US companies were banned from carrying out business with firms from the military and technology sectors: Bazalt, Kret, Kalashnikov Concern and others (EU Observer, 17 July 2014). The US also suspended Russian companies from the medium and long-term capital markets. As a sign of solidarity with the US, the EU agreed to target another 15 individuals and 18 companies on the sanctions list. The new sanctions targeted Russian largest banks as Gazprombank, Sberbank, VTB Bank, among others. These financial institutions were prohibited from a credit line exceeding 90 days. The European Investment Bank, and the European Bank for Reconstruction and Development, announced the suspension of new

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lending to Russia as well. In addition, cooperation programs between the EU and Russia worth € 450 million were cancelled. In line with the US, the EU introduced an arms embargo with certain companies and banned the export of technologies for oil exploration and production as well as shale gas projects. Subsequently, Australia, Norway and Switzerland joined the EU sanctions list, imposing travel bans and asset freezes. In a response to Western sanctions, Russia imposed a 12-month ban on a wide range of food products from the US, the EU, Canada, Norway and Australia (BBC News, 7 August 2014). However, the retaliation was short-lived. Importing food products from Belarus, Russia was de facto buying Western goods labelled as the Belarusian ones. In December 2014, the EU banned any European investments in Crimea in real estate, oil and gas exploration and outlawed ship cruises calling at Crimean ports (Reuters, 18 December 2014). The position of the EU member states During the Brussels summit on 20 March 2014, a divided position was indicated by European countries over Russia’s actions in Ukraine. Different approaches towards the “red line” triggered a split within the EU over the arms embargo and financial sanctions. As a Spanish diplomat explained, “some countries want to go very far at this stage, and others to give more room to diplomacy as much as we can. If we go too far, we won’t have anybody to talk to because Russia might close all its doors” (EU Observer, 14 March 2014). Italy, Greece, Cyprus, Portugal, Bulgaria, Luxembourg and Spain were reluctant to impose new sanctions on Russia. The Cypriot foreign minister Ioannis Kasoulides pledged for free opt-outs in the sanctions policy. "There are very strong economic ties between Cyprus and Russia. If sanctions are really necessary, then every member state should decide for itself whether to take part," he added (EU Observer, 17 April 2014). France and Germany quietly supported southern countries (EU Observer, 17 March 2014); Germany did not treat the annexation of Crimea as a premise for the imposition of economic and trade sanctions. Only further incursion into eastern Ukraine was understood to be a trigger for the introduction of third level sanctions (The Telegraph, 20 March, 2014). Nevertheless, some Member States raised concerns. For instance, the Austrian Foreign Minister, Sebastian Kurz, claimed that "we should not yearn for economic sanctions, as they would not only hit Russia but also definitely hit us... If we went a step further with our sanctions with every provocation, we would already have war" (EurActiv, 13 May 2014). Italy, which has close economic ties with Russia, opposed tougher sanctions as

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well, arguing that such policy would "take us back to an Iron Curtain situation" (The Telegraph, 20 March 2014). The Italian prime-minister Matteo Renzi favoured maintaining an open dialogue with Russia. The Bulgarian leaders were also reluctant to challenge Russia as the country is heavily dependent on energy supplies from Russian and on revenues stemming from Russian tourists. “Besides the common position of the European countries we have our national interests," said Stanishev, the Bulgarian Socialist Party leader (EurActive, 17 March 2014). In contrast, the UK held a tougher stance on the annexation of Crimea advocating far-reaching measures if further destabilisation in the region followed. The inclusion of Turkey and Switzerland in the UK’s deliberations highlighted London’s hard line against Moscow. While Turkey is a popular touristic destination for the middle class, Swiss cantons are a safe tax haven for the Russian economic capital (EU Observer, 13 March 2014). Together, the UK, Sweden, Poland and the Baltic States pushed for the introduction of tougher sanctions, including economic and trade restrictions. However, due to diverging interests, the resultant EU package of sanctions was “limited both in terms of their rank and the number of people” (EU Observer, 17 March 2014). The sanctions regime highlighted not only the division within the EU, but also the discrepancies between the US and the EU approaches. While the US was ready to impose sanctions on the whole economic sectors in Russia, the EU’s position was more cautious. "To the extent that the sanctions appear timid they are not having the message in Moscow that they could have," said Steve Pfifer, a former US ambassador to Ukraine (Foreign Policy, 12 May 2014). Due to longstanding and entangled economic relations with Russia, the EU could not cut off economic ties so swiftly and easily. The turnover between the US and Russia amounted to $ 28 billion in 2013, whereas the turnover with the EU estimated at $ 480 billion. While the US administration targeted Russian businesses, like Rosneft chief, Igor Sechin, the EU limited itself to another warning of new sanctions if the region was destabilised further. Germany, France, and Britain set the next trigger for the new restrictive measures in case Moscow intruded into the then upcoming presidential election on 25 May 2014. Being so economically dependent on the supply of Russian gas, fragile European economies were concerned about Russian retaliatory actions towards still vulnerable EU countries. The EU’s industry commissioner, Antonio Tajani, argued that “we are not the US, we don’t have shale gas as they do, so any move to sanction them [Russia] would hurt our companies a lot” (EU Observer, 17 April 2014).

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The division within the EU on a new package of sanctions favoured Russia. The Russian government attempted to undermine the severe effect of EU sanctions by bilateral negotiations with EU countries. Thus, despite the suspension of building the South Stream project, Alexei Miller, the chief executive of Gazprom, and Gerhard Roiss, the chief executive of OMV, signed a deal on the building of the 50 km long stretch of the South Stream. The gas pipeline initiated by Russia planned to deliver gas to Europe through Bulgaria, Serbia, Hungary, Slovenia and Austria, bypassing Ukraine. The controversial project was suspended first by the EU due to Russia’s unwillingness to defuse the situation in Ukraine, and later in December 2014 by the Russian president who indicated to the anti-EU stance on the issue as the reason (http://www.bbc.com/news/world-europe30283571). However, discrepancies among the EU countries on the sanctioning policy went even further beyond the energy sector. German companies lobbied against economic sanctions on Russia, even though interconnectedness of the Russian and German economies has significantly increased over the last decades. Germany belongs to one of Russia’s main European investors. In 2013, the trade turnover between the countries amounted to $ 74.9 billion. Germany imported about 38% of Russian gas and 20% of Russian oil. German companies like RWE and BASF have large business shares on the Russian energy market. The Metro Group and Deutsche Bank have considerably profited from chain expansion and assets acquisition (Novoe Vremya, 18 July 2014). Other discrepancies emerged in the domain of the arms embargo and financial sanctions. The UK introduced an arms embargo while France refused to support these sanctions because they had a € 1.5 billion contract for the delivery of two Mistral-class warships to Russia. In contrast, France initiated financial sanctions against Russia, which found less support in the UK as it would heavily hit the City of London. In an attempt to find an “equitably shared” solution to the EU sanctioning policy, the pressure on Russia was significantly diminished. While the UK, France, Poland, Sweden, Denmark, the Czech Republic, Lithuania, Latvia and Estonia pushed for tougher sanctions, Italy, Greece, Cyprus, Bulgaria, Luxembourg, Austria, Spain, Portugal and Malta were among the most reluctant EU states (EurActiv, 26 June 2014). Consequently, as unanimity among the EU countries was missing, the third stage of sanctions failed to be introduced at that point. The shooting down of the Malaysian airline proved to be the game changer. Germany and the UK pushed for further tougher sanctions against Russia’s actions in Ukraine. Lithuanian and Swedish leaders were

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also on the hard line. In their statements, EU leaders emphasized Russia’s insufficient contribution to the rebuilding of peace and their lack of respect regarding Ukraine’s territorial integrity (EurActiv, 17 July 2014). Nevertheless, despite targeting medium-profile oil and gas companies, the EU’s third level sanctions did not reach its full scope and solidarity with the US measures. The EU countries still remained divided over the imposition of wide-ranging sectoral sanctions. The sanctions regime remained quite leaky and inconsistent. Thus, the export of high technology for oil and gas exploration gas was barred only for future projects, but not for the ongoing ones. Specifically, the EU sanctioned technologies for deep-water drilling and excluded technologies for natural gas and conventional crude exploration. However, currently there are no deep-water exploration projects in Russia. Konstantin Smirnov, the head of Russia’s National Energy Security Fund, claims that these prohibitions are directed against future projects in the Arctic, but projects in Baltic Sea, Caspian Sea and Sakhalin can be continued (New Europe, 1 August 2014). Despite being targeted by the US sanctions, Rosneft started a joint project with American ExxonMobil on the exploration of gas and oil in the Kara Sea in the Arctic Ocean. The exploration was launched on 29 July 2014, a couple of days before the US and EU sanctions came into force. Technology licenses on drilling were provided by the Norwegian company, North Atlantic Drilling. As Norway is a non-EU member, the restrictions could be bypassed. “That is why, in my opinion, the Norwegian company signed this agreement with Rosneft one day before sanctions for a very simple reason. Because these sanctions are not concerning the already signed agreements,” Simonov said (New Europe, 1 August 2014). Likewise, despite the Western sanctions, BP and Rosneft signed a deal for the exploration of shale gas in the Volga-Urals region (WBP Online, 26 May 2014). The annexation of Crimea did not stop the plans of the AngloDutch oil giant, Shell, to invest into a huge project on the development of the LNG plant in Siberia (New Europe, 17 July 2014). Total SA, a French oil company, planned to proceed further with an earlier scheduled project on the Yamal LNG in the Arctic. The company saw no impediment to imposed sanctions in conducting business as usual. Similar sanctions were employed with regard to the arms embargo. The restrictions on military equipment applied only to future deals, so that the delivery of controversial French helicopter-carriers to Russia could still be possible. In the last episode of sanctions on investment in Crimea, efforts were made by France to mitigate it, as the French companies have the biggest commercial interests in the peninsula (EU Observer, 18 December 2014).

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These sorts of loopholes significantly diminished the EU’s credibility in imposing any pressure on the Russian government. Anxiety of Russia’s retaliation on some EU member states prevented the EU from targeting high profile gas companies. Countries like Bulgaria, Slovakia are nearly 100% dependent on Russian gas, which could potentially always impede unanimity and solidarity within the EU countries. Allegedly, Moscow has begun lobbying Russian-friendly countries to veto the EU’s next sanctions renewal (EU Observer, 11 December, 2014). Hungary, Slovakia, Cyprus and the Czech Republic have already expressed reservations against any further sanctions. Until now, longstanding and lucrative business interests with Russia have prevailed in the design and implementation of sanctions regimes, allowing Moscow to bypass the severity of restrictive measures. Nevertheless, so far, the EU sanctions against individuals and entities from Russia and Ukraine - and against some Russian sectors - represent a relatively strong and coherent policy in the EU’s sanctioning history. The EU Member States overcame their diverse national interests and showed their unity and cohesiveness against Russia.

Conclusions: The internal politics of the EU sanctions policies “If current trends continue, it risks turning itself into a sanctions machine” (Lange 2012). It may well sound somewhat exaggerated to interpret the current EU list, that lists 36 entities with restrictive measures, as a document of the EU’s newly emerging quality as a caterpillar in international politics. Nor do the findings of our research allow for drawing conclusions along these lines. And yet, with a focus on the internal politics of the EU sanctioning policy we are able to detect a number of insights into the dynamics of the vertical dimension of consistency. A challenge that remains, however, is the necessity to explain the strong and consistent reaction of the EU in the most recent crisis between Ukraine and Russia. But let’s turn to a summary of the findings first. To start with, the reasons why the EU has issued sanctions against countries in the post-Soviet space reflect the traditional set arguments, including violations of human rights and international law to the oppression of and violence against domestic civil societies. Concerning the type of measures taken, we find so-called targeted sanctions, such as visa bans and asset freezes, very prominently represented in our sample followed by arms embargos and sectoral sanctions—the latter being an

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exception and having been issued against Russia only at a later stage of the escalation. When it comes to the motivation of the Member States to take a position for or against a respective set of coercive measures, we can distinguish different dimensions. Firstly, the most prominent concern relates to economic interests, economic interdependencies, or close economic ties with respect to energy; commodities or finance are very prominent in this respect. Secondly, political considerations come into play in different shapes: (i) the embeddedness of EU or Member State policies in more encompassing forms of cooperation, and the respective policy objectives (e.g. Uzbekistan as only remaining Western military base in the conflict in Afghanistan or Portugal’s OSCE chairmanship and the corresponding necessity for impartiality); (ii) conflict with other EU policies or programmes (e.g. new neighbourhood strategy in the case of Belarus or a new approach towards the cooperation with Russia); and, last but not least, (iii) historically motivated security concerns. Thirdly, despite the unanimity rule, and the equal right of Member States to veto, the position of key Member States is of paramount importance for the coherent sanctioning policy. Thus, the position of old Member States, such as Germany, France and the UK, usually navigates the development of the EU sanctions policy either in favour or against the imposition. Consequently, other Member States might perceive their stance on the sanctions regime as a guiding reference. Alternatively, other countries can change their positions under old Member States’ lobbying (e.g. Germany’s strong position on the suspension of sanctions against Transnistrian and Uzbek leaderships). It was mainly these types of reasons that spurred the internal discussion on sanctions within the EU. In addition, it was the corresponding differences between the positions of the Member States that accounted for the relatively limited positive evaluation of the EU’s sanction policy so far. Unless there were some external factors, such as the alignment of EU measures with sanctions of the USA, differences in interests between the Member States could undermine the capacity of the EU to act in a coherent fashion and to refer to sanctions as a credible means in its foreign policy. This negative assessment of the implications of vertical incoherence in the EU’s sanctioning policies in the post-Soviet space is, however, at odds with the most recent case of sanctions against Russian and Ukrainian individuals and entities. Indeed, it seems that Russia’s aggressive behaviour is a game changer in the EU’s sanction history. The current sanction regime against Russia contradicts statements that claim that

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“sanctions are only imposed on weaker countries where the EU has no important security or economic interests and which have limited capacity to reciprocate, such as Sub-Saharan Africa” (Del Biondo 2011: 382). What is more, the entire history of the sanctions, with its strong and steady escalation despite the differences in the position of the Member States, requires an explanation. Was it that the mere scale of Russian aggression, and the potential for further actions, gave national leaders a real fright and contributed – at least for a time – to a position in which security concerns trumped other national interests? Or did the declaration of a three step escalation in the sanction towards Russian and Ukrainian elites gather momentum all on its own? While it was a means of compromising different positions of the Member States, the shooting down of the Malaysian airline almost inevitably induced the next level of more severe sanctions that still have repercussions – although to a different degree – on the economies of the Member States. Put theoretically, one might argue that the EU found itself rhetorically entrapped in standing back from a prior agreed action, which would have undermined the credibility of its action policy to both its external and domestic audiences. It remains to be seen whether or not the European institutions, and the Member States, translate the experience that a unified stance may provide a stronger leverage for the achievement of common objectives more than a lukewarm compromise for future action. This said, we are more cautious in our interpretation of the most recent episode in the EU’s sanctions policy. Rather than seeing it as a milestone on a new path of horizontal and vertical coherence, the EU’s sanctions approach might just have been driven by the exceptional external circumstances. Put differently, even if the case of the EU sanctions seems to indicate a closing of the (self) expectation-capability gap2 - as the EU institutions and the Member States have shown, firstly, the ability to agree and, secondly, the capability to develop instruments and to assign resource where necessary - we cannot take it for granted that the process of change in EU foreign policy will continue along these lines. The most recent behaviour, by the new Greek government, that threatens to veto any measures against Russia unless the EU provides financial support for its economic and fiscal challenges, is but one indicator for the continued importance of domestic interest politics (over)shadowing efforts to come to a common position in the EU’s foreign policy. 2

‘Toje refers to a similar interpretation as a consensus–expectations gap’,, that is “a gap between what the member-states are expected to agree on and what they are actually able to consent to” (Toje 2008: 122).

Fraudulent elections 2004, human rights violations, repression against the opposition leaders

Repression against the civil society, imprisonment of the opposition leaders

January 2011 – ongoing

Diplomatic crisis over the diplomatic residence

Reason

September 2004 – December 2010

Sanctions episode July 1998 – February 1999

Table 3-1: EU – Belarus

Visa bans and asset freezes, arms embargo

Visa bans and asset freezes

Type of sanctions Visa bans and asset freezes

Against sanctions: Slovenia, Latvia and Lithuania. Support from Italy, Spain, and Portugal

Against suspension: Denmark and the Netherlands Pro-sanctions: the UK, Sweden, Germany, Poland, Hungary

Neutral position: Germany

In favour of suspension: Poland, Lithuania, Latvia, France, Finland

Position of the EU member states Against sanctions: Portugal

Slovenia’s, Latvia’s and Lithuania’s close economic ties with Belarus

Poland’s and Lithuania’s concerns about Belarus’ closeness to Russia; France’s hosting of Interpol conference

Portugal’s chairmanship in the OSCE

Motivations

The EU sanctions policy in post-Soviet countries

EU Sanctions in the Post-Soviet Space

Partial fulfillment, sanctions still in power

Sanctions lifted after the diplomatic crisis was solved Sanctions suspended due to Belarus’ participation in the Eastern Partnership in 2008

Outcome

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August 2004 – February 2010

Sanctions episode February 2003 – September 2012

Closure of the Latin-script schools

Failed conflict resolution impeded by the Transnistrian leadership

Reason

Visa bans

Against sanctions: Cyprus, Germany, Greece, Finland, France, Italy, Portugal, Spain, Slovakia, the UK

Position of the EU member states Pro-sanctions: the Netherlands

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Type of sanctions Visa bans and asset freezes

Table 3-2: EU – Moldova (Transnistria)

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Sanctions suspended and then lifted due to a progress in the conflict settlement Sanctions suspended after the re-opening of the Romanianlanguage schools France, Germany and the UK: reluctance to challenge Russia directly in the region

Close economic relations with all the countries who were against the sanctions

Launched by Germany the Meseberg process aimed to test new relations with Russia

Outcome

Motivations

Sanctions episode November 2005 – October 2009

The Andijan massacre in May 2005

Reason

Table 3-3: EU –Uzbekistan Type of sanctions Arms embargo and visa bans

Against sanctions: Germany as a lobbyist; support from France, Italy, Poland, Spain

Position of the EU member states Pro-sanctions: the UK and Sweden as hard liners; support from the Netherlands, Denmark, the Czech Republic, Slovakia and Ireland

EU Sanctions in the Post-Soviet Space

Germany: energy supply to the EU, the only Western military base in Afghanistan

Motivations

Sanctions lifted due to progress with human rights and fundamental freedoms

Outcome

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The annexation of Crimea, illegitimate referendum Incursion into eastern Ukraine, illegitimate referendums

March 2014 – ongoing

May 2014 – ongoing

Reason

Sanctions episode

Table 3-4: EU – Ukraine/Russia

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Visa bans and asset freezes

Visa bans and asset freezes

Type of sanctions

Against sanctions: Austria, Italy, Spain, Cyprus, Greece, Portugal, Bulgaria, Luxemburg, Malta

Reluctant position of France and Germany

Position of the EU member states Pro-sanctions: the UK, Sweden, Poland, the Czech Republic, the Baltic states

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Outcome

Sanctions still in power

Sanctions still in power

Motivations

Poland, the Baltic states – in favour of sanctions due to security concerns The UK – against financial sanctions due to heavy investments by Russian oligarchs. France – against arms embargos due to a € 1.5 contract for warships delivery. Germany – against economic sanctions due to close economic ties with Russia. Bulgaria, Italy, Austria – against sanctions due to dependency on Russia’s energy supply

July 2014 – ongoing

Shooting down of the Malaysian airline MH17

Sectoral sanctions

Pro-sanctions: Germany, the UK, Sweden, Lithuania Against sanctions: Hungary, Slovakia, Cyprus, the Czech Republic, Greece

Slovakia – against sanctions due to dependency on Russia’s energy supply

Hungary, Greece, the Czech Republic – against sanctions due to sharing Eurosceptic sentiments

Germany, the UK, the Baltic states – in favour of sanctions due to security concerns and international order

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CHAPTER FOUR IMPORTANCE OF PREFERENTIAL TRADE AGREEMENTS (PTAS) FOR THE EU AND ITS PARTNERS: THE CASE OF DCFTA WITH GEORGIA ELZBIETA KAWECKA-WYRZYKOWSKA

Summary The EU has negotiated a big number of preferential trade agreements (PTAs) with its trading partners. PTAs are a more efficient way of reducing barriers to the EU economic cooperation with its partners than the multilateral forum created by the World Trade Organization (WTO). Apart from economic benefits stemming from trade liberalization the PTAs support the objectives of EU foreign policy, first of all by stabilising situations in the EU’s close neighbourhood. In view of the relatively low level of tariffs in world trade, PTAs are important not so much because of the removal of tariff barriers, but for the reduction of barriers to other areas of cooperation (trade in services, investment flows), as well as for the mutual elimination of regulatory barriers (technical and sanitary barriers, public procurement rules etc.). In this way PTAs make the business environment less costly and more open. Due to their broad coverage the EU calls such new generational agreements as Deep and Comprehensive Free Trade Agreements (DCFTAs). DCFTA between the EU and Georgia is, for Georgia, an anchor for trade and related policy reforms. At the same time, however, its far reaching legal commitments to adopt the substantial part of the EU acquis, albeit indispensable to make the economy more competitive, may appear to be very costly for the Georgian economy. The required legal adjustments are very broad and fast, and are not compensated by broad Georgian access to the EU internal market.

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Introduction: objectives and research hypotheses Preferential trade agreements–PTAs (also referred to as regional trade agreements–RTAs) with individual countries, or groups of countries, have become a key element of the EU trade policy. They offer parties reciprocal trade and economic concessions. The PTAs provisions cover a wide range of topics, going much beyond the traditional tariff reductions, and include all issues and sectors covered by the WTO (trade in services, TRIMs, TRIPs, etc.) as well as issues which stay outside multilateral rules (e.g. competition rules). The first type of agreements are sometimes called the “WTO plus” (WTO+) obligations, and the second type are the “WTO extra” (WTO–X) obligations (Horn, Mavroidis, Sapir, 2009). The objectives of this chapter are: (a) to identify the coverage of the main PTAs, concluded by the EU and their common elements; (b) to analyse the determinants of the intensifying trend of the EU PTAs; and (c) in particular, to identify the coverage and reasons of the PTA with Georgia–as an example of a typical new generation PTA, concluded with a worse off partner. The preferential agreement with Georgia has been selected for a number of reasons: 1/ Its provisions are similar to those contained in other PTAs negotiated recently by the EU; and 2/ It is the first agreement (and the only one as of January 2015) out of three similar agreements that has been signed recently by the EU with its eastern neighbours, which has already entered into force (in September 2014). Its results will be a kind of test to see whether the declared objectives can be achieved. The theses are the following: As tariffs and other border measures have diminished in importance, provisions on liberalisation of non–tariff measures on trade (mostly of regulatory character, such as technical standards and requirements) - as well as relating to areas other than trade in goods - have become the key elements of PTAs. This new approach to the coverage of PTAs is motivated a great deal by economic factors, such as increased globalisation, involving a higher potential for cooperation and a higher demand for mutually compatible rules to facilitate business activities. For the EU, PTAs are generated also by the desire to achieve non– economic objectives, such as the reinforcement of the EU’s international influence and stabilisation of the economic and political situation in the EU close neighbourhood. Economic motivations are dominant in PTAs, particularly with high income countries, while PTAs with poorer countries are important for the EU also, but for non–economic reasons.

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The paper is structured as follows: It starts with a classification of purely trade preferences, offered by the EU to its partners, and it then offers very short characteristics of key types of PTAs aimed at finding out the main coverage of those agreements. Next, the motivations of these PTAs are identified. The next chapter on the EU–Georgia agreement validates the hypothesis that PTAs are - for the EU - an important instrument of its foreign policy. The last chapter contains the concluding remarks.

Categories of trade preferences offered by the EU Trade preferences (usually in the form of reduced or eliminated tariffs) can be divided into two broad categories: unilateral and mutual preferences. The first category is offered – by definition – unilaterally, and depends on EU decisions, albeit such preferences have to be applied in conformity with general WTO rules (first of all, with the non– discrimination principle)1. Unilateral preferences are not discussed in this paper. Reciprocal preferences are negotiated among interested parties. Under WTO rules countries can create preferential agreements, in trade in goods, in form of free trade areas (FTA) or customs unions (CU) – as provided for in Article XXIV of GATT. FTAs and CUs can also be applied in trade in services – on the basis of Article V of GATS. The customs unions are very seldom in the EU external relations and are also seldom in other countries. The main explanation is that they are much more demanding in terms of the reduction of national sovereignty. The EU has concluded agreements in the form of a customs union with three partners: San Marino, Andorra and Turkey (European Commission 2014a). Only the first agreement completely eliminated barriers to trade in goods. The agreement with Andorra – during 1990 – does not cover agricultural products. The agreement with Turkey, formally in force since 1996, in practice, started to work in 2001 (Ambroziak, 2014). Some non– processed agricultural products are, however, still outside the customs union rules. Since its establishment, the EU has negotiated many FTAs. FTAs are usually a part of broader agreements also aiming at facilitating other areas of cooperation (e.g. services) and at the elimination of regulatory barriers. Any classification of these types of agreements is impossible as they are 1

There are three broad types of unilateral preferences offered by the EU: Generalized System of Preferences–GSP, GSP plus and EBA (Everything But Arms), see: European Union 2012.

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very different. Therefore, in the next chapter we characterize the main types of PTAs without trying to make a typology by one single criterion.

Main types of preferential trade agreements concluded or negotiated by the EU The deepest and broadest coverage of preferences, negotiated so far by the EU, applies to EFTA members, who are parties to the European Economic Area – EEA (EU plus Iceland, Liechtenstein and Norway).2 The EEA entered into force on January 1, 1994, mainly aiming at avoiding negative implications of closer integration among the EU countries in the form of the internal EU market, which started to work on 1 January 1993. This concept means much more than a free trade area. The EEA countries benefit from the four freedoms of the internal market (from the elimination of barriers to trade in goods, services, capital and workers among all EEA members). Most of these benefits are enjoyed also by Switzerland on the basis of several bilateral agreements with the EU. The main difference between the EU members, and the other EEA partners, is that the last group does not take part in the decision making process (and is not a part of the customs union, either). One might argue that EFTA countries are close to EU membership, in terms of the scope and depth of commitments relating to the adoption of EU laws. At the same time, all of them right now, are not interested in EU membership3 (or they prefer to retain sovereignty in terms of issues not related to the internal market, e.g. energy, and fishery policies, foreign relations etc.). For those reasons the EEA is not a good example of a new generation of PTAs negotiated by the EU during the beginning of the 1990s, and we omit it here. In recent EU history, many PTAs have taken the legal form of association agreements4, and have been negotiated mostly in the following 2

This Agreement was preceded by bilateral FTAs concluded between the EEC and individual EFTA countries in 1972. 3 Norway applied for EU membership but the society rejected this option in referendum twice: in 1972 and in 1994. Swiss society rejected the terms of accession to the European Economic Area in 1992. Iceland submitted an application for EU membership in July 2009. Following a decision of the European Council, negotiations were opened in June 2010. At the beginning of 2015 the procedure was underway in Iceland to formally withdraw the EU application. 4 They are based on art. 17 of the Treaty on Functioning of the European Union: “The Union may conclude with one or more third countries or international organisations agreements establishing an association involving reciprocal rights and obligations, common action and special procedure.” This type of agreements is

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framework of two dimensions of EU policy: Process of Stabilisation and Association (PSA), and the European Neighbourhood Policy (ENP). The PSA includes the Western Balkans (Table 4-1). All the Western Balkans states have been offered Stabilisation and Association Agreements (SAAs) and have a clear EU perspective, but only some of them are “official” candidates for EU membership; Montenegro (in 2012) and Serbia (in 2014) started accession negotiations with the EU. Official candidates for EU membership are also FYROM and Albania. Bosnia and Herzegovina and Kosovo are recognised by the EU as potential candidates for membership. In view of the EU perspective, the SAAs aim at a broad opening up of markets and a unilateral adjustment of the legal systems of candidates to the EU acquis.5 The EU's strategy includes massive financial assistance for those countries. The European Neighbourhood Policy, as a single framework for relations with Eastern and Southern neighbours, was officially launched in 2003 before the completion of the EU eastward enlargement process. The ENP aims at deepening relations with partners through the option of “a stake” in the EU internal market (Hoekman, 2005), albeit on a selective basis, which excludes elements sensitive for the EU. Therefore, association agreements offer the integration of partner countries into specific elements of existing and evolving EU structures and laws. A basic principle underpinning cooperation under the ENP is commitment to common values including: democracy, the rule of law, good governance, and respect for human rights. Technical and financial assistance (development cooperation) is focused on the areas that are identified as priorities under country–specific ENP action plans.6

broad enough to include all elements important for the EU. The result is however that concrete agreements vary substantially. 5 In 2000, the EU granted autonomous trade preferences to all the Western Balkans. These preferences, which were renewed in 2005 and subsequently in 2011 until December 2015, allow nearly all exports to enter the EU without customs duties or limits on quantities. Only wine, baby beef and certain fisheries products enter the EU under preferential tariff quotas, see: European Commission 2014b. 6 The first association agreements preceding the idea of similar agreements with neighbouring countries were concluded by the EU at the beginning and in the middle of the 1990s with 10 Central and Eastern European countries. To distinguish them from other agreements the EU labeled them as “Europe Agreements”.

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Table 4–1: Main agreements on free trade areas and association concluded and still negotiated by the UE (as of the middle of 2014) Partners

European Economic Area (close integration into the EU internal market) FTA supplemented by a number of agreements similar in scope to the EEA (alignment of many domestic laws with the law of the EU internal market) Stabilisation and Association Agreements (SAAs)

Iceland, Liechtenstein and Norway (since 1 January 1994)

European Neighbourhood Policy

Name of the agreement (program)

Association Agreements negotiated in the framework of Eastern Partnership of ENP

Association Agreements negotiated in the framework of Euro– Mediterranean partnership (Euro–Mediterranean Agreements) Economic Partnership Agreements– EPA–with African, Caribbean and Pacific, Overseas Countries and Territories (countries covered previously by the Cotonou Agreement)

Switzerland (first bilateral agreements entered into force in 2000)

Agreements in force with: former Yugoslav Republic of Macedonia – FYROM (2004), Albania (2009) and Montenegro (2010)–dates of entry into force. The trade part of the SAAs came into force through an Interim Agreement with Bosnia and Herzegovina (2008) and Serbia (2010). In July the Stabilisation and Association Agreement with Kosovo was initialed. Armenia (in 2013 it withdrew from negotiations), Azerbaijan, Belarus (both countries are included into the multilateral framework of ENP), Georgia, Moldova, Ukraine (the last three countries signed the agreements on 27.06.2014) Algeria, Morocco, Egypt, Israel, Jordan, Lebanon, Libya (lack of an agreement), the Palestinian Authority, Syria (lack of an agreement), Tunisia, Turkey (negotiates accession to the EU) Cariforum; Pacific; Central Africa, West Africa; Eastern African Community (EAC); South African Development Community (SADC) EPA Group; Eastern and Southern Africa (ESA)

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EU–Central America Association Agreement

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama, (trade part of the agreement in force since 2013)

Bi–Regional Association Agreement with Mercosur

Argentina, Brazil, Paraguay, Uruguay, Venezuela (ongoing negotiations)

Bilateral agreements

EU–Chile Association Agreement (entered into force in February 2003); EU – Mexico Economic Partnership, Political Coordination and Cooperation Agreement of 1997, supplemented in October 2000 by a comprehensive Free Trade Agreement; EU–South Africa Trade, Development and Co–operation Agreement (concluded in 1999); Association Agreement EU–Chile (entered into force in February 2003); FTA with Korea (entered into force in July 2011); Japan (FTA negotiations launched in 2013); Singapore – September 2013–initialing of FTA; EU–Canada trade agreement (CETA– negotiations completed in autumn 2014); Transatlantic Trade and Investment Partnership EU–US (negotiations started in spring 2013); Negotiations are going on also with India, Malaysia, Thailand, and Vietnam. Source: Based on: European Commission 2014b and WTO 2013, p.32–35.

The eastern dimension of the European Neighbourhood Policy covers the six Eastern neighbours – Armenia, Azerbaijan, Belarus, Georgia, Republic of Moldova and Ukraine – to get them closer to the EU and to avoid creating new borders in Europe; Armenia in 2013 withdrew from negotiations. In view of the political situation in Belarus, no action plan is yet in place. The legal framework for the EU–Azerbaijan bilateral relations is based on the old Partnership and Cooperation Agreement of 1999. Three other countries of the region signed Association Agreements

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with the EU on the 27 June 2014.7 We might also add that Russia, being the EU neighbour, has declined to be a part of the general rules of the ENP. It has a special status with the EU, in the form of cooperation in the framework of Common Spaces, which are of quite a general character. Trade is regulated by the non–preferential Partnership and Cooperation Agreement of 1997. After Russia’s annexation of Crimea, in spring 2014, negotiations on the upgrading of this agreement have been suspended. Negotiations with eastern partners of the ENP have made way for Deep and Comprehensive Free Trade Agreements – DCFTA (see chapter on DCFTA with Georgia). The agreements with southern partners (Euro–Mediterranean partners) – negotiated at the end of the 1990s8– concentrate on the liberalisation of barriers to trade in goods and they foresee EU financial assistance. In December 2011, the Council of the EU adopted negotiating directives for Deep and Comprehensive Free Trade Areas (DCFTAs) - with Egypt, Jordan, Morocco and Tunisia - to upgrade the trade agreements with these countries (WTO 2013, p.35). Negotiations on a DCFTA with Morocco were launched in February 2013. The Economic Partnership Agreements (EPAs) between the EU and African, Caribbean and Pacific (ACP) regions result from a different background. The ACP countries are mostly former colonies and dependent territories. Over the past 40 years (since the Lomé I convention of 1975 till the end of 2007), exports from the ACP countries were given very generous access to the European market. The preferences for ACP countries were contested by some WTO members as being incompatible with WTO rules (on the grounds of their more preferential status as compared with the GSP). In order to ensure a non–discriminatory status of preferences, the EU decided to continue a unilateral preferential status (one of the types foreseen by EU law, depending on the eligibility of 7

The AAs EU–Georgia and EU–Moldova entered into force on provisional basis on 1 September 2014. Ukraine signed its agreement on the same day as Georgia and Moldova but the implementation has been delayed till the beginning of 2016 because of Russian critique. The country has been, however, benefiting from the preferential access to the EU market due to the EU unilateral suspension of import duties for Ukrainian products. 8 The first comprehensive policy for the southern region was the Euro– Mediterranean Partnership (or Barcelona Process) a wide framework of political, economic and social relations between member states of the EU and countries of the Southern Mediterranean. It was initiated in 1995 through a conference of Ministers of Foreign Affairs, held in Barcelona. Besides the member states of the European Union, the remaining Mediterranean partners are all other Mediterranean countries including Libya (which had observer status from 1999 to 2012).

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partners– see endnote 1) for the poorest ACP parties and to negotiate FTAs with the better off partners from this region. The result is a concept of seven regional configurations of partnerships (Table 1)9. Negotiations on FTAs with more developed partners were to be completed by the beginning of 2008, but encountered many difficulties, for example, the weaker ACP countries were afraid of tougher competition, despite the fact the EU offered long transitional periods (15–25 years) for the elimination of their trade barriers (in exchange of one–off elimination of many tariffs in the EU). The general objective of EPAs is the promotion of trade between the two groupings – through trade development, sustainable growth and poverty reduction (European Commission 2013a). Agreements are also designed to be drivers of change to enhance reforms and help strengthen the rule of law in the economic field, thereby attracting foreign direct investment and thereby helping to improve the legal and institutional framework for growth. The EU–Central America Association Agreement, which came into effect in 2013, eliminated the most import tariffs and improved access to government procurement, services and investment markets. It established also a mediation mechanism for non–tariff barriers, and a bilateral dispute settlement. It was only recently that the EU decided to come back to negotiate agreements with high income partners - given the deadlock in multilateral negotiations under the Doha Round; intensification of trade flows; the resulting demand for the elimination of regulatory differences; and the new challenges incurred for growth and jobs after the deep financial and economic crisis at the end of the first decade of the XXI century (2007– 2008) etc. The first agreement of a new generation of comprehensive Free Trade Agreements was launched in 2007 with South Korea, and entered into force in July 2011. It eliminated duties on nearly all trade in goods; addressed a long list of non–tariff barriers to trade; and also included provisions on issues ranging from services and investments, competition,

9

Parallel to its PTAs with developing countries the EU encourages those countries to establish their regional integration. The EU believes, basing on the own experience of the organization, that regional integration leads to numerous economic benefits, including creation of larger markets and new trading opportunities, lowering prices for consumers, inflow of foreign capital. The EU advocates regional integration also as an effective means of achieving security and peace because closer regional links among countries make it easier and more efficient to solve existing conflicts, prevent new ones and tackle common challenges–such as the HIV/AIDS pandemic, migration or climate changes etc.

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government procurement, intellectual property rights, and transparency in regulation to sustainable development. In March 2013 the EU–Japan Free Trade Agreement negotiations were officially launched. They aimed at concluding a set of very broad issues going beyond traditional trade barriers. In September 2013, the EU and Singapore initialed the text of a Comprehensive Free Trade Agreement. The EU considers the FTAs, with individual ASEAN countries, as stepping stones towards an agreement in the regional framework, which remains the ultimate goal. The agreement with Singapore is of key importance, as the country is the largest EU trading partner in the bloc. Key issues on the negotiating agenda include better access to services and procurement markets, tariffs, technical barriers to trade, the protection of intellectual property rights like geographical indications, as well as trade and sustainable development. In September 2014 the negotiations of the EU–Canada trade agreement (CETA) were concluded. The agreement will remove over 99% of tariffs between the two economies and create sizeable new market access opportunities in services and investment. Among the most important PTAs for the EU, but also for the whole world economy, is the Trans–Atlantic Trade and Investment Partnership (TTIP) - negotiated with the USA since June 2013. The importance of negotiations for both partners, and for the world economy, results first of all from their huge trade and production position; in 2013 the value of their bilateral trade reached EUR 680.5 billion - this figure equates to 1/3 of world trade and they contributed 47% to the world GDP. At the same time it is the most controversial agreement for both partners. Proponents say the agreement would substantially boost the bilateral trade, thus contributing also to an increased demand for goods and services from other countries. Critics argue it would increase corporate power and make it more difficult for governments to regulate markets for public benefit. The most questioned individual issue is probably the "Investors–state dispute settlement" clause, which would allow corporations to bring actions against governments for breach of governments’ commitments resulting from the agreement (Gerstetter et al., 2013, p.8). Probably, for the first time in the history of trade negotiations, there is a very active involvement of civic society organizations, many of which object to the TTIP. The coverage of the TTIP is very broad. At the same time, positions of both partners are different in a number of areas. For example, the EU would like to have greater access to the American public procurement market and retained bans on imports of Genetically Modified Organisms

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(GMO) crops and hormone treated beef. The US’s priorities, in the area of trade in goods, include better access to the EU market of dairy - and other agricultural products - and tariff–free motor vehicle exports. For both partners these have been always extremely sensitive issues. Given that most tariffs are already low in trade between the EU and the USA (with some exceptions, however), it is expected that the majority of gains of their PTAs would come from the elimination of regulatory differences, some of which are estimated to create high costs - for example, costs created by regulatory differences in the EU and the USA are estimated to be equivalent to a 10–20% tariff (European Commission 2013b). The EU and the USA have relatively high food safety standards; differences in their regulatory requirements result in the double testing of some products. Different safety, technical, and quality etc., standards are applied also in many other areas. Negotiations aim at regulatory convergence; it is the elimination of such barriers that would make transatlantic trade easier and cheaper. The important problem is how to eliminate the regulatory barriers. The history of international negotiations shows that three supplementary approaches can be offered: harmonization; the mutual recognition of partners’ regulatory requirements; or the adoption of international standards - but none of them is easy to apply. In particular, international standards do not exist for all products, and partners do not always agree to adopt them. The expected economic benefits of the TTIP include, first of all, an increase of the GDP which, according to one of the estimates, is to be 0.5% for the EU and 0.4% for the US (Gerstetter et al., 2013, p.8). Apart from the expected economic benefits of lifting barriers to form a cohesive sense of mutual cooperation, both partners hope that the successful completion of negotiations will reverse the recent trend of the declining strategic role of transatlantic cooperation in solving global problems. They also count on the hope that the agreement would set up new standards for international trade agreements in such areas as regulatory barriers, barriers to foreign investments etc. These effects (benefits) seem to be important in view of the deadlock of the Doha Round, and of the WTO deficiencies. The above information presents a short overview of PTAs with poorer countries - and with high income partners, allows for several general conclusions on common and different elements of the agreements. The key element of all PTAs is the creation of the FTA based on the reciprocal elimination of tariffs, and other border barriers (usually on an asymmetric basis in the case of lower income countries, thus making liberalisation faster in the EU and slower in weaker partner countries). The elimination

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of all trade barriers applies only to industrial products (to put it precisely: non–agricultural products), and agricultural products are always subject to exceptions (which reflects a high sensitivity of agricultural products for producers of majority partners). Moreover, apart from tariff elimination, almost all PTAs contain a broad coverage of other economic issues, both of WTO plus, and WTO extra character, such as trade in services, investments, public procurement, TRIPs etc. The scope of this non–trade liberalisation is very different in individual agreements, reflecting negotiating powers of partners; their different interests and preferences etc. In the area of legal commitments, PTAs for poorer countries offer a hub–and–spoke mechanism - meaning that those countries adjust their laws unilaterally to EU acquis. Such an approach reflects a much stronger EU negotiating position. At the same time PTAs for high income countries provide for balanced commitments consisting in harmonisation and/or mutual recognition of partners’ regulatory requirements, or the adoption of international standards in areas in which they exist. Such a mechanism usually requires a great deal of time for satisfactory outcomes to ensue. Typical of PTAs for poorer countries are also non–economic clauses; aligning partners with EU systems of values. The enforcement of those values, and other commitments, is supported by EU financial aid. ACP countries also benefit financially under a special scheme named the European Development Fund. We might add that some regional agreements have been difficult and slow to negotiate, because the EU’s partners are often unable to make much progress towards integration into the EU system (Woolcock, 2007, p.4; Borrmann, Grossmann and Koopmann, 2006). As already mentioned, such situation characterizes most of the ACP countries.

Determinants of PTAs Before we identify the concrete EU motives for the recourse to PTAs we must remind the reader that from 1999 until the recent policy shift, the EU in fact refrained from negotiating new FTA negotiations. During the preparations for what is now called the Doha Round of the WTO (launched in 2001), the priority was given to the comprehensive multilateral round. In particular, the then EU Trade Commissioner, Pascal Lamy, favoured negotiations on a multilateral basis and considered same to be a better option for the EU. In 2006 this policy was rejected. The shift towards PTAs was partly a result of the failure of the Doha Round to make a substantial progress in negotiations. Also, the internal economic situation had changed. The Lisbon Strategy of 2000, to make the EU “the most

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competitive economy in the world”, appeared a failure. The EU badly needed a new policy to support growth and jobs creation. In 2006, the Commission tabled a communication on a new strategy of common trade policy entitled “Global Europe: Competing in the world”. Trade policy was recognized in this document as an important instrument to strengthen the competitiveness of the EU economy. Confirming the importance of multilateralism, the EU declared that Free Trade Agreements (FTAs) would be a driving force towards achieving this goal. In the later communication of November 2010, the "revised trade policy" was confirmed and recognized “as a key element in the external dimension to the Europe 2020 strategy” (European Commission, 2010). Thus, PTAs were there to bring standard economic benefits of trade liberalization by means of the following: opening new markets; increasing investment opportunities; making trade cheaper (due to the substantial elimination of all customs duties); making trade faster – by facilitating goods' transit through customs; and setting common rules on technical and sanitary standards. It must be repeated once again that these benefits were to be achieved, mostly due to the liberalisation of other barriers than tariffs as the latter have diminished in importance.10 Apart from those traditional trade motivations of FTAs, other economic factors became important reasons for the EU, and its partners, to engage into deep and broad legal commitments. One of the most important has been the willingness to make the policy environment for business more predictable and less costly. This can be done in the form of regulatory convergence – by taking joint commitments in areas that affect trade, such as technical and sanitary standards; intellectual property rights; and competition and public procurement rules. This direction of PTAs reflects the simple fact that the great variety of national requirements, in all areas of economic activities, have become - in recent decades important impediments faced by companies trying to expand abroad. In other words, with the liberalisation of border barriers to trade (tariffs, quotas etc.) differing regulatory policies become more salient, creating complex challenges of accommodation and coordination. Moreover,

10

According to WTO Secretariat, the simple average tariff rate in the EU in 2013 amounted to 14.8% on agricultural products and 4.4% on non–agricultural products, see: WTO 2013, p.45. Applied tariffs were reduced substantially also in many developing countries and “Despite variance in tariff rates around the average, low average MFN rates suggest that the scope for exchanging preferential market access is unlikely to be extensive” (WTO 2011, p.124).

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“Trade openness–along with the new forms of trade that technological development makes possible – creates new pressures to reconcile divergent national practices, and generates new forms of cross–border policy effects (spillovers). These developments produce demands for governance and the rule of law that transcend national borders” (WTO 2011, p.109).

An important contributor to PTAs has been the intensification of globalization, involving the internationalization of production processes in the form of global value chains. R. Baldwin argues that: “The economic effects of global value chain (GVC) –linked trade, i.e. 21st century trade, differ fundamentally from those of made–here–sold–there trade, i.e. 20th century trade. GVC–linked trade changes nations’ comparative advantage, since it de–nationalises the whole notion of comparative advantage” (Baldwin, 2014, p.5).

In this situation regional agreements offer faster and more effective benefits, which “come from knitting together diverse sets of disciplines” (Baldwin 2014, p.6). Common (regional) rules apply not only to the market access (focus was on tariffs, rules of origin and rules of cumulation) but also to issues unrelated to border measures (to production facilities), which facilitate the internationalization of production – especially between high–tech and low–wage countries. Thus, PTAs address disciplines related to the making, as well as the selling, of goods and services.11 The demand for new ways of the promotion of the export of goods and services has become particularly urgent in the period after the deep recession of 2008, when the EU economy is trying to overcome this crisis and each idea - serving growth and job creation - deserves careful attention. It is expected that FTAs will open up market opportunities for EU businesses, leading to increases in production and jobs. Moreover, regional preferential agreements offer specific advantages as compared to a multilateral approach, such as faster and more flexible negotiating processes. A smaller group of countries negotiating PTAs is able to achieve a faster satisfactory agreement than almost 160 members of the WTO, which – by definition – have very different interests. The WTO members find it almost impossible to agree on “one–size–fits–all 11 In this context Richard Baldwin has noticed „While the WTO remains relevant to 20th century trade, global rules for 21st century trade are being written in the TPP, TTIP, TISA and the like” (TPP–the Trans Pacific Partnership, TTIP–the Trans–Atlantic Trade and Investment Partnership, TISA–The Trade In Services Agreement), see: Baldwin 2014, p.39.

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disciplines”. For the same reason, regional agreements make it easier to include issues, which are not covered by the WTO or are regulated to a limited scope due to difficulties to achieve deeper compromises among different WTO members. Good examples of such areas are the so called “Singapore issues”, which refer to four working groups set up during the World Trade Organization Ministerial Conference of 1996, in Singapore. They include transparency in government procurement; trade facilitation (customs issues); trade and investment; and trade and competition. These issues were supported by the EU (and many other developed countries) but were opposed by most developing countries. The EU tries to include those areas into the PTAs. The other broad area important for the EU is the liberalisation of rules on trade in services.12 All economic motivations for PTAs are extremely important, taking into account that - over the next ten to 15 years - 90% of the world demand will be generated outside of Europe (European Commission 2014b). That is why a key priority for the EU is to take advantage of this growth potential by opening up market opportunities for EU businesses abroad. One way of ensuring this is through negotiating agreements with key partners. Also, the EU uses the PTAs for political reasons. It declares that PTAs: “…play a role in foreign affairs and global management commensurate with our economic weight. Trade and trade policy reinforce the EU's international influence and concerted action at EU level should pursue and support EU economic interests in third countries" (European Commission 2010, p.15).

Thus, the EU trade and foreign policies should be mutually reinforcing. This applies to areas such as development policy and the application of UN sanctions. For the EU it is also a way of “creating the right incentives within trade and political relations with third countries”. Adoption into the AA of non–economic values, such as democracy, human rights, and good governance, is definitely an expression of such an approach. At the same time, the promotion of non–economic values - through trade policy - can 12 For example, a number of countries (Australia, Canada, Chile, Chinese Taipei, Colombia, Costa Rica, European Union, Hong Kong, Iceland, Israel, Japan, Liechtenstein, Mexico, New Zealand, Norway, Pakistan, Panama, Paraguay, Peru, Turkey, Republic of Korea, Switzerland, United States) have decided to negotiate TISA (Trade in Services Agreement) aimed at broader elimination of barriers in this area than under the GATS (e.g. elimination of restrictions on purchase of land, in the area of public procurement, see: Coalition of Services Industries 2014).

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be interpreted as having a lack of political power to do it through foreign policy and is a “by–product of the EU’s political weakness” (Pisani–Ferry 2009, p.vi–vii). During the early 2000s a new non–economic factor of PTAs appeared, in the form of socio–political changes along the EU external borders, resulting from the victory of the so called colour revolutions in Eastern Europe and the Caucasus in 2003–2005, and in the Middle East in 2011.13 The EU decided to support those anti–authoritarian and pro–democracy movements in order to hold a destabilisation of the situation and enhance security along its borders. Association agreements negotiated by the EU with its neighbours, in the framework of the European Neighbourhood Policy, have become a response to the revolutionary movements. The security argument has gained in significance after the annexation of Crimea by the Russian Federation in March 2014. For the partners, the PTAs are lock–in mechanisms that anchor their economic policies and political reforms into the EU acquis system, thus making reforms more credible. In cases when interest groups request to depart from the reform process, the governments can tell that violating the commitments would result in retaliation by the EU (Hoekman, 2007).14

The case of DCFTA between EU and Georgia A good illustration of the new generation of PTAs in EU policy is the AssociationAgreement15 (AA) concluded between the EU and Georgia, which partially came into force on 1 September 2014 (pending ratification by all EU Member States). This Agreement aims at deepening political and economic relations between the EU and Georgia. Its general principles (title I), include, among others: respect for democratic principles; human rights and fundamental freedoms; commitment to the principles of a free market economy; respect of the principles of the rule of law and good

13

These movements include usually: Rose Revolution in Georgia (2003); Orange Revolution in Ukraine (2004/2005); Purple Revolution in Iraq (2005); Cedar Revolution in Lebanon (2005) and Jasmine Revolution in Tunisia (2010–2011). 14 Also, the Europe Agreements signed by the Central and Eastern European countries with the EU in the 1990s played an important role as instruments anchoring transformation of those countries into the market economy system, see more: Kawecka–Wyrzykowska 2014. 15 Its full name is: Association Agreement between the European Union and the European Atomic Energy Community and their Member States, of the one part, and Georgia, of the other part (OJ L 261 of 30 August 2014).

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governance; commitment to the rule of law; good governance; and the fight against corruption, etc. It can be added that the objectives, and the coverage, of the AA resemble the Europe Agreements on association of individual CEEC with the then EC, which were signed at the beginning of the 1990s. Details differ however, in particular the depth of individual commitments under the EAs and the AAs, which affects the balance of costs and advantages expected from both types of agreements.16 An important issue is also that the Europe Agreements were treated by the associated countries of the CEEC as an instrument supporting their future membership in the EU, and the Copenhagen criteria - for applicants aspiring for EU accession adopted by the European Council in June 1993 - offered a green light for the CEEC to join the EU in the future. The prospect of EU membership made the CEEC relatively easy to be accepted with the demanding provisions of legal approximation with the EU acquis, and the broad opening up of their markets to EU competition. Regarding Georgia, it is difficult to imagine the country retaining its membership in the EU in the foreseeable future, although legally it is not impossible.17 The EU has not given Georgia a clear prospect that the country will ultimately join the Single Market or benefit from the freedoms of the huge EU market, either. Such a situation may discourage the Georgian authorities, business circles, and the whole society, from undertaking costly changes and making economic adjustment to the commitments of the AA. The main element of the AA is a “deep and comprehensive free trade agreement” (DCFTA), which consists in provisions going beyond the elimination of traditional border barriers, and involves measures aligning Georgia with selected areas of the EU internal market (through a comprehensive programme of approximation of Georgia’s legislation to EU legal system). The AA provides for the full liberalisation of trade in non–agricultural products (art. 26.1). The opening up of the market took place on the day of entry of the Agreement coming into force. Neither Georgia, nor the EU, made substantial concessions here, as they both offered a relatively open 16

On the comparison of both types of agreements see: Kawecka–Wyrzykowska 2015. 17 The Association Agreement recognized Georgia as an Eastern European country and only a European state “may apply to become a member of the Union” (art. 49 of Treaty on European Union). Even stronger prospects for closer future relations are declared in the paragraph of the preamble stating that “this Agreement shall not prejudice and leaves open the way for future progressive developments in EU– Georgia relations”.

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access to their markets before the AA came into force: (a) the MFN import duties were already very low;18 (b) for many years the EU had offered Georgia GSP plus status, which resulted in easy access to the EU market; (c) Georgia plays a very insignificant role in EU trade (less than 0.1% of total external EU imports and 0.1% of extra–EU exports); (d) there are almost no processed industrial products exported from Georgia to the EU, thus posing a very insignificant competitive threat to EU producers. In the area of trade in agricultural products (art. 26–27), Georgia immediately opened up its market for EU products. This decision did not greatly increase competition as the Georgian market was relatively open earlier. Liberalisation, implemented by the EU, was partial and selective: 1/ for garlic, the EU established a duty free quota (amounting to 200 tons); 2/ for a number of products (fruit and vegetables) liberalisation consists in the exemption of the ad valorem component of import duty (i.e., other protective elements have not been eliminated); 3/ there is a long list of processed and non–processed agricultural products, which are subject to the anti–circumvention mechanism.19 As both partners are WTO members, the WTO contingent protection measures can be applied by both of them (including antidumping and countervailing measures and those under Article XIX of GATT 1994–arts. 37–43). A substantial part of the Agreement is devoted to detailed provisions on the elimination of technical barriers; technical to trade (arts. 44–49). This will be done through the gradual alignment of Georgian laws to the EU acquis (to 21 EU New Approach and Global Approach Directives), in line with timetables contained in Annexes. Georgia shall also continue to gradually approximate its sanitary and phyto-sanitary, animal welfare and other legislative measures to those of the EU (arts. 50–65). The list of concrete laws in Georgia, to be aligned with EU laws, is to be presented by Georgia not later than six months after the entry into force of the Agreement. Compulsory approximation of laws in this area, apart from the already mentioned ones, includes customs legislation (concrete dates are provided for different EU laws). 18

The average applied tariffs (MFN levels, %) in 2010 amounted to 0.3% on industrial products and 7.7% on agricultural products in Georgia and in the EU respectively to: 4.6% and 13.5% (Messerlin et al., 2011, p.22). 19 The average annual volume of imports from Georgia into the EU for each category of those products is provided for. When those imports reach 100% of the volume established, the EU may temporarily suspend the preferential treatment for the products concerned. Most of those products are not exported from Georgia to the EU right now. Thus, negative implications of these provisions may appear only in the next years.

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Apart from the liberalisation of trade in goods, the DCFTA lays down “the necessary arrangements for the progressive reciprocal liberalisation of establishment and trade in services.” (Article 76). The instruments of liberalisation are mostly national treatment and most favoured nation treatment (MFN). Both partners, however, are presented with long lists of economic activities, which are excluded from the establishment (arts. 78– 80).20 Services mentioned in the AA are described in a very detailed way; most of them contain reservations to concrete modes of supply of those services. Moreover, reservations at the EU level are supplemented by many national reservations, which reduce the access to the EU market for Georgia’s service providers and make the legal conditions of operating on the EU market extremely complex and burdensome. Besides, some sectors have been excluded from national treatment, and the MFN treatment, by the parties as regards a cross border supply of services (art. 83). Due to many exceptions from general rules, liberalisation of the supply of services, and conduct of service suppliers, seems to be modest. For the same reason, it is impossible to assess ex ante to what extent the provisions on improved access to the market will be used in practice. There are also provisions on the temporary presence of natural persons for business purposes (on mutual basis), aimed at making business easier. Separate provisions apply for key personnel, graduate trainees, business sellers, contractual service suppliers and independent professionals (Art. 88). In each case, as in the area of services, there are general limitations accompanied by national (EU Members’) reservations.21 The Parties undertook to impose no restrictions on payments and transfers on the current account, as well as of the capital account of the mutual balance of payments (arts. 137–140). Thus, these laws provide for totally free access to the capital markets of partners, including access to the weaker market of Georgia. 20

The excluded activities cover, among others: mining, manufacturing and processing of nuclear materials; production of or trade in arms, munitions and war material; audio–visual services; national maritime cabotage; some types of domestic and international air transport services (art. 78 of AA). 21 For example, key personnel and graduate trainees have received the right to be employed in the Party’s establishments covered by the Agreement but for a limited period (usually for a period of no longer than three years and one year for graduate trainees)–art. 89 of AA. Independent professionals (natural persons) are allowed to supply services into the territory of the other Party on a temporary basis. They have to obtain a service contract for a period not exceeding twelve months. In addition, residency is required for auditing services offered in Denmark and other specific requirements apply in other EU countries.

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Chapter 8 (arts. 141–149), on public procurement, allows Georgia’s access to the EU public procurement market for bids (on a reciprocal basis), following a period of transition during which Georgia will approximate the current and future EU legislation on public procurement. It is difficult to imagine that Georgian suppliers of goods and services will be able to participate successfully in a big, but also very competitive, EU public procurement market, which is available mostly to strong firms. The rules on TRIPs (arts. 150–202) are extremely detailed, covering many sectors, such as copyrights, trademarks, geographical indications, designs, and patents. Chapter 10 (arts. 203–209) covers the competition rules. Here, the parties agree to maintain effective anti–trust and merger laws, and an effectively functioning competition authority. On trade–related energy issues (arts. 210–218), the DCFTA has introduced binding provisions on the uninterrupted transit of energy goods, and access to energy transport facilities with a view to ensuring the security of supply. Also, the independence of regulatory authorities in the energy field has been ensured, and parties have committed themselves not to regulate prices of gas and electricity for industrial purposes. Summing up, economic provisions are numerous and demanding in terms of concrete commitments and dates for their implementation. This is the main reason for the very critical opinion expressed by several authors on the AA with Georgia and with other EU partners from the eastern region. The most concise critical opinion has probably been presented by I. Dreyer arguing: “The EU continues to push for regulatory alignment. Yet this is problematic. The EU is dealing with economies that are much poorer than the EU’s poorest member states. For them [those economies - EKW], integrating EU standards into their legislation, and in particular putting them into practice, will be costly and will probably fail” (Dreyer, 2012, p.10).

Several critical remarks seem to exaggerate possible negative implications for Georgia (e.g. the estimate that prices of agricultural products will go up by 90% as a result of the adoption of EU sanitary and phyto-sanitary (SPS) standards by Georgia) (Messerlin 2011). Some other fears, on the impact of the AA on the Georgian economy, seem justified (e.g. those relating to high costs of adjusting domestic products to EU technical standards in a relatively short time). The truth is that the majority of technical and sanitary adjustments provided for in the AA are necessary to enter the huge EU market; the

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reforms will not be easy, however. The short term costs include adapting to EU product standards, which will require investment, changes in technologies applied, and will take time, thus hurting many businesses in the process. The negative impact of reforms will appear before experiencing the long–term benefits and this may discourage many people from changes and awaken public discontent. The problem is also that the DCFTA offers very limited access for Georgian businesses to four freedoms of the EU internal market, in particular to the market of services and labour. The balance of benefits and costs will depend a great deal on the following: the authorities’ determination to bring about the implementation of legal changes; the ability to organize an information campaign and mobilise social support for reforms (or at least mitigate internal opposition for changes); the ability to encourage the inflow of FDI; the scope of EU financial support for adjustments; and the evolution of the political situation in the region (political tension with Russia will not stimulate FDI).22 The alternative for Georgia is a closer cooperation with Russia and a possible accession to the Eurasian Economic Union; some politicians, as well as business circles, prefer the latter option. So far, Georgia has made the political choice to become more politically and economically aligned with the west. Furthermore, Georgia’s Prime Minister, Irakli Garibashvili, who signed the association agreement in June 2014, stated: “Unofficially we applied for EU membership today; officially, it depends on the progress that we will make, but I can guarantee you that we will do our best to meet all of the requirements of the European Union” (European Institute 2014).

Concluding remarks The EU has successfully concluded a number of important agreements with trading partners and is in the process of negotiating agreements with many more. As tariffs are relatively low in world trade today, trade barriers lie behind the customs borders. Hence the EU has been concluding a new generation of agreements called Deep and Comprehensive Free Trade Agreements that, apart from removing tariffs, also open up markets for services, investment, public procurement and eliminate regulatory barriers to make the business environment less costly and more open. The inclusion of the provisions on technical and sanitary standards in PTAs, 22

On the assessment of the DCFTA see more: Kawecka–Wyrzykowska, 2015.

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with poorer partners, appears to follow a hub and spoke structure, with the EU as a larger partner representing the hub to whose standards the spokes (poorer countries) have to conform. Provisions on technical standards, with high income countries, are negotiated on the basis of harmonisation or mutual recognition, or – less often – of the adoption of international standards. In the first period after the EEC creation, preferential agreements (in the form of standard FTAs) were negotiated mostly with developed countries in Europe (with EFTA members). In the 1990s, an important incentive for PTAs was the transformation wave in the CEEC. The association agreements with the CEEC resulted in the future EU enlargement. In the meantime, many PTAs were negotiated with developing countries, both for economic and non–economic reasons. The main function of PTAs, with developed countries, is to achieve various economic benefits stemming from deeper international specialisation and new opportunities for businesses. PTAs reflect: on the one hand, the inefficiency of the multilateral WTO forum to deepen and extend rules in meeting the needs of the present stage of globalisation; intensified cooperation in areas other than trade in goods; the deepening of specialisation in the form of global value chains; and the resulting demand for regulatory convergence to facilitate business activities. On the other hand, differentiated regional PTAs - better than uniform multilateral rules - address the specific issues of a changing situation in the EU (implications of recent EU enlargements, need to increase markets for EU goods and services, etc.). Apart from the expected benefits, PTAs bring about some undesired implications, which reduce the potential benefits. A proliferation of PTAs create transaction costs for businesses, as the different agreements create incoherent trading conditions; this applies first of all to differentiated rules of origin, technical barriers etc. Due to its strong negotiating position, the EU has been successful so far in negotiating agreements that protect the domestic EU market in sensitive areas (e.g. in a number of agricultural products) and at the same time induce partners to accept rules important for EU exporters (e.g. adoption of EU competition rules, on public procurement etc.). More difficult are the negotiations with high income countries. They require a balanced set of commitments. At the same time they offer more economic benefits for the EU, and its partners, due to big markets on the one hand and huge potential for future cooperation on the other. For EU partners, PTAs are an attractive way to get better and broader access to the huge EU internal market. The implementation of PTAs, with

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poorer countries, is usually supported by financial aid. For the reforming countries, PTAs are also anchors for trade and related policy reforms, making reforms more credible. At the same time, however, the agreements create much stronger competition than before on the markets of poorer countries. The experience of the recent agreements is too short to state that the balance of costs and advantages will be positive for all parties to the agreements. The final result will depend very much on the internal economic policies and the determination of EU partners to implement the contractual commitments. The recent conclusions apply also to Georgia, the first country of the Eastern Partnership, which has been struggling with the implementation of demanding obligations of the Association Agreement with the EU.

CHAPTER FIVE RECONFIGURATION OF EXTERNAL RELATIONS OF THE EUROPEAN UNION NICOLAE MARINESCU

Summary In the current world context, the European Union (EU) is facing extraordinary challenges. Eaten up internally by numerous problems, at an external level the EU seems fragile, given the turmoil of international politics. Nevertheless, the EU is one of the key global players participating in all the important economic and political aspects of the planet. The external relations of the EU became more complicated once the EU grew in size, and its membership became increasingly heterogeneous. Through the European Commission’s voice, the EU became actively involved in multilateral commercial negotiations; has become the main provider of assistance and humanitarian aid in the world; and has insisted on setting international environmental protection provisions. In time, the EU has developed a wide range of bilateral and multilateral agreements with a large number of countries. This chapter revises the most important economic and political ties of the EU: to the United States, to Russia, to China. It also investigates recent and interesting developments, such as the agreement with Korea; the heated situation in Ukraine; the controversial relationship with Turkey; and the policy towards neighbouring countries. Under pressure from many sides, it becomes evident that the EU needs to rethink and reassess its external relations.

Introduction In the current world context, the European Union (EU) is facing extraordinary challenges. It is internally eaten up by numerous problems, such as slow or even stagnating economic growth; differences between its

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member states as regards their status within the Union and the policies to be followed; a cumbersome functioning of its institutions, which implies a rigid approach, as well as the corrosion of its positive image in the eyes of its own citizens. Although apparently fragile, at an external level, the EU is, nevertheless, one of the key global players participating in all the important economic and political aspects of the planet alongside the great powers of the world. As its position on the map suggests, the ‘little’ EU, is caught in the middle between some territorial and political giants, such as the United States, China and Russia. Therefore, its role is all the more important as a balance between the ambitions and huge egos of the economic super-powers represented by the United States and China, and the controversial Russia. The EU's credibility as a partner in discussions on important global issues is given by its rich history; after all, the European continent has always been a core of civilisation. Furthermore, the European Union is designed as a mosaic of countries with a secular tradition in international treaties - and with great historic significance - such as Great Britain, the Netherlands, Germany, France, Spain, to name only a few, in no particular order. Apart from its history and diplomatic tradition, we should not forget the fact that the EU boasts the largest internal market in the world, with approximately 500 million consumers, which means significant purchasing power. Most countries of the world are represented in Brussels through diplomatic missions. This underlines the importance and appreciation enjoyed by the European Union on all continents. Thus, the EU undertakes the role of a mediator; of an intermediary, and negotiator, in solving serious crises faced by the entire world. The planet is undergoing obvious turmoil: official warzones, disparate and random terrorist acts, unusual weather phenomena, major political events in the Arab countries and in Africa, etc. These times of unrest call on a balanced, stable partner, which any international third party can trustfully address. It is not to be neglected that the EU has proved to be a ‘peace oasis’ for the long term, avoiding any armed conflicts on its territory since its inception. Moreover, trust is also based on competence, and competence is given by the professionalism achieved in time by European Union institutions and is embedded in many of the EU's organizational structures.

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Specific features of EU external relations A policy of the European Union in the field of external relations was not mentioned explicitly in the Treaty of Rome, apart from the common commercial policy. However, once political cooperation in the field of foreign affairs started following a Hague European Community (EC) Summit in 1969, it carried on continuously. The so-called Davignon Report - issued after the Summit - laid the foundations for the EU’s foreign policy cooperation, bringing together EC foreign ministers for organized meetings. Political cooperation was officially formalized under the 1986 Single European Act (SEA). Member states committed to ‘jointly formulate and implement a European foreign policy’, according to Article 30 of the SEA. Foreign policy became an important part of the discussions held in the European Council meetings. Even though, at times - as in other policy areas - national interests played opposition to developing a common and stronger position of the EU in external relations, the cooperation in foreign policy advanced further. Leonard (2005) observes that, in practice, foreign policy cooperation within the EU has manifested itself in three main aspects: presenting a common EU position; imposing sanctions; and taking initiatives. In these aspects, the EU worked together and spoke on an international level with one voice. Otherwise, as with all fields of EU policy, the external relations of the EU became more complicated once the EU grew in size and its membership became increasingly heterogeneous; decision-taking at a political level proved a more difficult process. The Maastricht Treaty (1992) initiated the common foreign and security policy (CFSP) to be gradually implemented by a joint action on behalf of the member states. This established the so-called second Pillar of the EU, which was entirely intergovernmental in nature. The Amsterdam Treaty (1997) added the function of a High Representative of the EU in matters of foreign policy, intended to be a key political position. Starting with 1999, the EU developed a European Security and Defence Policy (ESDP), later renamed the Common Security and Defence Policy (CSDP). This policy is destined to deal with three major issues: intervention in the case of military crises; civilian crises management; and the prevention of conflicts. To maintain security in Europe, peace-keeping operations are provided along with humanitarian and rescue initiatives. To this end, cooperation with the North-Atlantic Treaty Organization (NATO) is essential.

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As Tescasiu (2009) points out, political decisions in the EU are based on two coordinates: the EU representation at an external level and ensuring its independence and security. The European Union international representation is made through some European Commission representatives, while ensuring security for peace and democracy preservation and defending EU's interests is the main objective of CFSP, where the European Council and the EU Council play a major part. Unlike other international (intergovernmental, as regards their internal structure and process) organisations, the EU can be regarded as a supranational player from several points of view. This supranationalism resides mostly in the European Commission’s executive powers; in the post-Maastricht European Parliament’s legislative powers; and in the competences acquired by the post-Lisbon European Council. To make its own voice better heard on the international political scene, the Lisbon Treaty (2009) officially installed two new official EU positions: a President of the European Council, and a High Representative for foreign affairs. Thus, the EU answered historical American mockery about a specific and personalized EU representation in external relations. The EU has tried, through the European Commission’s voice, to become an important player at a global level. It has become actively involved in multilateral commercial negotiations within the World Trade Organization (WTO); has become the main provider of assistance and humanitarian aid in the world; and has insisted on setting international environmental protection provisions. The EU is currently the world leader in issues related to the protection of the environment on an international scale. It was instrumental in signing the Kyoto Protocol (1997) with the aim of setting certain targets for reducing the emission of greenhouse gas. Although the United States withdrew from the Protocol, the EU - as well as Japan - pressed ahead with meeting the targets set. Since then, various other summits concerning the dire condition of the environment were initiated by the EU. In time, the EU has developed a wide range of bilateral and multilateral agreements, which cover almost all the relevant commercial and political aspects with most countries in the world. It then tried to combine this network of international agreements with certain political conditions and requirements, in accordance with its objectives and principles. By creating the world’s biggest market, the EU has also begun to act like a magnet, because businesses and producers who want to access this vast number of consumers, in order to make a larger profit, have to play by the rules set by the EU. Thus, although the EU cannot match the military

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power of the United States, it has a great influence on what states and business do throughout the world, every day (Warleigh-Lack, 2007). The EU’s external relations generally follow its interests in the economic field. As noted by Molle (2006), the EU uses economic instruments (carrots and sticks) to foster non-economic objectives. The carrots are generally: increased aid to countries that comply with agreements on, for instance, the combating of global warming (Kyoto Protocol), and cooperation in the fight against terrorism or peace processes (Palestine). Sticks are less in use, although the EU has used sanctions (for instance, against South Africa, Myanmar and Belarus) to show its commitment for the respect of human rights and the enforcement of labour standards, or imposed export restrictions on strategically important goods (for example, arms to China).

Trade relations Being the largest integrated market in the world, the EU is an economic ‘superpower’, active in most aspects of international production, world trade and foreign investment. The EU is the world’s largest trading entity, which accounts for approximately one-third of total trade - if we consider both intra-EU and extra-EU trade. Extra-EU trade relations account for a 15% share in world trade (see table 5-1). The EU primarily trades in between the member states. Intra-EU trade represents more than 60% of total EU trade relations (see table 5-2), a share which has increased over time, driven by European integration. The core of the EU’s external relations lies in its initial Common Commercial Policy (CCP), which has widened in scope over the years. As Nugent (1994) notes, the CCP and the Common External Tariff (CET) enable, and indeed oblige, the member states to act as one on such vital matters: as the fixing and adjusting of external customs tariffs; the negotiation of trade agreements with non-member countries; and the taking of action to impede imports when unfair trading practices are suspected. EU external trade relations are generally governed by WTO rules. The European Commission represents the EU at the WTO, and it participates in multilateral negotiations with a common position for all EU member states. Thus, negotiation power is much more significant compared to an individual representation.

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Table 5-1: Top merchandise traders in the world, $bn (2013) Exporters

Value

Share

Importers

Value

Share

Extra-EU

2307

15.3

2329

15.4

China United States Japan Korea

2209 1580

14.7 10.5

United States Extra-EU China

2235 1950

14.8 12.9

715 560

4.8 3.7

833 622

5.5 4.1

Japan Hong Kong

Source: WTO data, 2014

Apart from its WTO status, the EU concluded a vast array of cooperation agreements and partnerships with a diversity of individual countries, and regional blocks of countries. These trade agreements, which include different degrees of preference and thus, represent an exception from WTO principles, were termed ‘spaghetti bowl’ by Bhagwati (1995). The trade instruments the EU uses in relation to third parties are concerned either with promoting trade, by initiating new agreements, negotiating preferences and facilitating market access, or with protecting its own internal market, by means of tariffs, non-tariff barriers, antidumping taxes, technical standards, safeguarding clauses, and other measures. However, the EU was repeatedly accused of inconsistencies regarding the methods it uses for determining unfair commercial policies, such as dumping, in that they were not being honest and transparent enough (Marinescu, 2011). As a general consideration though, inside the General Agreement on Tariffs and Trade (GATT) and then the WTO, the EU was one of the key players in driving the liberalization of international trade further. With successive rounds of multilateral negotiations, tariffs were torn apart and many non-tariff barriers were removed. The EU also actively supported the development of international trade law. As Prisecaru (2004) stresses, despite a difficult decisional system at Community level for the Common Commercial Policy, the EU played an important role of leader and initiator inside the Uruguay Round of the GATT. The ‘Achilles heel’ though, has always been the strong protection of agricultural and food products, determined by the Common Agricultural Policy (CAP) and the lobby of European farmers. For a long time, based

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on protectionism and dependent on the practice of subsidies, the CAP has enraged agricultural exporters all over the world. They found it excessively difficult to enter the EU market with their goods and considered export subsidies of the EU an unfair practice, which hindered their access on third-country markets as well. Consequently, during the current negotiation round within the WTO, the Doha Round, and the protectionist EU policy regarding agriculture, was found to be driven into a corner by most of the countries exporting agricultural products (Marinescu, 2013). Table 5-2: Bilateral trade of the EU with selected partners, $bn (2013) Total EU United States China Russia

EU exports 6076 100.0% 3769 62.0% 383 6.3% 197 159

3.2% 2.6%

EU imports 6004 100.0% 3769 62.8% 260 4.3% 372 274

6.2% 4.6%

Source: WTO data, 2014

Apart from the agricultural goods, the average weighted level of custom duties on manufactured goods upon entering the EU is very small. Also, as a general rule, the external trade policy of the EU has been consistent in encouraging an open, liberal and level-playing field regime in international trade. In 2006, the EU announced a new phase in its external trade policy with the publication of the „Global Europe” strategy. The rationale for the new strategy was the fostering of open markets - through the pursuit of a ‘new generation’ of bilateral and regional trade agreements - that would boost trade and investment, and thus contribute to economic growth and job creation within the EU by acting as a ‘powerful stimulus to competition, innovation and productivity growth’ (European Commission, 2006). In order to maximize the benefits from its external trade relations and foster strategic links to various partners, the EU has strived to negotiate deeper agreements, going beyond pure liberalization. De Ville and Orbie (2011) underline that although the EU has long been denounced as a protectionist actor, especially regarding agriculture, over the past fifteen years it has embraced a free trade agenda. Moreover, in the wake of the crisis, the EU has continued to staunchly defend its

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neoliberal trade paradigm, and has even reinforced its liberalization agenda. This becomes clear not only from a discourse analysis of the EU’s trade policy response to the crisis, but also from an examination of EU anti-dumping policies and of new trade agreements it has concluded.

Economic and political relations As several authors document very well, any study of the EU’s external relations raises questions about the competence and identity of the EU. What exactly the EU can, and cannot, do in the international sphere ranges from having exclusive power in some policy areas, like trade relations, to little or no competence in other policy areas, like defence (Gowland, Dunphy and Lythe, 2006). It is genuinely difficult to precisely define the position of the EU as an international player. The catchphrase used by many authors is to define the EU as an ‘economic giant, but a political dwarf’. That is surely an exaggeration, but contains some truth. The EU is rich, it is stable, and it is skilled, and thus it inevitably occupies a prominent position in the handling of global economic issues (Smith, 2007). But, the EU has struggled until now to represent itself in a common position on matters such as: terrorism; civil wars at its borders; wars in various conflict zones; and the United Nations Security Council, etc. Its approach of external relations is based more on diplomacy, negotiating, and international laws, than on exercising military prowess. Indeed, in a civilised world where military violence is rejected, economic pressure through sanctions - as emphasized by the EU - may develop into a strategic advantage over a powerful military capacity. Unlike other powers, the European Union does not have its own army. The EU member states are joining efforts as regards their international relations. Nevertheless, divergent opinions occasionally arise and EU member states are allowed to have different interventions in third countries, from a military point of view, for instance. Even if not a military superpower, the EU has a vast array of ‘soft power’ instruments at its disposal, such as trade concessions, development assistance, and European Investment Bank preferential lending, which it may use to try to alter the behaviour of non-member states and shape the international system to its liking (Dinan, 2005). Unfortunately, the EU’s use of ‘soft power’ in external relations is currently limited by its slow decision-making at home, as well as by its erosion of legitimacy with voters, the citizens of the EU. In the past, the

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procedures per se and maintenance of stability, namely reaching compromise in international relations, have often been primary to the content and substance of the results reached and adopted within the EU's foreign policy. Also, as Tsoukalis (2005) argues, even if soft power may be indeed the comparative advantage of the Europeans in a world of many failed states, as we experience now, major regional conflicts and the rising threat of international terrorism - which is often linked to religious fundamentalism - brings with it the consideration as to whether soft power on its own is enough. The violent break-up of former Yugoslavia and the looming return of war to Europe as a continent, so close to EU borders, urged the EU to rethink its foreign policy. It is evident, by now, that the EU should actively intervene to prevent and to protect, and not only react after the unfolding of certain events. The resolute US intervention in the Balkan crisis, and the feeble and unconvinced response of the EU in joining the US efforts, brought forward the weaknesses of the EU in terms of foreign policy. The EU did not seem to be able to act on its own in the event of an international crisis. A sooner and more determined intervention of the EU in former Yugoslavia might have brought conflicts earlier to a halt, with less bloodshed and fewer losses of human lives. A major problem with the CFSP, right from its initiation with the Maastricht Treaty, has been the unbalanced connection between its ambitious aims and objectives and the relatively limited existent means belonging to the EU so as to accomplish them. Some of the stumbling blocks for the EU’s foreign policy also stem from its heterogeneity. The EU is composed of different nation-states, which are all sovereign over their territory. Thus, the EU does not ‘own’ its territory in the same sense other individual countries do. So when it comes to defence, the EU has to protect a ‘collection of territories’ rather than its own. Also, some of the countries included in the EU are and have always been strong political powers. Accordingly, their own political interests did not match entirely with the aims of the EU’s foreign policy at all times. On several occasions, some of the member states had to choose between pursuing their own national interests and convictions, and partnerships built around the world, and the EU’s common stance towards third parties. Military forces fall under the full sovereignty of the member states, and defence is firstly a matter for the national governments. This became very clear with the Franco-German opposition to the US military intervention in Iraq, in 2003. On this occasion, EU members adopted divided positions.

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While Germany and France declined to participate (coined by the US ‘Old Europe’), the UK, Spain and Italy, alongside most CEE countries, manifested themselves pro-interventionist (and were subsequently termed ‘New Europe’). The division was possible due to the intergovernmental nature of decision-making processes under the CFSP.

United States The relationship with the US is a classic example of the strengths and weaknesses of the EU’s international involvement. Despite the US support for it, the process of European integration inevitably contained the seeds of transatlantic political discord. Not surprisingly, mutual frustration - and occasional unproductive rivalry - has marked political relations between the United States and the EU (Dinan, 2005). As El-Agraa (2004) notes, the EU has complained about unilateralism in the regarding United States trade legislation, ‘Buy American’ restrictions, and discriminatory taxes. For its part, the United States feared a protectionist ‘Fortress Europe’ and accused the EU of unfairly subsidizing high-tech sectors, such as aviation. The most acute and enduring cause of friction, however, has been the trade in agricultural products. Following a protracted conflict concerning the trade in bananas, which lasted for more than ten years, the WTO has found the EU guilty of imposing unfair barriers to Latin American exporters; these countries were supported by the US. As the US filed the complaint to the WTO and finally won the dispute, the US gained the right to retaliate. Subsequently, the US imposed duties on a list of EU-exported products, to compensate for the impairment. For the first time in their bilateral trade, the EU imposed sanctions against US merchandise in 2004, after a ruling by the WTO. Considering that the US followed an unfair export subsidy system, the WTO authorized the EU to retaliate. Sanctions against imports from the US were imposed by the EU with caution, on goods such as paper, toys, jewellery, and refrigerators, among others. After almost one year, the sanctions were abolished. Trade relations between the EU and the US have at times been tense, degenerating into surprisingly acrimonious disputes over issues as varied as bananas, hormone beef, trade legislation and subsidies regarding aircraft (Senior-Nello, 2005).

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However, these ardent trade disputes have been solved inside the regulatory framework of the WTO, and did not lead to trade wars. As stated before, the history of the EU's relationship with the US has had its ups and downs. Although with common roots, the position adopted in the EU’s and US’s foreign affairs with third parties differs considerably; their mutual perception is different as well. European officials accuse the US of ‘arrogance’, recklessness and precipitated actions, while American officials complain about the rigidity and bureaucratic delays undergone by EU decisions. A central role in the debate on the EU–US external relations is occupied by the question of defence for Europe. Should the EU be more inclined towards an Atlantic defence under the NATO together with the US, or should it be less prone to that, relying rather on its own reaction force under the CFSP. As McCormick (2008) argues, among governments, there are two main schools of thought: Atlanticists, such as the United Kingdom, the Netherlands, Portugal, and Eastern European states, which emphasize the importance of the security relationship with the US; and Europeanists such as France, Italy, Spain and sometimes Germany, which look more towards a reduced reliance on the American defensive shield. After the tragic events in September 2011 that led to the fall of the World Trade Centre towers in the US, a more adversarial relationship between the EU and the US emerged. The EU was not always satisfied with the new security strategy of the US, which implied meddling in a lot of countries in the world that were deemed potential terrorist threats. The crisis in Ukraine, and Russia’s armed intervention in the country, resuscitated the ‘dormant’ friendship - which has characterised the EU-US relationship. Although it has long since criticised the US for its hegemonic tendencies in the world, the European Union needs the US to stay close during this tense period. On the other hand, the US does not doubt Europe’s military friendship within NATO, but it doubts its capability. The budget allotted to defence on average is considerably lower in EU countries than it is in the US. Otherwise, the relations between the EU and the US are based on strong political ties, a common cultural heritage as well as common economic interests. The two economic powers are highly interdependent. Although the share of transatlantic foreign direct investment (FDI) flows has declined in the post-crisis period, the EU and the United States are important investment partners. For the United States, 62 per cent of inward FDI stock is held by EU countries and 50 per cent of outward stock is located in the EU. For the EU, the United States accounts for one third

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of FDI flows into the region from non-EU countries, according to UNCTAD (2014) data. The inter-relationship is pivotal for both parties, generating as many as 12 million jobs across the US, and the EU, with many of these jobs in high-wage, high-skilled, knowledge-intensive sectors (Johnson and Turner, 2006). In order to forge deeper economic ties, discussions between the EU and the US to conclude a Transatlantic Trade and Investment Partnership (TTIP) began in July 2013, and since then several rounds of negotiations followed. The TTIP is an ambitious trade deal between the EU and the US, which is supposed to harmonize and mutually recognize non-tariff barriers. It is different from a typical free-trade agreement, as most of the products traded between the EU and the US are already duty-free or are subject to low tariffs. Rather, it focuses on the technical obstacles to trade, such as regulations, standards, safety norms and certification schemes. It also goes beyond the classic liberalization of trade in merchandise, aiming at establishing rules for trade in services; intellectual property rights; public procurement; foreign investment; and the movement of workers. The TTIP envisages cutting all sorts of red tape costs for companies, by simplifying customs procedures and reducing regulatory barriers. The potential benefits are hard to estimate, but one reasonable guess is that an “ambitious” TTIP could raise America’s Gross Domestic Product (GDP) by 0.4%, and the EU’s by slightly more (La Guardia, 2014a). Besides bringing the two economic giants closer together (the deal covers around 40% of the global GDP), the TTIP would also carry political weight. It represents the biggest trade deal ever negotiated.

The neighbourhood The EU always showed a commitment to gradually liberalize trade with Mediterranean countries. This process started in the late ‘70s with the conclusion of bilateral cooperation agreements. Building on these, the Euro-Mediterranean partnership (EuroMed) was launched at the European Council in 1995, in Barcelona (and then re-launched in Paris in 2008). As a result, bilateral association agreements were signed with 12 Mediterranean countries. These association agreements implied the gradual elimination of tariffs on a consistent range of goods between the two sides. Virtually all tariffs on industrial goods were dropped, while the liberalization of agricultural products and services followed a progressive scheme.

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Alongside trade liberalization, the stimulus package of the EU included mainly aid, foreign direct investment, and technical assistance, on the economic side. The mixed results in the economic growth and political maturity, of the neighbouring countries, followed the mixed arrangements offered by the EU. These included association agreements, trade and cooperation agreements, aid agreements, the Everything-But-Arms initiative, and the Mediterranean Policy, among others. As Dauderstadt (2005) observes, the most successful EU policy so far, however, has been to offer EU membership. That incentive has led to farreaching political and economic reforms in the candidate countries. But, membership obviously offers no guarantee of catch-up growth. Moreover, plagued with its internal problems, the EU does not seem keen on further enlargement and even in the long run, some neighbouring countries - especially to the south - are never set for full membership. As a consequence, the EU offered mostly a trade liberalization deal to most non-candidate countries in the surrounding region. However, there is no substantial evidence that trade liberalization leads to higher economic growth (Rodrik, 2001). In the mid-2000s, with the imminent eastern enlargement in sight, the EU tried a more unitary approach towards the surrounding region. Thus, setting aside the 10+2 countries set to join the EU, in 2004 and 2007 respectively, the EU launched its European Neighbourhood Policy (ENP) in 2004, by including 16 countries that lie geographically to its south and east. The ENP comprises all EuroMed countries, with the exception of Turkey, which had already started accession negotiations, plus Eastern European countries, but not those in the Balkans. This suggested for some observers that the countries included in the ENP are actually those that will never be invited to join the EU as a full member state. Thus, somehow confusingly, the EU created parallel partnerships with several neighbouring or close-by countries, in overlapping frames. The EuroMed still remains the central structure of the system of governance in the Mediterranean with the ENP playing a supporting, albeit important, role. The further development provided through the ENP is on a bilateral basis, rewarding those partner states who wish to pursue deeper integration with the EU, with certain advantages in return for specific reforms (Cardwell, 2011).Within the Barcelona process, partner countries of the EU were treated in the same way. This may be one of the reasons for which relations didn’t develop at a fast pace. To counter this, the EU tried a different approach with the ENP, envisaging customized partnerships with each neighbouring country according to the latter’s level of economic development and objectives.

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Nevertheless, the EU should carefully monitor its Neighbourhood Policy from time to time, especially because it adds together very different countries. This group includes Maghreb countries in North Africa, Arab countries in the Near East, Balkan countries as well as republics detached from the former Soviet Union. These countries have different aspirations as regards their relationship with the EU, and their aims vary significantly with respect to the EU. While some of them have a long-term ambition to be integrated within the EU, others do not share this vision. Another concern in the region is linked to immigration. The EU confronts itself with high illegal immigration from the neighbourhood, mainly from Africa, and especially since the Arab Spring began. Poor living conditions in African countries drive many citizens to flee across the Mediterranean towards Europe. Since 2011, Italy, Spain, Malta and Greece constantly report high figures of illegal immigrants trying to enter the EU. These countries carry a large burden and face massive costs to deter immigrants. However, they are just transit countries as most immigrants head north for their final destination in other EU member states. Despite the continued and long-lasting EU efforts to stimulate, or at least support, economic growth and democracy among its neighbouring countries, there are serious doubts about its effectiveness. Various policies, intended to boost the performance of countries surrounding the EU, brought modest to no results to the south, and partial to slightly better results to the east. Even if the external trade of Mediterranean countries has increased over the years, their share in world trade remains modest. These countries are highly dependent on the EU as a trade partner. Usually, more than half of their external trade is carried out with the EU and the relationship is quite asymmetrical in nature. Whereas Mediterranean countries depend heavily on their exports to the EU market, their respective markets are non-significant for EU exporters. Statistics show that the trade between the EU and Mediterranean countries remains rather underdeveloped. As trade barriers fell all over the world and trade liberalization became widespread, the preferences awarded by the EU to its partners eroded. Despite having zero tariffs set on a number of goods, import duties were still paid when the preference exceeded the cost of complying with the rules of origin. Thus, it is considered that trade with neighbouring countries has still a lot of potential to grow, if harmonization of standards advances and non-tariff barriers (NTBs) are removed. The application of NTBs, both in the EU and Mediterranean partner countries, is often

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considered as a major obstacle to a genuine trade liberalization process (Marinescu, 2013). This is why the EU should reassess its diversity of trade deals offered to developing countries in the neighbourhood. Improving further market access to the EU would be a good solution, as it proved useful for candidate countries. Including agricultural and fisheries products in the liberalization scheme would constitute a great welcoming sign that the EU opened up its agricultural market. Mitigating a lot of the technical barriers to trade would definitely help exporters from partner countries. Aid schemes should be properly supervised to ensure that the money does not flow into personal pockets. Also, capital flows for regional projects such as infrastructure should be subjected to fulfilling certain best-practice conditions by the beneficiary countries, and should truly and actively involve enterprises from these countries in the development and implementation of these projects.

Turkey Turkey initiated accession negotiations to the EU during 1959, but discussions advanced slowly. One of the reasons was represented as being the occupation of Northern Cyprus by Turkey in 1974. However, since 1964, Turkey benefitted from an Association Agreement with the European Economic Community (EEC). In 1987, Turkey applied for full membership in the EEC, but was met with refusal, mostly on political grounds. At the Luxemburg European Council in 1995, when ten of the Eastern European countries were granted application status to join the EU, it was considered that Turkey did not fulfil the political and economic conditions to start the accession negotiations. This decision led to much dissatisfaction with the Turkish authorities and the Turkish public, which increasingly felt that the EU applies double standards to Turkey. The EU policy has frequently been unclear, ambiguous or even misleading to the extent that it has at times encouraged high expectations on Turkey’s part when in reality there was no possibility of the country’s accession in the foreseeable future. Turkey, for its part, has shown an eagerness to embrace the high expectations engendered by occasional Commission rhetoric to the point of self-delusion, and has simply failed to deliver on many of its commitments to the EU (Redmond, 2007). Until now, only the customs union - established with the EU in 1996 remains in place, as a first step towards integration. The customs union is,

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however, a more profound form of integration than a preferential trade agreement or a free-trade agreement (FTA). Even if Turkey made significant progress in a lot of areas (political, economic, social, administrative, etc.) it never completely fulfilled the Copenhagen criteria for accession to the EU and, as such, its integration perspectives remain unclear. There are surely many advantages associated with Turkey’s accession to the EU. The size of the EU would grow considerably and thus it would gain a lot of weight on the international scene. As with each enlargement before, the economic argument of increased economic efficiency in the allocation of factors of production still holds. The EU’s slogan “unity in diversity”, would be truly fulfilled. By letting Turkey join, the EU would send out an extraordinary signal of tolerance for the Muslim culture and religion. Still, there also remain many obstacles in place for Turkey’s accession. Turkey is a large country, mostly located in Asia and its population (second to Germany) would bring a reallocation of powers in EU institutions. Being relatively poor, it would also require a significant transfers of funds, including those for the CAP. By incorporating Turkey, the EU’s eastern borders would shift out to politically unstable areas, such as Syria, Iran and Iraq, requiring thus increased defence efforts. Also, hardcore manifestations of the Muslim religion raise concerns for many European citizens. As regards Turkey’s accession to the EU and the implementation, even if not right away, of the principle of free movement of people, a significant number of Turkish citizens in search of a job is likely to be attracted to economically stable countries, such as those in Western Europe. That is why public opinion fears that one of the direct effects of Turkey’s accession may be an invasion of Muslim migrants towards the west of the continent. Even if a similar concern may have existed in connection with some other poorer countries, such as Romania or Bulgaria, it proved to be ungrounded in practice. The rise of extremist Muslim factions such as the jihadists – “the Islamic State”, however, throws an implicit shadow of doubt over Turkey. Consequently, France, a country with an already high percentage of Muslim minorities and major problems associated with it, has become more cautious and has adopted a slightly more negative attitude towards Turkey’s accession. Until recently, Turkey has praised several advantages in sustaining its accession aspirations, such as its dynamic economy and geostrategic position, as well as its NATO membership, which would bring stability to the region. However, the effects of the economic crisis, the implications of

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the revolutions burst in the Arab states in the area and especially the retrograde policy of the former Prime Minister and then President Recep Tayyip Erdogan has tensed the relations between Turkey and the European Union.

Ukraine With a rich history behind it, Ukraine won its independence as a country only in 1991, following the collapse of the Soviet Union. Unfortunately, its territory has always been the witness of battles between the East and the West. Geopolitically, Ukraine is extremely important to the EU, due to its size (of both the population and the territory) and strategic position (border with both the EU and Russia). Also, the EU supplies about one-quarter of its gas from Russia, and half of it flows through Ukraine. Short breakdowns are not a problem, but in the mid-term the EU could be very affected if gas pipelines in Ukraine were to be cut off. Following the 2012 talks for an Association Agreement between the two parties, in 2013, Ukraine was about to secure a deep and comprehensive free-trade agreement (DCFTA) with the EU, which would have brought it closer to the West, and partially removed it from under Russia’s omnipotent influence. The free-trade agreement was intended to introduce a major liberalisation of bilateral trade, with most of the import duties set at zero, while the remaining tariffs were to be reduced; export duties were to be gradually eliminated over a 10-year period. Ukraine’s separation has never been looked favourably upon by Russia though, which considers Ukraine as being an integrant part of the Russian history, culture and territory. In November 2013, following an unofficial meeting between the two presidents at the time, when Russia was promising natural gas supply and opening a credit line for Ukraine (among others) - as well as Ukraine’s inclusion in a future customs union with Belarus and Kazakhstan Ukraine dropped the agreement with the EU. This upturn brought the Ukrainian citizens out into the streets. The authorities’ attempt to brutally repress protests led to violent forms of demonstration, and fights between pro-EU protesters and the forces of order. Since then, the political situation in Ukraine has always been tense. Following the shooting down of a plane by pro-Russian rebel factions in eastern Ukraine, a long series of regional fights followed, which led to many casualties and loss of lives.

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Russia’s military involvement in these fights strained relations with the EU and brought Ukraine between a ‘rock and a hard place’. Under pressure from the protesters and the general public, Ukraine finally managed to sign a Europe Association Agreement in September 2014, although delaying several of its provisions. The agreement is asymmetrical in nature. Ukrainian exports are admitted duty-free to the EU but not the other way round, until 2015. On the military front, a peace agreement was signed in February 2015 in Minsk by the leaders of Germany, France, Russia and Ukraine with the intention to cease hostilities between Ukrainian rebels backed by Russia and the Ukrainian army.

Russia The EU’s relation to Russia has always been controversial. Even before the split of the Soviet Union, the connection between the EU and Russia has never been true. This is an important insight about the role of the EU as an international actor, showing its limitations in world politics. As Tsoukalis (2005) puts it, EU-Russian relations were for years a case of mutual neglect. Traditionally, Russian leaders have shown little understanding and interest in the intricacies of low politics and the refined diplomacy of the post-modern civilian power of the EU, choosing instead to behave in the fashion of a traditional great power. They did not comprehend the world of Brussels and, in perfect reciprocity, EU institutions showed themselves incapable of dealing with a big country, which was not duly impressed by offers of diluted versions of association agreements, including some technical assistance. In the wake of the disintegrated Soviet Union, the EU negotiated with Russia, in 1994, a Partnership and Cooperation Agreement (PCA). Russia saw the PCA primarily as a means by which it could gain access to European markets, to compensate for the collapse of its traditional markets in Central and Eastern Europe (Timmins, 2003). The implementation of the PCA was delayed until 1997 though, after Russian troops invaded Chechnya for the first time. Other attempts of the EU to bind closer political ties to Russia were subsequently hindered by a second Russian invasion of Chechnya. Nevertheless, despite the absence of a balanced economy and persistent question marks over the policy direction of the country, Russia remains a key partner for the EU, for both economic and political reasons (Johnson and Turner, 2006).

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EU-Russian annual trade amounts to around $450 billion (see table 52). While the EU is Russia’s most important export partner, Russia is only the fourth export destination for EU merchandise (excl. intra-EU trade), after the United States, Switzerland and China. As demonstrated by Benkovskis, Pastusenko and Woerz (2014) in a comprehensive study of bilateral EU-Russian trade, the importance of the EU for the Russian economy is significantly higher than Russia’s importance for the EU. First, the EU economy is much larger than that of Russia. Second, many European producers are positioned downstream in the global value chains, which explains the larger share of exports from the EU in the final domestic use in Russia. Finally, higher participation in global value chains increases the importance of EU value added for Russian consumers and producers. The souring of relations between the EU and Russia, as a result of the latter’s having invaded Crimea at the beginning of 2014 and subsequently attached it to Russia, has expedited the EU’s attempts to reduce its energetic (oil and gas) dependence on Russia. The EU launched its first sanctions against Russia in March 2014, by cutting off foreign exchange operations and freezing assets. Companies in the EU have lobbied against tougher sanctions on whole industries, as they feared the collapse of the bilateral EU-Russian trade. After two stages of milder sanctions and more threats, the EU and the US agreed though on a tougher package of sanctions. They came as a reaction to the continued intervention of Russia in Ukraine. These sanctions were imposed, starting with July 2014. The export of technology for oil, and the defence industry, ceased and some Russian state-owned banks were cut off from long-term external financing. Russian trade officials responded with an import ban on EU food exports that (partially) ‘hurt’ European food producers. Some of the financial sanctions imposed on Russia have led, in time, to the dramatic fall of the rouble and have badly damaged the Russian economy. At the end of 2014, Poland submitted a proposal for the European Union to act as a single buyer for the gas resources imported from the Russian company. Gazprom. Thus, the EU’s negotiation power would increase considerably, as compared to the individual-country negotiating option, thereby limiting Russia’s power to divide and turn customers one against another. European countries themselves have expressed divergent stances towards Russia - not only the western members, but also the eastern ones. Dependence on trade with Russia, concerning the oil and gas supply, is

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only a partial explanation. Germany and France, backed by Italy, Hungary, Bulgaria and the Czech Republic, have shown the most prudent attitude. Great Britain, Sweden, Finland and Poland have adopted a more blunt attitude, along with the three Baltic countries (Lithuania, Latvia and Estonia). For the Baltic States, with large Russian minorities, the choice is not between sanctions and doing nothing, but between sanctions and the risk of disappearance (La Guardia, 2014b). Since the seizing of Crimea and the intervention in eastern Ukraine, the EU worries about Russia’s territorial and historical ambitions to reassemble a lost empire. In order to reduce the political and economic influence of the EU on the former Soviet republics, Russia initiated the Eurasian Union (built on the model of the former Eurasian Economic Community), together with Belarus and Kazakhstan in 2014. Armenia entered the union at a later stage. Kyrgyzstan is also set to join in 2015. Russia is viewed as a great Eurasian power whose role it is to organise and stabilise Eurasia’s heartland, and to operate as a buffer or bridge between Europe and Asia (Smith, 1999). This is consistent with the Eurasian view; a rather new stream of thought about the place and role of Russia in relation to Europe, popular with current Russian political officials.

China China began to transform itself from a centralized into a market economy in the late ‘70s. It took a very long-term approach and the process of transformation is still ongoing after more than 30 years. The reforms led to outstanding results and China enjoyed a long period of significant, at times even spectacular, economic growth. A lot of China’s development is owed to the rapid expansion of Chinese exports, especially in manufactured goods. China became the world’s largest exporter of merchandise in 2009 and it still holds the top position (see table 5-1). Consequently, China became an important trade partner of the EU, replacing the US as the largest supplier for the EU market. The trade balance usually shifts in favour of China, whose exports - albeit from affiliates of foreign multinationals as well as from domestic exportoriented Chinese firms, which benefitted from technology transfer surpass EU exports (see table 5-2).

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Following China’s ascent in world trade, the EU sought to foster a good diplomatic relation with China. A first trade agreement was signed in 1978, and bilateral cooperation was then extended to several areas. After the repression of protesters by Chinese authorities in Tiananmen Square in Beijing in 1989, trade sanctions were imposed by the EU and relations grew cold. In the early ‘90s, commercial relationships were resumed, and the European Commission published its first strategy paper on EU-Chinese relations. China issued its first policy paper on relations with the EU in 2003 following its historical accession to the WTO in 2001. At the beginning of the 2000s though, China became the number one target for the EU’s antidumping measures. Most of the dumping investigations were launched for chemicals and metals, as well as other miscellaneous manufactured goods. China’s low-cost competition in many industries raised general concerns for the European industry. Also, European companies are increasingly annoyed as they struggle to cope with many trade and investment barriers when operating in the Chinese market. Despite these hardships, in recent years, EU-Chinese relations took off in a number of fields, spurred by the desire of both entities to gain a better reciprocal market access, to increase foreign direct investment, and develop trade links. This also shows the preference of the two parties for a multi-polar world. Moreover, China recently became the world’s third largest economy by GDP - after the EU and the US - overtaking Japan. China’s development into an economic superpower brings opportunities as well as threats to the European Union economy.

Korea Along with the consistent economic growth of South-East Asia in the last decades, South Korea (Korea, hereafter) established itself as one of the largest exporters in the world (see table 5-1). Imitating the Japanese model of outward-orientated domestic companies, Korea climbed the rankings of world exports in an impressive manner (see table 5-3). Being aware of this development, starting with a first Asia-Europe Meeting in 1996, the EU has sought to develop its relationships to Asian emerging economies, including the Republic of Korea. Negotiations for a free-trade agreement with Korea started eventually in 2007 and the agreement was finally signed in 2010.

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It was the first free trade agreement concluded by the EU with an Asian country. The agreement entered into force in 2011 and was also the first of the DCFTAs concluded by the EU, after departing from its multilateral stance at the end of the ‘90s. As Lakatos and Nilsson (2014) observe, the agreement is unprecedented both in its scope and in the speed at which trade barriers are removed. The majority of customs duties on goods were removed at the entry into force of the agreement and by 1 July 2016, practically all EU customs duties on industrial goods will be removed. The FTA also eliminates quantitative import restrictions and all forms of duties, taxes, charges and restrictions on exports, and includes provisions on issues ranging from services and investments, competition and government procurement to intellectual property rights. A distinctive aspect of the EU-Korea FTA is the liberalization of trade in services, covering shipping, air transport, express delivery, telecommunications, use of satellites, and some financial services, among others. The EU’s main concern that led to the conclusion of this agreement was about market access. European companies find it very hard to penetrate the Korean market effectively. One important reason for this is the intricate network of supplier-producer-distributor system of logistics inside the Korean ‘Chaebol’ structures. .

Table 5-3: Shifting positions in world merchandise exports, $bn 1980 Rank 1 2

Extra-EU United States China 31 Korea 33 Russia Source: WTO data, 2013

2011 Share 14.51 11.09

Rank 1 3

Share 11.68 8.11

0.89 0.86 -

2 8 10

10.40 3.04 2.86

Once the agreement had entered into force, exports increased on both sides as a positive effect, with a slightly better margin in the case of the EU. Contrary to popular belief and nationalistic fears that an opening up of the EU market to Korean exports will lead to a flood of cheap manufactures, estimates show that EU exporters will benefit more from the trade liberalization induced by the agreement compared to Korean exporters. This stems from the fact that the business environment in Korea

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will become more predictable in terms of trade policy, whereas the EU market did not bear too many secrets anymore to Korean exporters. Also, the initial level of protection was higher on the Korean side. Thus, the FTA will most probably lead to a significant increase in bilateral trade in the years to come with a further extension of intra-industry trade in specific sectors, such as car manufacturing.

Conclusion The share of the EU in world trade has fallen over the last years, even when considering both extra and intra-EU trade, despite the increasing number of member states, whereas the rise of some Asian economies has been phenomenal (see table 5-3). This calls for a balanced trade approach of the EU towards emerging economies, not only the US. The EU should keep all external trade and political relations in good shape simultaneously, both to its left and right of the map, according to its geographical position and its role of international mediator. The EU would be wise to defend its liberal attitude towards international trade, for which it fought so hard since the formation of the EEC. On the one hand, the EU should make all efforts to keep the TTIP on the right path. Advanced talks to the US administration will be geopolitically very important in the years to come. On the other hand the EU should deepen the already concluded agreements discussed during this chapter (with Korea, Turkey, Ukraine, and neighbouring countries) so as to generate more consistent benefits for the parties involved. Apart from those, establishing a sound partnership with China is absolutely compulsory for the EU, taking into account the paramount role played by China in the world. This is why the EU should carefully rethink its cooperation with Chinese authorities, as politics still holds a great degree of influence over economic matters. Moreover, maintaining a peaceful relation with Russia, the closest of the EU’s trade partners - geographically considered - would further legitimate the diplomatic powers of the EU. The outburst of a large military conflict involving the European continent is for sure the worst case scenario for the future of this region. Considering all this, the EU needs to rethink its external relations. It is not any more important if it already wished to do so or not. Confronted with the current troubles of the Eurozone, in need of a Greek bailout, and constantly searching for consistent solutions to restart economic growth, the EU has focused a lot on its internal problems.

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Adding to this, the shadow of a possible military threat from Russia following the Ukrainian crisis, as well as the rise of terrorism in the Middle East, have bluntly brought forward major external challenges for the EU. Now the EU has to live up to these complex events by taking a more resolute course of action. It should send clear-cut signals after going through its typical procedures of institutional decision making. Moreover, it has to arrive at these decisions in a relatively short period of time, so as to avoid costly delays in implementation, which may also be interpreted as weaknesses by international partners. In the process of negotiation, the EU should ‘flex its economic muscles’ by bringing forward the strength of its internal market and the benefits of economic ties, whilst avoiding a military confrontation of any kind.

CHAPTER SIX THE MONETARY POLICY OF THE EUROPEAN CENTRAL BANK DURING THE INTERNATIONAL CRISIS VICENTE ESTEVE AND MARIA A. PRATS

Summary The financial crisis and the ensuing problems caused by its duration worsening fiscal conditions, and the fragility of the banking systems in some European countries - all played a part in the increasing fragmentation of the main European finance markets, the break in monetary transmission, and the deterioration of macroeconomic variables in the Eurozone. The scenario led to growing rumours of euro reversibility, which were fed by climbing risk premiums in stressed countries, and this opened the way to the systemic phase of the crisis. To tackle this intense vicious circle economic adjustment was required, including structural reforms by the Governments of the hardest hit economies. The European Central Bank (ECB) also had to take a strong line in defence of the single currency. Lastly, European authorities also had to give a boost to the idea of advancing towards a genuine Economic and Monetary Union (EMU). The analysis of the conventional and nonconventional measures adopted by the ECB to save the monetary transmission mechanism and avert the risk of deflation in the Eurozone; the problems of financial fragmentation caused by balance sheet weaknesses among credit institutions and the growing divergence of national financing costs; and, finally, the role of the euro; are broached in this chapter.

Introduction Summer 2007 saw the first stirrings in the heart of the USA’s financial situation, regarding the current international crisis, as problems started to

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show in financial institutions. These were as a result of the real estate bubble in America, which set off the fierce selling of complex structured finance products including residential mortgage backed securities that were heavy in subprime mortgages the world over; risk levels spread uncontrollably till they reached a highpoint in September 2008, when Lehman Brothers collapsed. Figure 6-1 reflects the explosive effect of this financial turbulence from its origins to its ensuing development, by presenting the evolution, from 1999 January to 2015 January, of the Composite Indicator of Systemic Stress (CISS)1. This new index was prepared by the European Central Bank (ECB) and provides a working tool for the European Systemic Risk Board (ESRB), whose function is to conduct a macroprudential supervision in order to identify, assess, and monitor the levels of friction, tension, and pressure within the European financial system. Figure 6-1 Systemic Stress Composite Indicator, Index pure number 1.0 Subprime Crisis 0.84

0.9 0.8

Debt Crisis 0.70

0.7 0.6 0.5 0.4 0.3

Dot-com Crisis 0.30

0.2

0,2

0.1 0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: ECB

It can be seen how the indicator captures stress deriving from the subprime crisis and shows that the maximum level of global instability was reached in December 2008 (0.8), while the record minimum occurred early in 2014. The maximum value has been unequalled in any other crisis; it marks the moment that deep recession set in, with the almost 1

In the characteristics of the CISS and its methodology, see Holló et al. (2012).

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complete disappearance of liquidity and rampant financial risk. The crisis swiftly hit the real economy. In the Eurozone it took the form of sovereign debt crisis, which was particularly severe for vulnerable countries like Greece, Ireland and Portugal, although Spain and Italy, two of the main euro economies were also hit hard. The value of this indicator reflects high instability from May 2010, when the Greek debt crisis appeared, and which peaked in November 2011 (0.6). The problems stemming from the worsening financial crisis - the deterioration of fiscal conditions and the fragile banking systems in some European countries - all played a part in breaking up the main European financial markets and in the worsening macroeconomic variables in the Eurozone2. This led to talk of abandoning the single currency, which sent risk premiums soaring in the over-stretched countries and opened the door for the systemic phase of the crisis. In an attempt to counter such a gloomy scenario a three-pronged action plan was deemed necessary3: an intense economic adjustment policy along with structural reforms on the part of the affected Governments; a strong line taken by the ECB to shore up the single currency; and, lastly, the drive from the European Commission and European Council towards a European Banking Union built on three pillars: the Single Supervisory Mechanism (SSM), which the ECB took on in November 2014; the Single Resolution Mechanism (SRM); and related funding arrangements, including a Single Resolution Fund (SRF), deposit guarantee schemes (DGS) and a common backstop (credit line)4. The crisis is not over, but it does seem that it has started to remit, although there are latent problems that will take a long time to disappear, especially the impairments in the monetary transmission mechanism and the financial fragmentation provoked by the combination of bank and sovereign debt risks. The rift between unstressed countries like Finland, Germany, Holland or Luxemburg, and those in a more precarious situation, like Greece, Ireland, Italy, Portugal and Spain, may take a decade or more to heal. This chapter analyses the role of the European Central Bank (ECB) during the international crisis, and is organised as follows: Section 1 addresses the conventional and non-conventional monetary policy measures employed by the ECB during two phases: the international financial crisis, and the sovereign debt crisis. Section 2 looks at the effects of the high degree of financial fragmentation that ensued 2 For more information on the loss of financial integration see the ECB (2012a, 2013a, 2014a) reports on “Financial Integration in Europe”. 3 For more details on the characteristics of the crisis in the euro area and the role of the shortcomings in the institutional design Shambaugh (2012). 4 See de Grauwe and Ji (2014).

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from credit institutions' balance sheet problems, and the wide divergence in national financing costs. Section 3 examines the use and the role of the euro in the international economy, and section 4 concludes.

The response of the Central European Bank to the international crisis The ECB has adapted its response by combining common monetary policy tools and incorporating extraordinary measures, also referred to as non-conventional measures. In the main, this strategy coincides with strategy adopted by the Federal Reserve (FR) of the USA and the Bank of England (BoE)5. Differences in the application of the tools are due to the limitations imposed on the ECB by the Treaty of Lisbon and by its own normative, and can be specified as follows: x The primary objective of the ECB’s monetary policy is to maintain price stability, while the FR and the BoE have the added aim of employment. x The ECB is the sole competent authority in monetary policy, while economic policy is in the hands of fifteen sovereign states6, each with their own Treasuries and Parliaments, which means that monetary and fiscal interactions are far more complicated than in the USA and the UK. x The ECB is prohibited from financing the public sector and therefore cannot acquire debt on the primary markets nor can it act as a lender of last resort for the member states. x The ECB cannot act as a lender of last resort for a financially troubled credit institution. The emergency liquidity assistance programme (ELA) has to be performed through the corresponding national central bank. x The sole valid counterparts of ECB monetary policy operations are Eurozone credit institutions, so it is not possible to inject liquidity directly into households or non-financial firms. x All liquidity injection operations need to be supported by collateral assets.

5

For more details on measures adopted by the ECB, Federal Reserve and the Bank of England between 2007 and 2009, see Lenza et al. (2010), Cour-Thimann and Winkler (2013) and IMF (2013). 6 Including the incorporation of Lithuania, in January 2015.

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The overall strategy of the ECB can be summarised in two large areas of action: 1. The reduction of official rates to a fixed rate very close to zero is reached. This has reduced room for manoeuvre in monetary policy based exclusively on a policy of interest rates, and hence on the capacity of the ECB to bring in new stimuli once official interest rates hit very low levels7. Figure 6-2 Central Banks interest rates %

FR

BoE

ECB

6 5 4 ECB: 0.25% from 2013 Nov., 0.15% Jun and 0.05 from 2014 September

3 BoE: 0.50% from 2009 March

2 1

FR: 0.25% from 2008 December

0 2007

2008

2009

2010

2011

2012

2013

2014

2015

Source: ECB, FR, BoE

Figure 6-2 shows the movements in interest rates of the ECB, the FR, and the BoE, between January 2007 and January 2015. The possibility of a strong recession, and an enhanced risk of deflation, led the ECB to drop its official rates between October 2008 and May 2009 by 325 basis points, until it reached about 1%. Since September 2014 it has hovered around 0.05%, an all-time low and very close to the bottom level fixed in the USA in December 2008, and below that in effect in the United Kingdom since March 2009. 2. The incorporation of non-conventional monetary policy measures has meant that policies have been developed around rates close to zero, which do not respect the limits of interest rate policy. The actions comprising these steps have set off an expansion of the ECB balance sheet, and a change in its composition and risk profile. 7

See Bernanke et al. (2004).

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Figure 6-3 Central Banks balance sheet Assets = Liabilities, 1 January 2007=100 RF

BI

BCE

550 508

486

500

475 450 400 321

350

306

300

269

250 200 201

172

150 Mr. Draghi's mandate 100 2007

2008

2009

2010

2011

2012

2013

2014

2015

Source: ECB, FR, BoE and calculations

Figure 6-3 shows the trajectory of the three central banks between January 2007 and January 2015. There is a clearly appreciable effect of these non-conventional measures8 on the statements of the central banks and the paths followed. The ECB shows the lowest increase in the balance sheet of the three. Since January 2007, the FR and the BoE have multiplied their balance sheets by 5 and 4.8 respectively, as a result of a clear, firm and decisive large asset purchasing policy. The growth of the ECB balance sheet peaked in June 2012, when it was 2.7 times higher, as a result of a massive liquidity injection (with two 3-year very long term refinancing operations, VLTRO). Since then the amortizations of public and private asset purchases programmes, the decrease in the ELA programme budget, and early repayments of the liquidity injections, explain the contraction in its balance sheet. In order to address the set of actions undertaken by the ECB to counter the international crisis, we divide the time period into two large stages: the financial crisis and the sovereign debt crisis (see Table 6-1). This is not meant to imply that the financial crisis is over but that from it there arise factors related to the deterioration of peripheral economies in the EMU area.

8

For a theoretical exposition and justification of the effectiveness of this type of measures see Cúrdia y Woodford (2011).

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Table 6-1 Phases of the international crisis

FINANCIAL CRISIS

SOVEREIGN DEBT CRISIS

First or initial phase of the financial crisis Second phase or the heightening of the financial crisis Third phase or the start of the sovereign debt crisis Fourth phase or the systemic phase of the sovereign debt crisis Fifth phase or the aggravation of the systemic phase Sixth phase or the drive towards a real EMU

August 2007 - September 2008 October 2008-December 2009 January 2010-June 2011 July 2011-February 2012 March 2012- November12 since December 2012

First or initial phase of the financial crisis (August 2007 - September 2008) Until September 2008, two types of measures were adopted: liquidity management and those adopted in collaboration with other central banks. The liquidity management had a triple aim: to reduce tensions on the wholesale cash markets by increasing the number of long-term refinancing operations (LTRO) with complementary operations of 3 and 6 months; to get the euro overnight index average (EONIA) to hold steady around the official rate and so continue to guarantee monetary policy transmission; and to improve the distribution of liquidity through the system by extending guarantees and returns. Elsewhere, lines of foreign currency injection - in the main, USA dollars - were also incorporated through agreed swaps among the central banks. All the measures introduced by the ECB were incorporated without having to make modifications to the operational framework of the monetary policy instrumentalisation, or to the size of its balance sheet. The official rate remained constant and even rose slightly in July 2008. Second phase or the heightening of the financial crisis (October 2008-December 2009) As of this moment, the effects of the monetary policy actions began to kick in and official rates plummeted to record lows. In October 2008, the ECB brought in a set of exceptional measures known as Enhanced Credit Support. These marked the beginning of a non-conventional monetary policy whose aim was that the flow of credit to the economy remained well above the levels attained with conventional tools, with decreases in the official rate (the interest rate of the main refinancing operations, MRO), and a tightening of the corridor of the standing facilities. In May

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2009 the official rate stood at 1% and the standing facilities corridor fell from 200 to 150 basis points. The non-conventional measures supposed the expansion of the ECB balance sheet through the following actions: x The unlimited supply of liquidity to credit institutions: MRO and the LTRO are, from now, conducted via fixed rate tenders with full allotment. x A longer list of acceptable assets as collaterals and the reduction of rating demands on collaterals. x The extension of the maturity date of the LTRO through additional operations at 6 and 12 months (since June 2009), making the tool from then on the main route for credit institutions in the Eurozone to seek liquidity. Figure 6-4 shows just how much it strengthened against the MRO which, until then, had been the basic tool for liquidity injections. Figure 6-4 Liquidity providing operations: MRO and LTRO EUR millions MRO

LTRO

1400000 1200000 1000000 800000 600000 400000 200000 0 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Source: ECB

Direct purchases of private debt securities conducted in both the primary and secondary market. In July 2009, the ECB decided to provide support - in terms of liquidity, issuance and spreads - to the covered bond market in the euro area through outright purchases of covered bonds under the Covered Bond Purchase Programme (CBPP1). Under the CBPP19 the Eurosystem made outright purchases of covered bonds, in the primary and 9

See Beirne et al. (2011) to analyze the impact of this program in the primary and secondary markets.

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secondary markets, to the nominal value of EUR 60 billion over the 12month period from 6 July 2009 to the end of June 2010, when the programme was completed. It was mainly bonds with maturities of three to seven years that were purchased under the programme (this equates to an average modified duration of 4.12 years). The programme succeeded in increasing the scope and depth of this important European market, with a significant increase of issuers and outstanding amounts on some national markets. Towards the end of 2009 the satisfactory results of these measures and the observable improvement in financing conditions in the Eurozone, led the Governing Council of the ECB to announce and to initiate the gradual phasing-out from the ‘non-standard’ policy measures as of the first term of 2010. Third phase or the start of the sovereign debt crisis (January 2010-June 2011) In early 2010, when the strategy to exit the crisis was being designed, the first tensions appeared in Greece. Since then, market distrust of the sustainability of public finances in peripheral Eurozone countries (Greece, Ireland, Italy, Portugal and Spain) grew until reaching a critical peak on April 23 that year, when the Greek Government sought a bailout from the European Union (EU) and the International Monetary Fund (IMF). The ECB response, to what is now known as the sovereign debt crisis, was to bring in a new extraordinary measure based on the purchase of public and private securities (the Securities Markets Programme, SMP), through which it sought to avoid the contagion of other EMU states and to improve monetary transmission. The SMP allows the central banks of the Eurosystem to purchase public debt securities on the secondary market that have been issued by member states in euros, and to purchase negotiable debt instruments on the primary and secondary markets issued by private institutions constituted within the Eurozone. The programme introduces two limitations: first that SMP purchases are to be neutral, which implies sterilising10 through the capturing of fixed term deposits that allow the injected liquidity to be reabsorbed by the purchasing programme. Second, that sovereign debt purchases should not be directed to financing States, otherwise they would be in violation of article 123 of the Treaty of Lisbon and article 21 of the ECB (which expressly prohibit the ECB being a lender of last resort for 10

5 June 2014, Governing Council of the ECB decided to suspend the weekly fine-tuning operation sterilizing the liquidity injected under the Securities Markets Programme.

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States). The SMP was not able to prevent either the application for a bailout by Ireland in November 2010 or that of Portugal in April 2011. Furthermore, in October 2010 in an attempt to increase the complementary lines of liquidity injection, the ECB conducted the second Covered Bonds Programme (CBPP2), again with a one-year duration and a provision of EUR 40 billion, of which only a small part was covered (EUR 16.4 billion) due to a shortfall in issues on the primary market and an overlap with the positive effects of the 3-year very long-term refinancing operations (VLTRO). The official interest rate was raised twice and stood at 1.5% at the end of this phase. Fourth phase or the systemic phase of the sovereign debt crisis (July 2011-February 2012) As of the summer of 2011, in a period characterised by great macroeconomic deterioration, instability heightened by the interaction between sovereign and bank risks. From July 2011, some reactivation began - with greater intensity - of the sovereign debt purchase programme, especially in Italy, Spain and Greece, requested for a second bailout. Figure 5 shows the growth in purchases made through the SMP and the importance of the interventions from this moment onwards of the crisis. Figure 6-5 Securities Market Programme EUR millions 250000 225000 200000 175000 150000 125000 100000 75000 50000 25000 0

Source: ECB

2010 May purchases of sovereig debt of Greece, Irland and Portugal

2012 March suspension of SMP 2012 September cancellation of SMP 2011 August purchases of soverign debt of Italy and Spain

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The SMP peaked in March 2012 with debt purchases of EUR 219,500 million. Since then, the ECB has made no further purchases under the programme, which came to a halt. The massive acquisitions of sovereign debt by the ECB on the secondary market were having a positive indirect effect - in terms of profitability and risk premium - for the country issuing the debt, and the SMP began to be perceived by the markets as a tool for disguised bailouts that could damage the reputation of the ECB, which finally halted the programme. In this heightened climate, of the sovereign debt crisis, panic spread about just how much the banks were going to be affected. This led to the markets having repercussions on the banks of peripheral risk-countries, regardless of whether their balance sheets had been affected. The number of banking institutions that have seen their access hampered, if not closed, to wholesale funding markets grew and spread to Italian and Spanish banks as well. Despite the drop in the official rate to 1.25% in November 2011, the need to introduce new measures to alleviate the serious deterioration of liquidity conditions - and the fractioning of the European finance system - led to the incorporation of the following actions, announced in December 2011: x The lowering of the official rate to 1%. x The increase of the number accepted as collateral in liquidity injection operations, continuing the policy of flexibilizing credit ratings, started in October 2008. x The lowering of the minimum reserve ratio from 2% to 1%, a tool that since the birth of the Eurozone had suffered no change at all in composition or level. This freed up EUR 103 billion at European banks, which have been frozen in deposit accounts at the ECB before. Direct liquidity injection into the banking system, via two long-term refinancing operations, with an exceptionally high maturity of 3 years (VLTRO), through fixed rate tenders and with the possibility of early repayment after one year. The allotments took place on December 21 (EUR 489 billion) and February 2012 (EUR 530 billion), giving a total value of over EUR 1000 billion. The true magnitude of this intervention can be appreciated in Figure 6-5. The measures were aimed mainly at a stabilisation of the interbank market and easing the funding pressure on banks. The measures, while temporarily alleviating the tensions on the banking sector, fell far short of

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removing them, and did not lead to an increase in credit to the private sector. Fifth phase or the aggravation of the systemic phase (March 2012- November12) All the above measures served to stave off tensions for a short time, but the growing fragmentation of the financial markets in the area persisted. The pressure on the risk premium returned in force and with it came problems for Spain and Italy. In March the SMP was halted, in April Greece applied for the second programme of assistance and finally, on June 9, Spain sought a bank bailout, followed on June 25 by Cyprus. A firm suspicion regarding the reverse of the single currency had seized the financial markets, causing instability that was hard to counter. Other countries like France and Belgium began to show clear signs of high tension. In July 2012, at a business summit meeting in London held for the opening of the Olympic Games, Mr. Mario Draghi, the president of the ECB, stated that the ECB was ready to do whatever it took to preserve the euro. This sentence was an unmistakable signal that the euro was irreversible, and the market tensions eased. In the same month the official rate was lowered to 0.75%. Finally, in September 2012, the ECB brought in a new debt purchasing programme based on Outright Monetary Transactions (OMT)11 and cancelled the SMP. The programme, which introduced the severest conditions yet for a Eurozone country to benefit from it, can be summarised as below: x Conditionality: A necessary condition for conducting outright monetary transactions is strict and effective conditionality, attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme, or a precautionary programme (enhanced conditions credit line) provided that they include the possibility of EFSF/ESM primary market purchases and a member state has access to the bond market. x Coverage: transactions will be focused on sovereign bonds with a maturity of between one and three years.

11

http://www.ECB.europa.eu/press/pr/date/2012/html/pr120906_1.en.html

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x Creditor treatment: The ECB accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through OMT, in accordance with the terms of such bonds. x Sterilisation: the liquidity created through OMT will be fully sterilised. x Transparency: Aggregate OMT holdings and their market values will be published on a weekly basis. Publication of the average duration of OMT holdings and the breakdown by country will take place on a monthly basis. Figure 6-6 Long term interest rate %

Spain

France

Italy

Netherlands

6 5 4 3 2 1 0 2007

2008

2009

2010

2011

2012

2013

2014

2015

Source: Eurostat

OMTs can also be considered in those member countries undertaking a macroeconomic adjustment programme and which have recovered their access to the bond markets12. To date, no country has applied to use this resource, although the financial markets quickly discounted its full potential. OMT announcements13 decreased the government bond yield, especially in Spain and Italy, although also in France and Belgium, where relatively high tensions were being noticed. Figure 6-6 shows the increase in the return on 10-year sovereign debt in Spain, Italy, France and 12

This measure has been deeply criticized in Winkler (2014). For an analysis of financial and macroeconomic effects of OMT announcements in Italy, Spain, France and Germany, see Altavilla et al. (2014)

13

146

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Belgium and how the introduction of the OMTs is finally reversing this process, which is especially apparent in the first two of these countries. Sixth phase or the drive towards a real EMU (since December 2012) Addressing a long-term solution to the crisis requires strong concerted action on the part of14: the national governments most affected by the crisis; the European authorities; and the ECB. In the first place, the actions of governments of countries under the severest pressures have focused on the introduction of macroeconomic programmes, important structural reforms and fiscal consolidation. Secondly, the action of the European authorities sheds an important light, since the current crisis has underlined the need for in-depth strengthening and the implementation of new economic governance in Europe. The meeting of the European Council on 14 December 2012 closed with a new roadmap for a new EMU, based on tighter integration and greater solidarity15. The project proposes that over the next decade there should be a move towards a more solid EMU architecture based on four columns: an integrated financial framework (fiscal union), an integrated framework of economic policy (economic union) and the strengthening of democratic legitimacy and responsibility. Clearly these issues have to be addressed on all fronts: the ECB, the Eurogroup, the European Commission and the Council of Europe. Bank union, which seeks to create an integrated financial framework that safeguards financial stability and minimises the costs of bank bankruptcy, comprises a single regulatory system which is the responsibility of the European Banking Authority (EBA) and three mechanisms: the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM), and a Single Resolution Fund (SRF). The assumption of the role of single supervisor by the BCE, on 4 November 2014, has supposed a landmark in the creation of a banking union and a more authentic EMU.

14

See Asmussen (2013). See the four presidents report (Council of Europe, Eurogroup, Commission and European Central Bank) entitled: Towards a Genuine Economic and Monetary Union http://www.ECB.europa.eu/ssm/pdf/report/ReportbyPresidentofEuropeanCouncil2 012-06-26ES.pdf the conclusions of the Council of europe at http://www.ECB.europa.eu/ssm/pdf/Conclusions/ConclusionsoftheEuropeanCounc il2012-12-14ES.pdf 15

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Thirdly, and finally, the action of the ECB has been very forceful and of great importance throughout the period in question. In July 2013 it introduced a new communication policy ‘forward guidance’ that can be described as: explicit statements by a central bank about the likely path of future policy rates. Expectations of future interest rates matter because they affect important economic decisions, such as investment and durable consumption and thus, indirectly, employment, production and pricesetting (ECB, 2014b, p.65-66). Therefore, by influencing expectations of future short-term interest rates and – through that channel – the maturity spectrum of interest rates over intermediate to medium-term horizons, a central bank can ensure that its policy stance is transmitted to the broader economy. This new, non-conventional measure, seeks to clarify the view of the economic situation, to firmly fix market expectations and reaffirm the commitment to an expansionary monetary strategy. The ECB forward guidance policy is more qualitative than the quantitative forward guidance of the Federal Reserve or the bank of England, which sets the threshold levels of unemployment and inflation above which makes interest rates start to rise. However, the ECB can have no other mandate than price stability and cannot link its monetary policy to any variable other than inflation. The ECB interventions from 2013 to January 2015 have, however, been clearly directed towards a policy of expansion. The main aim here is to get inflation stable at just under 2%, while also having credit flowing to the private sector. The new measures specifically address the interest rate and balance sheet expansion. x The interest rate is progressively lowered16until standing at 0.05% since September 2014 (Figure 7). x A negative rate17 is applied also to average reserve holdings in excess of the minimum reserve requirements and other deposits held with the Eurosystem, in order to penalise credit institutions that put the liquidity received back into ECB (Figure 7). In June 2014 this penalty interest rate was fixed at -0.10% and since September18 it has been -0.20%.

16

The sequence followed is: 0.5% in May 2013, 0.25% in November 2013, 0.15 in June 2014 and, finally, 0.05% since September 2014. 17 See Benoît Cœuré (2014). 18 Ilgmann and Menner (2011) analyze the history and actual environment of negative interest rates in different countries, and Kacperczyk and Di Maggio (2014) focus in the consequences of such policy in the US money markets.

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Figure 6-7 Main ECB rates and EONIA rate %

MRO

credit facility

deposit facility

EONIA

1.2 1 0.8 0.6 0.4 0.2 0 -0.2 2013

2014

Source: ECB

x June 2014 saw the introduction of targeted longer-term refinancing operations (TLTRO)19, with mature (in September 2018) and early repayments two years after each TLTRO. They will not exceed EUR 571 billion and will be implemented through three-monthly tenders, at the MRO interest rate in effect20. In the first stage, counterparties might participate in two tenders, held in September and December 2014, and were entitled to an initial borrowing allowance equal to 7% of the total amount of their loans to the euro area non-financial private sector, excluding loans to households for house purchase, outstanding on 30 April 2014. In the second stage, March 2015 to June 2016, there will be six further operations and participants will be entitled to additional borrowing allowances. In these operations, the credit institutions will be able to ask for an amount of up to three times the amount of their net lending to the euro area non-financial private sector, excluding loans to 19

See more details in:https://www.ECB.europa.eu/press/pressconf/2014/html/is140605.en.html 20 In January the 10 basis point spread over the MRO rate that applied to the first two TLTROs was removed.

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households for house purchase, over a specific period in excess of a specified benchmark. Net lending will be measured in terms of new loans minus redemptions. Starting 24 months after each TLTRO, counterparties will have the option to make repayments. A number of provisions will aim to ensure that the funds support the real economy. Those counterparties that have not fulfilled certain conditions, regarding the volume of their net lending to the real economy, will be required to pay back borrowings in September 2016. Under this programme the counterparties are obliged to increase their net credit to support the real economy and if they do not, they will be required to pay back borrowings in September 2016. The goal is to avoid, as in the 2011-2012 three-year TLTRO, the banks using them simply to buy government bonds (Gros et al. 2014, p. 9). After the first two tenders this programme is not enjoying the success that was expected. x In September 2014, the ECB announced two new purchase programs, namely the asset-backed securities purchase programme (ABSPP) and the third covered bond purchase programme (CBPP3). The aim of these measures, joint with TLTRO, was twofold: to increase the measures that produce credit easing for the banking sector; to steer the size of the ECB’s balance sheet towards the dimensions of 2012. x The third covered bond purchase programme (CBPP3) up to an amount of EUR 160 billion and a two-year term. Purchases of assets will be made on the primary and secondary markets and will not be sterilised. The basic aim is to provide support to this specific segment of the financial market, which is important in the financing of credit institutions and which was particularly hard hit by the financial crisis. x The asset-backed securities purchase programme (ABSPP) for an amount up to EUR 250 billion over a two-year term. Non sterilised purchases will be made on the primary and secondary markets of simple, transparent asset-backed securities (ABS), whose underlying assets serves as collateral of the private non-financial sector, with a minimum credit rating: mortgage-backed securities (MBS) and asset backed securities (ABS) in the strict sense, which will be backed up by non-mortgage assets (loans to SMEs, or for the purchase of vehicles, among others). The basic aim of the new programme is to get credit through to the private sector (especially to SMEs and households).

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x January 2015 sees the announcement of an enlarged programme of public asset purchases, which is to be tagged on to the existing private assets purchases. This opens the door to a true policy of Quantitative Easing (QE)21. This enlarged programme will, as of March 2015, make monthly purchases of public and private assets to an amount of EUR 60 billion on the secondary market. The purchases will be made until the end of September 2016, and could be extended until the ECB see a sustained adjustment in the path of inflation, consistent with its medium-term inflation maintenance target below, but close to 2%. The profile of the expansion22 of the ECB balance sheet is given in Figure 6-8. Figure 6-8 ECB balance sheet projection EUR billion 3400000 3200000

ECB target: March 2012

3000000 2800000 2600000 2400000

Projection based on Jan. 16, 2015 level

2200000 2000000

2010W04 2010W17 2010W30 2010W43 2011W04 2011W17 2011W30 2011W43 2012W04 2012W17 2012W30 2012W43 2013W05 2013W17 2013W30 2013W44 2014W05 2014W17 2014W31 2014W44 2015W04 2015W17 2015W30 2015W43 2016W05 2016W17 2016W30

1800000

Source: ECB

Some of the conditions imposed on the enlarged ECB purchasing programme have generated serious doubts as to its effectiveness in driving economic growth in the Eurozone:

21

For technical details: https://www.ECB.europa.eu/press/pressconf/2015/html/is150122.en.html 22 For further information over the Governing Council’s expanded asset purchase programme, see box 1 in ECB (2015).

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a) The new quantitative easing programme is very limited in its amount. The aim of the purchasing programme is to inject EUR 1.14 billion more through to September 2016, which would take total ECB injections from the current EUR 2.16 billion (16 January 2015) to EUR 3.30 billion, which is slightly higher than the amount in March 2012 (EUR 3.02 billion). In short, it is a quantitative easing, large scale asset-purchase program which lacks ambition since it slightly surpasses the ECB balance sheet levels of 2012, which fell in 2013 and 2014 because the banks returned the very long-term refinancing operations (VLTRO). b) The new quantitative easing programme is far more complex, conditioned and limited than that applied by the USA Federal Reserve. In the first place, as regards the distribution of possible losses incurred through the programme, the Governing Council decided that only 20% of asset purchases will be subject to a regime of risk sharing. The remaining 80% will be subject to a regime of no-risk-sharing. The lack of cohesion between countries is manifest; the most important part of the risk is not mutualised. Secondly, the extended programme focuses on securities issued by central governments or certain agencies established in the Eurozone, or certain international or supranational institutions located in the euro area (which would include the European Stability Mechanism, ESM). This leaves out corporate bonds, unlike the QE programmes of the USA Federal Reserve. Thirdly, asset purchases are distributed among the Eurozone countries according to each country's capital share in the ECB. Hence, there is no solidarity between countries. Finally, the ECB asset purchases are self-limited, unlike the QE programmes of the USA Federal Reserve. On the one hand, they must not exceed 33% of the issuer's outstanding debt and, on the other; they cannot exceed 25% of the total amount of the issue. c) The new quantitative easing programme may provide banks with cash but that does not mean that it will encourage credit to non-financial corporations and households. On the one side, the ECB claims that the programme will have effects for the real economy because the banks in the Eurozone can remove the public assets from their balance sheets, and use that liquidity to grant credit to non-financial corporations and households. However, the money might also be used to pay off the banks' own debts or to make use again of the ECB deposit facility, even at nominal negative interest rates. If banks do not transform the new liquidity released by the extended asset purchase programme it is because of the pressure to increase bank solvency under the rules of Basel III, and the very strict rulings passed by the G-20 for the big Eurozone banks (a problem of credit supply).

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d) The new quantitative flexibilisation programme may provide banks with liquidity but it clashes with the excessive debt of non-financial firms and homes. The debt of non-financial corporations and households in the Eurozone remains excessive. The problem is that nobody wants to borrow, even at low nominal interest rates. Non-financial corporations and households wish to continue deleveraging, i.e. pay back the debt accumulated in the economic boom (a problem of credit demand). In this sense, credit demand will not be recovered until there is a recovery in the total demand, particularly in household consumption and private investment. Furthermore, the ECB itself recognises that without a fiscal expansion focused on increasing public investment - which means a relaxation of some of the fiscal reforms applied in the last six years - and without structural reforms in the Eurozone economies, its extended asset purchase programme could well fail in its attempts to reactivate euro economies.

Financial fragmentation and the breakdown in the monetary transmission mechanism The international crisis sparked a high degree of financial fragmentation arising from the problems of credit institutions' balance sheets and, at the same time, the sovereign debt crisis supposed yet further fragmentation due to the divergence in national financing costs23. This two-pronged rupture grew drastically with the spiraling macroeconomic deterioration - the banking crisis; the sovereign debt crisis; and a general loss of confidence in the euro. Today, despite some easing in the divergence of bank and sovereign debt financing costs, the rupture is still noticeable. Here we analyse the two sources of the fragmentation individually. Financial fragmentation due to bank funding risk Financial tensions, which appeared in August 2007, heightened during 2008 and hindered the functioning of the money market (ECB, 2008), and with it the liquidity management processes at world level. Figure 6-9 shows the slump in the market and especially that of the unsecured money market segment, which is the core reference for the money market and which is the fastest to facilitate liquidity management to credit

23

See Ciccarelli et al. (2013).

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institutions24. Today, this segment has still not regained its strength, due to the latent risk level, although it has for the first time since the beginning of the crisis shown in 2014 an increase in the volume of transactions. Figure 6-9 Euro money market EUR millions

unsecured

secured

35000000 30000000 25000000 20000000 15000000 10000000 5000000 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: ECB. Euromoney Market Survey

If credit institutions do not lend money in the interbank market, because of a high perceived credit risk, the transmission mechanism of monetary policy breaks the link between the official interest rate and the money markets rates disappears, and inter-bank rates - which are the first step in the monetary transmission process - begin to drift away from a rate that is compatible with the official rate (ECB, 2012b). When this happens, the transmission of variations in the official rate to the real sector becomes erratic and unpredictable, and the capacity of monetary policy to reach its aim of price stability loses credibility, which justifies the ECB beginning to introduce non-conventional balance sheet growth measures that guarantee that medium-term inflation is kept under control, and that the liquidity demand of financial institutions is met25. The ECB assumes an intermediary function between liquidity surplus banks and liquidity deficit

24

For empirical analyses of the effects of the crisis over money markets, see López-Espinosa (2012) et al, Bologna (2011); Huang and Ratnovski (2011). 25 See Rixtel and Gasperini (2013).

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banks and, thereby, replaces the interbank market and redistributes funds that had previously been use in the interbank market. Figure 6-10 Main ECB rates and EONIA rate (left). Spreads %

MRO

credit facility

deposit facility

EONIA

6 5 4 3 2 1 0 -1 2007

2008

(%)

2009

2010 spread eonia df

2011

2012

2013

2014

2015

spread eonia mro

1.50

1.00

0.50

0.00 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

-0.50

-1.00

Source: ECB

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Figure 6-10 (left) shows the evolution of official rates (MRO and standing facilities rates) and the euro overnight index average (EONIA). It is observed how the EONIA initially hovers around the official rate and, that after the onset of the crisis, it moves away as a result of the break in the monetary transmission mechanism, since the EONIA ceases to take its value from the signal given by the monetary authority and begins to shift gradually towards the deposit facility. In Figure 6-10 (right) it can be seen how the spread between the EONIA and the MRO widens until it reaches a mean value of -0.42, between October 2008 and January 2015, and that the spread between the EONIA and the deposit facility interest rate begins to decrease, reaching a mean value for the same period of 0.22. The main reason lies in the fact that the ECB monetary policy, since the beginning of the crisis and especially since the introduction of the two massive liquidity injections, has caused a relaxation in liquidity conditions that has led to the EONIA falling below the official rate and linking itself to the deposit facility rate, which has become the main reference for shortterm interest rates on the money market. The collapse of the monetary policy transmission mechanism, together with a sharp decline and rupture of credit institutions, has only served to accentuate asymmetries in the Eurozone. The crisis has fragmented banking institutions26, grouping them according to their risk, country, and whether they are in need of liquidity or not: a) Credit institutions requiring liquidity and with no access to the interbank market (due to risk of returns or contagion of sovereign debt risk) begin to be financed exclusively through the ECB, which becomes the sole provider of liquidity. These financial institutions have a higher marginal financing cost, determined by the MRO interest rate. Figure 6-11 (below) shows the applications to the ECB by credit institutions according to their country of origin. The dependence of Italy and Spain stands out, especially during the worst moments of the sovereign debt crisis, and the vicious circle growth in bank risk. Figure 611 (left) shows applications to the ECB by credit institutions according to groups of countries and highlights the existing financial fragmentation. While, in general, it is certainly true that since 2013, we observe a lesser dependence on the ECB and a decrease in fragmentation following the introduction of the Outright Monetary Transactions (OMT), it is also true that the advances in financial integration have been more fruitful in countries with fewer problems (basically, France and Belgium). However, 26 For an empirical approach to measure country-specific risk premia in banks' bond spreads, see Gilchrist and Mojon (2014) and Thiel (2014).

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Figure 6-11 Central Bank’s loans to credit institutions EUR billion 400

Germany Luxembourg Italy

350

Netherlands Greece Portugal

Finland Ireland Spain

300 250 200 150 100 50 0

EUR billion

GIIPS = Greece, Ireland, Italy, Portugal, Spain DNFL = Germany, Netherlands, Finland, Luxembourg Others = Austria, France, Cyprus, Belgium

1000 900 800 700 600 500 400 300

GIIPS

Others

200 100

DNFL

0

Source: Euro crisis monitor, Institute of Empirical Economic Research, Osnabruck University

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in countries suffering serious tensions, the fragmentation is as much a reality as ever, with much higher financing costs, as is the case in Spain and Italy especially. b) Liquidity stricken credit institutions that are able to access the interbank market (no risk on returns and no sovereign debt risk) enjoy a marginal financing cost determined by the EONIA interest rate - which since the crisis has shifted towards the minimum - represented by the deposit facility rate. In conclusion, the situation implies a very different monetary transmission in countries whose banking sectors are in a bad state and are highly exposed to the crisis together, with very unequal repercussions for their respective economies. c) Finally, credit institutions that do not require liquidity, and as a consequence of the latent risk, have made it clear that they prefer to offload their surplus liquidity onto the ECB, and make use of the resources offered by the deposit facility and hang on to their excess reserves rather than lend at higher interbank rates. On 5 March 2012, at the height of the crisis, the liquidity reserves deposited in the ECB in these instruments reached a record value of EUR 13,211 million. Figure 6-12 Deposit facility and excess reserves EUR million

deposit facility+excess reserves

deposit facility

excess reserves

1000000

0% fd and er: Jul.2012

800000 Second VLTRO Feb. 2012

600000

-0,10% fd. and er.: Jun. 2014 First VLTRO, Dic. 2011

400000

200000

0 -0,20% fd. and er.: Sep. 2014

Source: ECB

ene-15

jul-14

oct-14

abr-14

ene-14

jul-13

oct-13

abr-13

ene-13

jul-12

oct-12

abr-12

ene-12

jul-11

oct-11

abr-11

ene-11

jul-10

oct-10

abr-10

ene-10

jul-09

oct-09

abr-09

ene-09

jul-08

oct-08

abr-08

ene-08

jul-07

oct-07

abr-07

ene-07

-200000

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The ECB initially responded in its Governing Council Meeting of 5 July 2012, by fixing the deposit facility interest rate at 0%. It thus left this instrument with no remuneration, equating it to the excess reserves which, by definition, had never provided any. As Figure 6-12 shows, the sum of the deposit facilities and the excess reserves gave a volume of EUR 798,439 million at the beginning of July 2012, meaning that approximately 80% of the ECB's massive liquidity injections were deposited back into it; proof of the latent risk level. The entry into effect of this measure led to a partial transfer of funds from the deposit facility to the reserves account of the Eurosystem credit institutions. In the short term the measure had no very significant impact: the total liquidity amount at 0% in the ECB, at the end of December 2012 was only 20% lower than in July. In the medium term, maintaining surplus reserves above the minimum reserves level became a permanent fixture and, while access to the deposit facility was noticeably reduced, it has not disappeared. The second decision was adopted in the Governing Council Meeting of 5 June 2014. On this occasion, besides fixing the official interest rate of the Eurosystem at 0.15%, there was also a 0.10% reduction in the rate applicable to the deposit facility and the excess reserves. For the first time negative interest rates were resorted to in an attempt to end the credit institutions' risk aversion; for the first time these institutions were to pay for their deposits in the ECB. Again, the aim was to mobilise resources; minimise the deposit facility; eliminate the excess reserves; get credit flowing to the private sector; and finally reactivate the economy in the Eurozone, and get medium-term inflation back in line with its objective. The third, and final decision, was taken at the Governing Council Meeting of 4 September 2014. On this occasion the official rate was again cut, this time to 0.05%, and a symmetric band of +/- 0.25% was maintained for the standing facilities: the credit facility was fixed at 0.30% and the deposit facility at -0.20%. These measures sought to strengthen the monetary transmission mechanism and give greater liquidity provisions for the Eurozone economies, where very significant increases in the differences with the stronger countries were being observed. This more negative rate increased, yet more, the opportune cost of maintaining excess reserves and anchoring the EONIA closes to zero with the aim of boosting economic activity, internal demand and inflation. Despite everything, the immobilised flow of resources in the ECB, both in the reserves account and in the deposit facility, between December 2014 and February 2015, was still too high and financial fragmentation persisted and, with it, the divergence of financing costs between countries.

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Figure 6-13 TARGET2 balances EUR billion 750 650 550 450

Finland

France

Germany

Greece

Ireland

Italy

Netherlands

Portugal

Spain

Luxembourg

350 250 150 50 -50 -150 -250 -350 -450

EUR billion

DNLF = Germany, Netherlands, Luxembourg, Finland GIIPS = Greece, Italy, Ireland, Portugal, Spain

1050 750

DNLF

450 150 -150 -450 GIIPS -750 -1050

Source: Euro crisis monitor, Institute of Empirical Economic Research, Osnabruck University

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Financial fragmentation due to sovereign debt risk Since 2010, and especially since Greece sought its bailout, the sovereign debt crisis was unleashed and with it an important financial fragmentation. As Figure 6-13 (left) shows, the long-lasting position in TARGET2 of Spain, Italy, Greece, Portugal and Ireland contrasts with the systematic credit balance of Germany and, to a lesser extent, Holland and Luxembourg. This fragmentation is still more evident if we aggregate the balances of the creditor countries, and the debtors, as can be seen in Figure 6-13 (right). Again the situation implied a very different monetary transmission in countries most affected by the crisis. The problem was even greater if we take into account that loss of monetary transmission and fragmentation meant that the non-financial private sector27 had to bear very unequal financing costs depending on which Eurozone country they belonged to. Figures 6-14 (right and left) indicate the lending margin on loans to nonfinancial corporations, and to households for house purchase in December 2013 and 2014. The lending margins represent a good barometer of the cost of credit for small and medium-sized enterprises (SMEs), with no access to the bond market, and for households. In general, businesses in the Eurozone have benefited from a reduction in their mean financing costs of 0.09 percentage points. If we make an analysis by countries, the reality is highly heterogeneous. In Cyprus, Spain, Malta and, especially Ireland and Greece the cost of credit for SMEs rose on average by 0.46 pp. As regards homes, we again observe a decrease in the mean financing costs of 0.04pp in the Eurozone for purchasing a dwelling, although less than in the case of businesses. However, the number of countries whose financing costs have increased is higher. In Spain, Greece, Ireland, Italy, Malta, Portugal and Slovenia the costs have risen by an average of 0.61pp. All the above, points to an overall improvement in conditions for accessing credit for families and businesses, but also to a high degree of heterogeneity between countries and, hence, to high financial fragmentation. Spain stands out here, with its higher cost indicators for both families and SMEs.

27

See ECFIN (2012 and 2013).

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Figure 6-14 Lending margins of MFI’s Loans to non financial corporations Dec. 2013 - Dec. 2014 - percentage points

Dec. 2013

Dec. 2014

6 5 4 3 2 1 Slovakia

Slovenia

Portugal

Netherlands

Malta

Luxemburg

Italy

Ireland

Greece

France

Finland

Spain

Estonia

Germany

Cyprus

Belgium

Austria

0

Note: Lending margins are measured as the difference between MFI's interest rate for new business loans to non-financial corporations and a weighted average rate of new deposits from households and non-financial corporations

Loans to households for house purchase Dec.2013 - Dec.2014 - percentage points

Dec. 2013

Dec. 2014

6 5 4 3 2 1

Note: Lending margins are measured as the difference between MFI's interest rate for new business loan to households for house purchase weighted average rate of new deposits from households and non-financial corporations

Source: ECB (2014) ESRB Risk Dashboard, December.

Slovakia

Slovenia

Portugal

Netherlands

Malta

Luxemburg

Italy

Ireland

Greece

France

Finland

Spain

Estonia

Germany

Cyprus

Belgium

Austria

0

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The use and the role of the euro in the international economy There is no doubt that today the international function of the single currency is more closely related to financial than commercial trade. The main role of international financial activity, and the level of financial integration, is without precedents in recent history. Many factors have driven this change: new information and communication technologies financial deregulation and liberalisation, greater investor protection, lower transaction costs and recognition by investors that international investment can bring greater profits than traditional home investments (Papaioannou and Portes, 2008). The analysis of the use and role of the euro in international economy will be tackled from four positions: the euro as a means of exchange; the role of the euro in international trade; the euro as a store of value and exchange rate anchoring; and the euro in the financial markets. The euro as a means of exchange The movements of the euro against the dollar can be divided into three big periods (Figure 15): from its origins through to the end of 2001, when it was in constant depreciation until reaching a record low in October 2000 when it traded at 0.8252 EUR/USD; January 2002 till summer 2008, when the euro peaked in July (1.5990 EUR/USD); and since September 2008, and the onset of the crisis, during which time the euro's behaviour has been more erratic and volatile28, but one in which after peaking at in May 2014 (1.3945 EUR/USD), it began a drawn out depreciation, coinciding with the quantitative easing (QE) measures introduced by the ECB since June 2014. The perspectives for the Eurozone are different from those of the US. While the forecast for the EMU was economic stagnation with a high risk of deflation and uncertainty surrounding the effects of the ECB programme of more intense QE measures, with public debt purchasing from January 2015 to September 2016. In the US, in contrast, the expectations are for economic growth, rising employment and higher inflation, to the extent that there are voices in favour of a more restrictive monetary policy. Added to this, the official ECB rate, which had - since 2008 - been higher than that of the Federal Reserve, has shown a negative

28

For a detailed explanation of the evolution of market uncertainty surrounding the euro exchange rate during the sovereign debt crisis, see ECB (2013b).

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differential since June 2014, which explains the downward trend of the euro against the dollar in the second half of 2014. Figure 6-15 Exchange rate EUR/USD

15th July 2008: 1.5990

1.6000

1.5120

1.5000

1.4882 8th May 2014: 1.3953

1.4000 1.3000 1.2000 1.1000

17th Feb. 2014: 1.14

medium value: 1.22

1.0000 0.9000 0.8000 26th Oct. 2000: 0.8252 1999 2000 2001 2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: ECB

The role of the euro in international trade One key aspect of the international role of a currency is its use in international trade. The arrival of the euro spelt the end of the dollar hegemony (Eichengreen, 2010). The dollar had reigned supreme for three basic reasons (Papaioannou and Portes, 2008): First, because since before the appearance of the EMU, the US market was the most important in the world, which meant that most US imports and exports were made in dollars. The EMU has meant that a growing number of international trade transactions are now in euros, not only by the countries that have adopted the euro but by others too, especially those which link their monetary policies to that of the ECB (Kamps, 2006). Second, the use of the dollar has been favoured by a low exchange rate risk, low inflation, a lack of control of capital and the black market. However, the arrival of the euro has provided a viable and credible alternative. The main aim of the ECB is to keep inflation down; the euro does not suppose a greater exchange risk than the dollar. Likewise, within the Eurozone there are many well developed capital markets. Third, and last, the dollar has long since been a

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currency of reference on the international markets and once such a status is achieved, mere inertia may suffice for it to be maintained, even when other currencies offer similar or lower costs, and this may well be the biggest hurdle to increased use of the euro. The use of the euro in international trade had begun to grow very significantly until 2007, not only in the Eurozone itself, but also in other countries with institutional ties with the Eurozone or the EU (ECB, 2010). It was in the years following the introduction of the euro that there was a reconfiguration of portfolios and strategies to take on board the new currency. Since then the euro enjoyed a stable status that it has maintained, albeit with the ups and downs it has suffered since the crisis. The use of the euro by EU member states in extra-EU trade grew steadily from 2006 to 2013 (Figure 6-16). The share of the euro in exports of goods, to non-member countries, followed a gentle upward trend in the period 2006-2013 (from 59.5% to 67.2%). The most significant dips occurred during the crisis, first in 2010 and, especially, later in 2012 when the value fell by some two percentage points on that of the previous year, to 66.7%. In terms of imports, the euro share in the Eurozone countries' imports from third countries, rose slightly from 48.8% in 2006 to 51.7% in 2013, although there was a significant decrease prior to 2009, due in part to countries like France and Belgium (ECB, 2012c), which was followed by a good recovery. As for the extra-EU services trade of the Eurozone countries, the use of the euro in exports has been less than in imports (which is the reverse of what happened for goods). In exports the transactions in euros rose slightly over the period 2006-2013 (51% to 56.3%) but with slumps in 2009, 2010 and 2012, dates in which imports registered greater growth (53.8% to 61.5%). In general, the use of the euro in extra-euro area transactions of euro area countries in 2013 exceeded pre-crisis levels, although the importance of the euro has increased, mainly regarding when the trade is with an EU member country or an EU candidate country, giving it greater institutional weight (ECB, 2007 and 2014c). The overall advances in the use of the euro mask its unequal behaviour in Eurozone countries. Peripheral more stressed economies have been using it less in their transactions since the start of the sovereign debt crisis. This has been brought about by reduced trade with countries in the Eurozone and increased trade with Asian and Middle Eastern countries, and this has favoured the use of the dollar and Asian and Middle Eastern currencies, for example the yuan (ECB, 2014c). Elsewhere, the newer members of the Eurozone have appreciably increased their trade flows with

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Figure 6-16The euro’s share as a invoicing/settlement currency in extra-euro area transactions of euro area countries as a percentage of the total Exports of goods

Imports of goods

80 70 60 50 40 30 20 10 0 2006

2007

2008

2009

2010

2011

2012

2013

2012

2013

as a percentage of the total Exports of services

Imports of services

80 70 60 50 40 30 20 10 0 2006

2007

2008

2009

2010

2011

Source: ECB (2014) The international role of the euro, July.

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eastern European countries, in particular Lithuania29, Poland and Hungary, countries with which they enjoy traditional and close trading relations. Lastly, countries which are set to join the euro when the Eurozone is extended (Poland, Czech Republic or Croatia) are clearly fostering the use of the euro in anticipation of possible exchange risks. In any case, the net effect is favourable for the single currency and, for the time being, euroisation is compensating the spread towards Asia and other emerging markets. The increase in Eurozone exports to eastern countries grew by 2.6% and to Asian countries by 0.8%. The euro as a store of value and exchange rate anchoring Since its creation in 1999, the euro has experienced gradual growth as a reserve currency, and this has led to its becoming the second most accumulated currency in the world. In 2000 the outstanding amount of international reserves in euros, at current exchange rates, stood at USD 278 billion and in 2013 at USD 1521 billion, with a continued growth in the outstanding amount of reserves held in euros due to the currency's appreciation (Figure 6-17 below). The dollar continues to be the most demanded currency as an international reserve asset par excellence, but it is no less true that the euro is firmly established in second place, far ahead of other currencies. In general, at the end of 2013, the foreign exchange reserves reached a new record high of USD 11.7 trillion, but growth was moderate and unvaried in its composition, which was a consequence of a combination of factors, including network externalities, exchange rate anchoring and the liquidity properties of major reserve currencies (ECB, 2014c).

29

Lithuania joined the EMU in January 2015.

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Figure 6-17 Currency composition of global foreign exchange reserves

USD billions, at current exchange rate USD

EUR

JPY

undisclosed

12000 10000 8000 6000 4000 2000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 percentages; at constant end-2013, exchange rates shares EUR USD

JPY

70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: ECB (2014) The international role of the euro, July.

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In terms of share of total reserves, and at constant exchange rates (Figure 6-17 left), the euro has gone from 24.7%, in 2000, to 24.3% in 2013, while reserves in dollars stood at 61.2%; 4% in pounds sterling; 3.9% in yen; 3.4% in Canadian and Australian dollars; and 2.9% in other currencies. The euro share of reserves grew until 2002 (with a peak share of 28.7%), and then did not reach another peak until 2009 (26.9%) when, as a result of the European sovereign debt crisis and the decreasing credibility of the euro, it began to lose its importance30. However, since the onset of the crisis in 2007, the dollar has fallen 4.1 percentage points (at constant exchange rates), while the euro has lost only 0.6 percentage points. This decline in the shares of the US dollar, and to a lesser extent the euro, was mirrored by increases in the shares of reserves in Japanese yen and in Canadian and Australian dollars31. Thus an increase in holdings of non-traditional reserve currencies is accounted for by the heightened credit risk of some advanced sovereign economies (ECB, 2013b). The consolidation of the euro, as an international reserve currency, has been noted in both advanced and emerging economies despite its stagnant position (Figure 6-18). In the case of the former, its share was the same in 2000 and 2013 (24.8%), with a maximum in 2002 (28.2%). In emerging economies its share has dropped slightly from 2000 (24.4%) to 2013 (24.1%). In fact it is the dollar which has lost weight in global terms. Between 2000 and 2013, its share has fallen both in advanced economies (1.2 percentage points) and in emerging economies (8.4 percentage points). The yen has also lost ground in the advanced economies (2.6 percentage points) although it has gained slightly in emerging economies (0.2 percentage points). Currencies that have shown substantial advances in their shares, especially in emerging economies, include the pound sterling (2.5 percentage points) and ”other” non-conventional ones, among which the Canadian and the Australian dollar stand out. In general, but especially in the emerging economies, a diversification of reserves is being witnessed as a precautionary measure in response to the crisis (ECB, 2013b).

30 31

See Aizenman and Sun (2012). See Pomorski et al. (2014).

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Figure 6-18 Currency composition of global foreign exchange reserves

advanced economies shares at constant exchange rates 80

EUR

USD

JPY

GBP

Other

70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 emerging and developing

economies shares at constant exchange rates EUR

USD

JPY

GBP

Other

80 70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: ECB (2014) The international role of the euro, July.

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In 2014, the use of the euro as a reference currency to anchor exchange rates remained unchanged. This use is unilateral, except for the countries participating in exchange rate mechanism II (ERM II), and does not commit the ECB. Table 6-2 shows the countries and territories with exchange rate regimes linked to the euro32. It is mainly geographical with institutional factors that explain the use of the euro in the exchange rate regimes of countries outside the euro area; basically in nearby countries or those with special institutional arrangements with the EU, or its Member States (ECB, 2007 and 2014c). Table 6-2 Countries and territories with exchange rate regimes linked to the euro (as at end-May 2014) Region EU (non-euro area)

Exchange rate regimes Countries ERM II Denmark, Lithuania Euro-based currency boards Bulgaria, Croatia, Czech Republic Managed floating regime with the euro as Romania reference currency and an inflation target

Pro memoria : Free-floating regime with an inflation target EU acceding, candidate and Unilateral euroisation (no separate legal tender) potential candidate Euro-based currency boards countries Stabilised arrangement with euro as a reference currency Pro memoria : Free-floating regime with an inflation target Euroisation Others Pegs based on the euro Other arrangements using the Euro as a reference currency Crawling peg involving the euro Pegs and managed floats based on the SDR and other currency baskets involving the euro (share of the euro)

Hungary, Poland, Sweden, United Kingdom Kosovo, Montenegro Bosina and Herzegovina Former Yugoslav Republic of Macedonia Albania, Iceland, Serbia, Turkey European microstates, some French overseas collectivities CFA franc zone, CFP franc zone, Cape Verde, Comoros, São Tomé e Príncipe Switzerland Botswana

Algeria, Belarus, Fiji, Iran, Kuwait, Libya, Morocco (80%), Russian Federation (45%), Samoa, Singapore, Syria, Tunisia, Vanuatu.

Source: ECB (2014) The international role of the euro, July.

The record of the composition of international currency reserves shows high persistence throughout history. The pound sterling was the reference throughout the nineteenth century, followed by the dollar for much of the twentieth century (Reinhart and Rogoff, 2004). In general, the currency of 32

For further information see AREAER (2014).

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the peg; the direction of international trade; the currency of foreign debt; and a strong regionalism; are significant correlates of the currency shares of foreign exchange reserve holdings (Papaioanou and Portes, 2008). In Table 6-3 we report the share of the euro in the currency composition of reserves for some central banks. The euro is dominant in non-euro EU Member States (except for Poland, Sweden and United Kingdom, where euro-scepticism is deep rooted and explains the drastic reduction in euro holdings), while its share is, in general, minimal in Latin America with countries that are increasing euro holdings, like Peru, or others decreasing them, like Chile. The share of the euro is also high in countries that have strong trade and financial links with the euro area, such as, Norway or Switzerland33, and countries from Eastern Europe or North Africa. Canada or Russia present a stable holdings of euro reserves, since 2008, and very noteworthy is the high amount registered in the USA, which has to do with the bilateral exchange rate behaviour34. Table 6-3 The share of the euro in the currency composition of foreign exchange reserves for selected countries percentages; at current exchange rates Non-euro area EU Member States Bulgaria Croatia Czech Republic Lithuania Poland Romania Sweden United Kingdom Candidate and potential candidate countries Turkey Other industrial countries Canada Norway Russia Switzerland United States Latin American countries Chile Peru

2008 61,3 99,1 76,6 62,6 97,3 33,7 63,2 48,5 41,4

2009 63,7 99,1 71,7 61,3 96,9 36,7 65,2 48,1 65,5

2010 61,1 99,6 73,7 57,4 98,9 35 67,2 50 59,9

2011 60,9 99,9 75,9 60,1 94,9 30,4 77,8 37 59,1

2012 58 99,9 80,3 58,7 83,4 30,9 73 37,1 60,4

2013 55,6 100 68,7 69,7 79,1 30,7 65,9 37 43

46

44,6

46,5

40,3

27,3

0

40,4 48,3 40 47,9 53,7

41,9 47,2 33,2 55,6 54

40 36,4 43,1 54,9 54,2

37 36,1 42,1 57 53,5

34,9 35,9 40,4 50,1 57

31,9 36,5 41 49,2 62,8

37,3 14,9

34,8 17,4

35,2 16,8

35,5 38

20,3 30

19,6 30

Source: ECB (2014) The international role of the euro, July.

33

In the case of Switzerland, also its high level of reserves in euro is the result of the aggressive policy of the central bank to avoid the appreciation of the Swiss franc against the euro. 34 See also Goldberg et al. (2013).

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The euro in the financial markets As regards the equity markets, the segmentation of the organized stock exchanges in the euro area still causes liquidity problems and problems of access for non-residents, despite changes in regulations to allow nonrestricted financial investment throughout the EU capital market and to permit European stock exchange alliances. Today, the weight of the euro area stock exchanges, in terms of capitalization, stands between that of the United States and that of Japan (Figure 6-19). Figures 6-19 Market capitalization trillion

EMU

JPN

USA

25

20

15

10

5

0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: World Bank. World Economic Indicators.

Regarding the role of the euro in the international debt markets, Figure 6-20 shows the outstanding international debt securities by currency. Compared to the previous year, the total volume of outstanding international debt securities was USD 12.4 trillion, with an increase of USD 663 billion. Euro-denominated debt issuance increased by around USD 116 billion to a total of USD 3.1 trillion. In the last five years the share of the euro, at constant exchange rates (narrow measure35) has gradually decreased from 31.0% to 25.3%, as has the yen (from 5.8% to 3.5%). Meanwhile, the dollar has increased its share noticeably during the same period, rising from 44.3% to 54.8%. The factors that account for this behaviour are (ECB, 2014c):

35

The narrow measure concept of outstanding international debt securities comprises only issuance in a currency other than that of the country in which the borrower resides.

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 The lower cost of international debt issuance in the US dollar relative to other currencies.  The unconventional monetary policy of the Federal Reserve, with a large-scale asset purchase programme, triggered low interest rate and exchange rate expectations, until mid-2013.  The increasing of the issues in US dollars by the emerging markets.  The increasing of the demand for dollar-denominated international debt issuance. Figure 6-20 The euro in international debt markets, outstanding international debt securities by currency % Eur

% USD

% YEN

EUR

USD

JPY 60

8000

50

6000 40

5000 4000

30

3000

20

2000 10

1000 0

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

2012 2013

Source: ECB (2014) The international role of the euro, July.

With regard to the banking sector (see Figure 6-21), the stock of loans in euros in 2013 was worth USD 219 billion versus loans in dollars, which stood five times higher (USD 1068 billion). The stock of deposits in euros was USD 356 billion versus the more than three times greater amount in dollars (USD 1143 billion). Taking a longer-term perspective, and looking at developments in international loans markets since the onset of the global financial crisis, the share of the euro (at constant exchange rates) decreased strongly in loans from 26.0% in 2007 to 14.2% in 2013, producing a substitution effect in the denomination of loans in 2013, which went against the euro and in favour of the dollar and the yen because of their lower interest rates. The international deposits in euros also decreased, but slowly, from 24.2% to 21.1%. The bank union agreements signed in 2012 and the start of the Single Supervisory Mechanism put a brake on the deterioration of deposits.

%

USD trillon

7000

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Figure 6-21 Out-standing international loans and deposits, by currency Loans by by banks outisde the euro area to borrowers outside the euro area in USD billions, at constant exchange rates, end of period and percentages (right scale) eur percentages

dollar percentages

eur outstanding amounts

dollar outstanding amounts

1400

80

1200

70 60

1000

50 800 40 600 30 400

20

200

10 0

0 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Deposits by depositors outisde the euro area in USD billions, at constant exchange rates, end of period and percentages (right scale) eur percentages

dollar percentages

1400

80

1200

70 60

1000

50 800 40 600 30 400

20

200

10

0

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: ECB (2014) The international role of the euro, July.

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Meanwhile the dollar share rose from 66.4% to 67.8% between 2007 and 2013.

Conclusions To pull through the current crisis requires a strong, concerted threepronged action; Firstly, on the part of the ECB. The increasing strain on sovereign debt from 2010 drove the ECB to direct its attention to the problems of refinancing, and the asymmetries in the costs of national financing through the Securities Market Programme and the OMTs from September 2012 on. While the OMTs did prove a very important deterrent and enabled risk premiums to drop, and also spelled the return to financing by the finance markets in many of the affected economies (especially Spain and Italy), there remains a high level of financial fragmentation in peripheral countries. ECB interventions between 2013 and January 2015 have been directed at a clearly expansive policy. The main aim has been to get inflation back in line towards a stable rate just below 2%, but also to get credit through to the private sector. The new measures are basically interest rates and balance sheet expansion. The incorporation of measures like quantitative easing (QE) with monthly purchases of private and, especially, public assets, which will be in effect in existence through to September 2016, has set off enormous expectations, although there may be no effects on the real. Secondly, there are actions taken by Governments whose economies have suffered severe tensions. There have been three channels through which fragmentation has become a consolidated fact: the high level of public debt accumulated, low economic growth and the weaknesses of bank's balance sheets. These problems meant that the Governments in question have had to take specific measures in terms of fiscal consolidation, to bring in a set of structural reforms to boost medium-term growth and, finally, address the issue of recapitalising and restructuring troubled banks. Thirdly, the action taken by the European authorities has been fundamental in getting a definitive solution to the problem of fragmentation, thanks to a firm commitment to move towards a genuine EMU based on four pillars: economic union, banking union, tax union and political union. The establishment of mechanisms to achieve banking union have been entrusted to the ECB, with its designation as Single European Supervisor from November 2014.

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Finally, in this context, the role of the euro has not been substantially changed and remains the second world currency in international trade, as a store of value and exchange rate anchoring, and in the financial markets.

CHAPTER SEVEN CAPITAL FLOWS AND BOOM-BUST CYCLE IN EMERGING EUROPE: RESPONSES TO THE VOLATILE FINANCIAL GLOBAL CONTEXT JEAN-PIERRE ALLEGRET AND AUDREY SALLENAVE

Summary This chapter aims at analyzing the monetary policy constraints encountered in some emerging European economies to manage the boombust cycle over the period 2000-2013. We suggest a single interpretation by emphasizing the impact of the fixed exchange rate regimes, and the degree of the currency mismatch. While the former matters, both during the boom and the bust in capital flow, the latter is relevant during the crisis episode.

Introduction An extensive literature investigates macroeconomic fluctuations in emerging countries. Three lessons drawn from this literature are particularly important. First, macroeconomic variables tend to be more volatile in emerging economies relative to advanced countries (SchmittGrohé and Uribe, 2014). The globalization process has increased this volatility gap (Kose and Prasad, 2010). Second, the amplitude of recessions is dramatically higher in emerging countries than in advanced economies. Indeed, the former suffer from larger cumulative output losses, particularly in the aftermath of recessions associated with financial crises (Cerra and Saxena, 2008; Balakrishnan et al., 2011). Third, authorities in emerging countries encounter significant difficulties to respond to pro-

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cyclical capital inflows and, more broadly, to financial crises. Kaminsky et al. (2005) show that emerging economies tend to adopt pro-cyclical fiscal and monetary policies, and thereby exacerbate the destabilizing effects of capital inflows. They explain these responses by stressing the role of political distortions, weak institutions, and capital market imperfections. Cavallo and Izquierdo (2009) and Izquierdo and Talvi (2009), by considering the experience of Latin American and Caribbean countries, suggest that domestic liability dollarization exerts a strong influence on the monetary responses to external shocks. Our contribution is related to the previous literature. Indeed, we investigate monetary policy responses, to massive capital inflows and outflows, in 9 emerging Europe countries over the period 2000-2013. Our sample consists of Bulgaria, Croatia, Estonia, Hungry, Latvia, Lithuania, Poland, Romania, and Serbia. These countries are either new member states of the European Union or European Union candidates. As a consequence, they enter domestic and external financial liberalization in order to respect the European Union accession process. Despite these common features, the fundamental point - which we will pay special attention to - focuses on exchange rate regimes adopted in these countries. More specifically, Bulgaria, Croatia, Estonia, Latvia, and Lithuania adopted fixed exchange rate regimes (called ‘peggers’) while Hungary, Poland, Romania, and Serbia chose floating regimes (named floaters). The experience of these countries is particularly interesting, insofar as they follow a specific pattern contrasting with other emerging countries. First, while the relative share of bank flows has decreased in the total of capital inflows to emerging markets, capital flows in emerging Europe have been mainly driven by bank flows. Second, the boom in capital inflows has fueled the build-up of macroeconomic imbalances, leading some of our studied countries to become highly vulnerable to capital flows reversals. Third, monetary authorities have encountered important constraints to manage this capital boom-bust episode. On the one hand, during the period of massive capital inflows, monetary policy has been ineffective to prevent macroeconomic overheating. On the other hand, in many of our studied countries central banks adopted pro-cyclical monetary policy in the aftermath of the sudden stop in capital flows. The purpose of this chapter is to analyze the monetary policy constraints encountered in some emerging European economies, to manage the boom-bust cycle over the period 2000-2013. We suggest a single interpretation by emphasizing the impact of the fixed exchange rate regimes, and the degree of the currency mismatch. While the former

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matter, both during the boom and the bust in capital flows, the latter is relevant during the crisis episode. The rest of this chapter is structured as follows. Section 2 shows that the surge in capital flows, over the period 2000-2008, has led to an overheating in the recipients countries. Section 3 analyzes the main macroeconomic impacts of the sudden stop in capital flows in the aftermath of the Lehman Brothers collapse in September 2008. Section 4 presents the main reason and explains the low effectiveness of monetary policy in facing the boom-bust cycle.

Surges in International Capital Flows and Macroeconomic Overheating In a first step, an anatomy of international capital flows into emerging Europe is performed. We highlight the predominant role of cross-borders bank flows. In a second step, we show that these flows exert a critical influence on credit booms and overheating in many of our studied countries.

The anatomy of international capital flows During the 1990s, several waves of speculative attacks have hit emerging countries. Despite the variety of crises, a striking empirical regularity has been the accumulation of financial imbalances in the period preceding financial crises. For instance, both empirical and theoretical 1 studies have stressed that one of the main triggers of the Asian-5 crisis rested on sizeable financial vulnerabilities. As emphasized by Radelet and Sachs (1998), a notable feature of the Asian crisis was the extent to which foreign investors, especially foreign commercial banks, increased their loans to the Asian-5 economies up to the onset of the crisis. BIS data shows that international bank lending to Asia increased from less than US$ 150 bn., at the end of 1990, to about US$ 390 bn. In mid-1997, in contrast, foreign bank lending to Latin America only increased from about US$ 180 bn. to about US$ 250 bn. over the same period. In addition, BIS data show that most of the loans by foreign banks were short term ones. At the time of the crisis, short term loans, as a share of total obligations to the international banking community, were 68% in Korea; 66% in Thailand; 59% in Indonesia; 56% in Malaysia; and 59% in the Philippines. As a consequence, these 1

Indonesia, Malaysia, Philippines, South Korea, and Thailand.

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economies have been especially vulnerable to exogenous shock (such as an increase in the world interest rate), or a sudden loss of confidence leading to a massive reversal of capital flows. Interestingly, available information suggests that short term inflows suddenly reversed themselves during 1997. Data from the Institute of International Finance shows, in particular, that net international inflows of capital to the Asian-5 countries fell dramatically to US$12 bn. in 1997, from US$ 93 bn. in 1996. This fall in inflows is accounted for, by and large, because of the behavior of foreign banks, whose positions in the Asian-5 countries dropped by US$ 21.3 bn. in 1997, after increasing by US$ 55.5 bn. in 1996. Combining this information with BIS data, which shows that foreign banks increased their lending to the Asian-5 countries by US$ 13 bn. in the first half of 1997, Radelet and Sachs (1998) conclude that there must have been a capital outflow of about US$ 34 bn. in the second half of 1997, equivalent to a negative shock of 3.6 of GDP. In other words, international bankers are especially prone to panic behavior with destabilizing impacts on the recipient countries. The lesson from the Asian-5 crisis is clear: bank flows, notably short-term flows, are more volatile than other capital flows. So, a debt was seen as a vulnerability factor, its relative share in stock of external liabilities decreased in Latin American and Asian emerging countries (Fig. 7-1). The composition of external liabilities in our sample shows a divergent pattern. Indeed, Fig. 8-1 exhibits an increase in debt liabilities over the period 2000-2008. Interestingly, countries with fixed exchange rate regimes exhibit a higher share of debt liabilities, suggesting a more significant sensitivity to sudden capital reversals. Fig. 7-2 provides additional information: among external debt liabilities, a significant portion took the form of cross-border bank loans.

0

10

20

30

40

50

60

0

20

40

60

80

100

120

0

10

20

30

40

50

60

70

80

Debt liabilities

FDI liabilities

Portfolio equity liabilities

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Floating ERR

Fixed ERR

Emerging Europe: debt liabilities/GDP and exchange rate regimes

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Asia2

181

2

Argentina, Brazil, Chile, Colombia, and Mexico. Indonesia, Malaysia, Philippines, South Korea, and Thailand. 3 Bulgaria, Croatia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Serbia. Source: Updated and extended the External Wealth of Nations Mark II database, Lane and Milesi-Ferretti, "The External Wealth of Nations Mark II", Journal of International Economics, November 2007.

1

Debt liabilities

70

80

Emerging Europe 3

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Portfolio equity liabilities FDI liabilities

90

Debt liabilities

FDI liabilities

Portfolio equity liabilities

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Latin America1

100

0

10

20

30

40

50

60

70

Figure 7-1 Composition of external liabilities, stock, in % of GDP

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Sample

Latin America/Caribbean

Asia & Pacific

-20

30

80

130

180

230

Lithuania Romania

Poland Serbia

Hungary

Latvia

Bulgaria

Croatia

Estonia

Source: Authors’ estimations. Data extracted from BIS, Locational banking statistics.

0

20

40

60

80

100

120

140

160

180

Figure 7-2 External positions of reporting banks vis-à-vis all sectors, March 2007 = 100

182

Capital Flows and Boom-Bust Cycle in Emerging Europe

183

This high weigh of cross-border bank flows is explained by two related factors. On the one hand, both the transition process and the European Union accession process have led to a catching-up effect. In turn, higher growth perspectives attracted international capital flows as expected yields were high. On the other hand, the privatization process of the banking sector has allowed the penetration of foreign banks (Table 7-1), and, more especially, banks from the European Union. IMF (2008) provides an overview of the concentrated exposures of emerging Europe to banks in European Union. For instance, in December 2007, the weight of Sweden in the external funding for the Baltics amounted to 85%. Austria held 40% of the claims in Croatia and Serbia, and more than 30% in Romania. Table 7-1 Foreign bank assets among total bank assets, in % 2004

2005

2006

2007

2008

Bulgaria

72

71

77

76

80

Croatia

88

92

90

90

90

Estonia

95

99

98

97

99

Hungary

65

63

61

64

67

Latvia

51

58

64

65

66

Lithuania

91

92

92

92

93

Poland

72

76

75

74

72

Romania

54

55

87

89

89

Serbia

n.a.

n.a.

n.a.

n.a.

n.a.

Source: World Bank, Global Financial Development. 

As a consequence, these economies are exposed to a common creditor effect from Western European banks (Balakrishnan et al., 2011).

Credit boom and macroeconomic overheating The boom in capital inflows played a critical role in the build-up of financial vulnerabilities, especially in countries with fixed exchange rate regimes. Fig. 7-3 exhibits a positive relationship between bank flows and domestic credit to the private sector.

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CRO

Consolidated foreign claims of BIS reporting banks to GDP

40

-60

ARG -20

URU

-40

20

POL

-40

CHI

RUS THA 20 BRA TUR COL VEN IND MEX IDN 0 PHI 0PER SIN -20 MAL

40

60

80

KOR

UKR

CZE

HUN

LIT

SLO

60

EST

BUL

ROM

80

LAT

R² = 0,4012

100

Figure 7-3 Capital flows and credit expansion

Domestic credit to private sector

ARG, Argentina; BRA, Brazil; BGR, Bulgaria; CHL, Chile; COL, Colombia; HRV, Croatia; CZE, Czech Republic; EST, Estonia; HUN, Hungary; IND, India; IDN, Indonesia; KOR, South Korea; LVA, Latvia; LTU, Lithuania: MYS, Malaysia; MEX, Mexico; PER, Peru; PHL, Philippines; POL, Poland; ROM, Romania; RUS, Russia; SGP, Singapore; SVK, Slovakia; THA, Thailand; TUR, Turkey; UKR, Ukraine; URY, Uruguay; VEN, Venezuela.

Source: authors’ estimates. Data extracted from World Bank, Global Financial Development Database.

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This figure suggests also that fixed exchange rate regimes tend to lead to as stronger positive link between these two variables. An important implication is the increase in the currency mismatch in emerging Europe, during the period preceding the global financial crisis. Over the same period, currency mismatch decreased in Latin American and Asian emerging economies (Fig. 7-4).1 Two main indicators allow us to assess to what extent the domestic credit boom - fueled by foreign capital flows - was excessive. First, the growth differential between credit and GDP has been sizeable in emerging Europe relative to South-East Asia and, to a lesser extent, Latin America (Fig. 7-5). The growth differential is particularly striking in fixed exchange rate regimes. Second, as exhibited in Fig. 7-6, emerging Europe has experienced a higher discrepancy between changes in deposit and credit to GDP. Magud and Vesperoni (2014) investigate how economies with different degrees of exchange rate flexibility behave during capital inflows reversals. They find that, on the one hand, a higher degree of exchange rate flexibility is accompanied by a lower domestic credit growth, and, on the other hand, countries with flexible exchange rates are less vulnerable to episodes of capital inflows reversals. Table 7-2 portrays the evolution of output gap from 2004 corresponding to the fourth European Union enlargement - to 2008.2

1

We use as a proxy of currency mismatch the ratio foreign liabilities to money following the methodology of Levy-Yeyati et al. (2010). 2 The output gap is defined as the cyclical component of the Hodrick-Prescott filter, defined as the difference between the GDP and its long run counterpart named trend.

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 80

60

40

20

0

80

60

40

20

0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

100 100

Floating ERR 120 Asia 120

140 Am Lat

Emerging Europe 160

140

160

Fixed ERR

Figure 7-4 Ratio of Foreign Liabilities to Money in several emerging countries*, in %

*Foreign liabilities to money ratio: Foreign liabilities / (Reserve money + Demand deposits). Source: Authors’ estimates. Data extracted from IMF, International Financial Statistics.

C Capital Flows and a Boom-Bust Cycle in Emerrging Europe Figure 7-5 Grrowth differentiials between creedit and GDP, ppercentage poin nts

1 2

Argentina, B Brazil, Chile, Mexico, M and Colo ombia, simple aaverage. Indonesia, M Malaysia, Philipppines, South Korea, K and Thailland, simple average.

Sources: authhors’ estimationns. Data extracteed from World Bank, World Development Indicators, andd IMF, Internattional Financiaal Statistics.

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Figure 7-6 Changes in deposit and credit to GDP, 2002-2007, in percentage points

Private credit by deposit money banks to GDP (%)

60

-20

50

LVA

40

LTU

30

-15

-10 THA

10 IDN MEX 0 ARG 0 -5 PHL -10

BGR

HUN ROM

20 KOR

R² = 0,6233

EST

HRV

POL BRA

COL 5

10

SRB 15

20

25

-20 MYS

URY

-30 -40 -50 Bank deposits to GDP (%)

Source: Authors’ estimates, data extracted from World Bank, Global Financial Development Database.

-0,3 0,1 -1,2 0,6 -0,2

Hungary Poland Romania Serbia Average

0,1 0,4 -0,5 -1,1 -0,3

-0,8 -0,8 -3,5 -2,7 -1,0 -1,8

2004Q2

0,1 -1,1 0,9 0,1 0,0

-0,7 -1,4 -4,0 -2,4 -1,9 -2,1

2004Q3

-0,2 -0,7 0,3 2,7 0,5

-1,0 -1,7 -3,4 -2,6 -1,1 -2,0

2004Q4

Source: Authors’ estimation.

-1,0 -0,3 -1,0 -1,8 -0,2 -0,8

Bulgaria Croatia Latvia Estonia Lituania Avarage

2004Q1

-0,6 -0,9 -1,4 -2,0 -1,2

-0,3 -2,7 -4,4 -2,0 -1,4 -2,2

2005Q1

1,2 -1,6 -1,6 -0,2 -0,5

-0,8 -0,6 -2,9 -0,6 -1,3 -1,2

2005Q2

1,0 -1,3 -1,9 1,0 -0,3

-1,0 -0,6 0,1 0,4 -0,3 -0,3

2005Q3

Table 7-2 Output gap from 2004 to 2008

1,2 -1,2 -1,5 1,7 0,1

-0,6 -0,8 2,5 1,1 0,5 0,5

2005Q4

2006Q1 2006Q2 2006Q3 2006Q4 Fixed Exchange Rate Regimes -0,4 -0,2 0,3 0,9 -0,4 -0,2 1,0 0,5 0,7 2,6 5,1 8,5 3,2 3,9 5,2 6,6 0,5 0,9 1,1 2,8 0,7 1,4 2,6 3,9 Floating Exchange Rate Regimes 1,6 2,5 2,7 3,1 -0,9 -0,8 0,0 0,1 -0,2 0,3 0,4 0,9 -1,4 -1,1 -0,3 -0,1 -0,2 0,2 0,7 1,0 1,7 0,7 1,4 1,3 1,3

1,8 3,9 11,0 10,0 4,9 6,3

2007Q1

1,3 0,9 1,9 1,9 1,5

2,4 3,6 13,3 10,0 7,1 7,3

2007Q2

Capital Flows and Boom-Bust Cycle in Emerging Europe

1,5 0,8 1,7 0,5 1,1

1,4 3,5 14,1 9,9 8,4 7,5

2007Q3

2,2 1,9 3,8 1,4 2,3

3,1 2,0 12,6 10,5 10,0 7,6

2007Q4

3,7 2,6 7,0 5,3 4,6

6,7 6,7 15,6 7,1 10,5 9,4

2008Q1

3,9 2,3 8,7 3,6 4,6

5,7 6,3 13,1 8,2 11,3 8,9

2008Q2

3,4 1,8 8,3 2,3 4,0

5,4 4,6 7,8 7,4 8,9 6,8

2008Q3

0,2 0,2 4,9 1,3 1,7

4,8 2,1 2,9 -1,1 7,0 3,1

2008Q4

189

190

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An interresting featurre of this tab ble is the draamatic increasse in the output gap ddifferentials between b peggers and floateers. Specificallly, while the former eexperienced a growing positive output gap before th he global financial criisis, the outpuut gap remain ns relatively sttable in the laatter. The rise in outpput gap suggeests the preseence of an unnsustainable economic e boom. Inflaation differenttial heightenss our previou s remark. On n the one hand, as poortrayed in Fig. 7-7 from 2004 2 to 20077, floaters clo osed their inflation diffferentials relaative to peggerrs. On the othher hand, at th he peak of the boom, iinflation was higher in the last group of countries. In other words, in thhe case of emeerging Europee, we do not vverify the ressults from the open maacroeconomiccs textbooks according a to which fixed exchange rates reducee inflation, too the extent th hat they imprrove the cred dibility of domestic auuthorities. Figure 7-7 Infflation rates in fixed and floatiing exchange raate regimes

F Statisstics. Source: IMF, International Financial

Su udden Stop p in Interna ational Cap pital Flows and d Economicc Recession n Investigaating the factoors driving thee size of the ecconomic contrraction in 2009, Berkm men et al. (2012) ( find, within a sam mple of 43 emerging countries, thhat two main determinants d matter: m on thee one hand, the level of leverage in tthe financial system s and, on the other haand, the creditt boom to the private ssector. High leveraged l dom mestic financiaal system and d sizeable

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credit boom m lead to largerr output loss. In I addition, vuulnerabilities to shocks increase whhen the creditt boom is mainly m funded from abroad d (CGFS, 2009). The destabilizingg influence of o the cross--border bank flows domesticcreedit nexus - may m be due to t the procycclicality of th he former (Brunnermeeier et al., 20122). Some coountries in our o sample ex xhibit these driving facto ors. As a consequencee, Fig. 7-8 poortrays the draamatic changee in the outpu ut gap, in the aftermaath of the Lehman L Broth hers collapse in Septemb ber 2008. Peggers havve experiencedd the strongestt reversal conffirming the im mportance of financiall vulnerabilitties. Mitra (2011) ( showss that countrries who suffered from m the largest swing in GDP growth are those with th he highest concentratioon of capital fllows invested into real estattes, as in the Baltics. B Figure 7-8 O Output gap from m 2007 to 201 13 in fixed andd floating exch hange rate regimes

Source: Authors’ estimates.

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Blanchard et al. (2010) analyze the respective influence of trade and financial channels in the transmission of shocks. Given the scope of the financial vulnerabilities in emerging Europe, we focus in this chapter on financial channels. Two shocks are particularly important: the global financial crisis in 2008-2009, and the European sovereign debt crisis since 2010. To assess the importance of these two crises for emerging markets, and more particularly for emerging Europe, Fig. 7-9 portrays two indicators related to the perceived sovereign risks by investors. The first one is the EMBI Global spreads (Fig. 7-9, left side) that measures yield spreads (over safe or risk free assets that bear minimal credit risk) on emerging market countries’ debt instruments. The spread is the extra return required to compensate the investor for the additional risks faced when investing in emerging economies rather than in a safe asset (such as a US government bond). Spreads increase with the deterioration - effective or expected - of fundamentals and in periods of international financial strains. The second indicator concerns the Credit Default Swap spreads on sovereign bonds. This is a credit derivative contract that allows an agent (called the buyer) to purchase to a counterparty (called the seller) an insurance against the event of default, or other credit events The CDS spread is the premium paid by protection buyer to the seller. An increase in the probability of default leads to a spread rise as the demand for protection is higher. As a result, CDS spreads tend to increase in episodes of financial stress. The two indicators show that the Lehman Brothers collapse in September 2008 has been a common shock for emerging countries. Indeed, whatever the emerging region, we see a dramatic increase in spreads. But Fig. 7-9 gives us additional interesting information: the European sovereign debt crisis constitutes a specific shock to emerging Europe as sizeable tensions are observed in this region in the aftermath of the contagion to Italy, Portugal, and Spain.

01/01/2008

01/01/2009

Asia

01/01/2010

Latin America

01/01/2011

01/01/2012

Emerging Europe1

EMBI Global, Spread, basis points

01/01/2013

01/01/2014

0

100

200

300

400

500

600

700

Emerging Europe3

Source: JP Morgan, data extracted from Macrobond and Thomson Reuters, data extracted from Datastream.

1

Emerging Asia2

Credit Default Swap, Spread, basis points

EMBIG: Croatia, Hungary, Latvia, Lithuania, Poland, Romania, and Serbia. CDS: Brazil, Colombia, Mexico, Peru, and Uruguay. 2 CDS: Indonesia, Malaysia, Philippines, South Korea, and Thailand. 3 CDS: Bulgaria, Croatia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Serbia.

1

0 01/01/2007

100

200

300

400

500

600

700

800

Figure 7-9 Indicators of sovereign risk in emerging countries

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Latin America1

193

14/12/20… 13/02/20… 14/04/20… 12/06/20… 12/08/20… 10/10/20… 10/12/20… 09/02/20… 09/04/20… 09/06/20… 07/08/20… 07/10/20… 07/12/20… 04/02/20… 06/04/20… 04/06/20… 04/08/20… 04/10/20… 02/12/20… 01/02/20… 01/04/20… 01/06/20… 01/08/20… 29/09/20… 29/11/20… 27/01/20… 28/03/20… 28/05/20… 26/07/20… 25/09/20… 23/11/20… 23/01/20… 25/03/20… 23/05/20… 23/07/20… 20/09/20… 20/11/20… 20/01/20… 20/03/20… 20/05/20…

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194

Th he size of thee economic contraction: c : the impactt of the t deleveraging proces s In the im mmediate afterrmath of the Lehman L collaapse, interbank k funding markets disrrupted. Fig. 7-10 estimates the spreads bbetween the unsecured u money marrket segment (EURIBOR)), and the seecured money y market segment (EU UREPO). As expected, durring the perioods of intense financial stress, the sppreads increasse as banks lose confidencee in their coun nterparties in the interbbank market. Figure 7-10 T Tensions on inteerbank funding markets

Source: Macrrobond.

The maajor consequence of thiss disruption has been the t bank deleveragingg process at a global levell (Fig. 7-11). The negativee shock is particularly large in counttries with fixeed exchange raate regimes. As pegggers were espeecially depend dent on crosss-border bank k flows to finance the ddomestic creddit boom, the corollary c to thhis global deleeveraging process has been a domeestic deleveraging one as eexhibited by the t credit 1 crunch afterr 2008-Q3 (Figg. 7-12). 1

The size off the deleveragging process in n Central and E Eastern Europee has been mitigated by the Vienna Inittiative. The maiin goal of this iinitiative was to o maintain exposures andd to support thheir subsidiariess. Using data inn 1 294 banks in Central

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Figure 7-11 C Changes in exteernal positions of reporting baanks vis-à-vis all a sectors, in terms of 20013 GDP in fixeed and floating exchange rate rregimes

Source: Autthors’ estimatees. Data extrracted from Bank for Intternational Settlements.

Fig. 7-8 and 7-12 sugggest that eco onomies experriencing moree reliance on cross-borrder flows perrformed the worst w during th the crisis. Succh finding is in line with Alvarez and a De Grego orio (2014), w which shows a positive relation betw ween the degrree of financiaal openness annd growth performance during the gglobal financiaal crisis. The colllapse of Lehm man Brothers in Septembeer 2008 highllights the importance of financial channels forr emerging E Europe. The European E sovereign ddebt crisis provides p the opportunityy to assess financial transmissionn from the Eurro area to emeerging Europee.

and Eastern E Europe during the global finaancial crisis, Dee Haas et al. (2 2012) find that foreign bbanks involved in the Vienna Initiative I have been more stab ble lenders than other forreign banks.

196

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Changes in the ratio domesticc credit to the pprivate sector/G GDP , year Figure 7-12 C on year changge

Source: Authhors’ estimatess. Data extracted from IMF, International Financial Statistics.

Th he impact of the European sovereign n debt crisiss Allegret and Sallenavve (2015) inveestigated the im mpact of the European E debt crisis bby estimating rolling correlations betwe en credit defaault swap (CDS) spreaads in emerging Europe and a European Union. They y indicate two main fiindings. First, during the period p July 20011 - Septemb ber 2012, where the Greek crisis has a spillo over to otherr peripheral European E countries, thhe rolling coorrelation betw ween CDS soovereign debt for our sample andd the weighteed CDS soveereign debt for IIPS draamatically increased.2 During this period, which correspondds to the peaak in the European crrisis, IIPS CD DS Granger caused c CDS in Emerging Europe.3 Second, rollling correlatioons - between n the sovereiggn CDS of ou ur studied countries annd the CDS of o the banking g sector from the European n Union increased foor all economiies, except Seerbia, from M May 2010 to November N

2

IIPS for Itally, Ireland, Porttugal, and Spain n. We use the shhare of the pub blic debt of these countriees in the total puublic debt of Eu uro area as weigght. 3 A variable X Granger-causses Y if Y can be b better prediccted using the histories h of both X and Y than it can by using u the history y of Y alone.

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2010. The sovereign CDS of the Baltics were Granger caused by the banking sector CDS.

The ineffectiveness of monetary policy during the boom-bust cycle This section assesses to what extent monetary policy, conducted in emerging Europe, has been weakly ineffective in facing the boom-bust cycle in capital flows. We highlight three main motives.

International capital boom and macroeconomic imbalances: the role of the exchange rate regime As stressed above, peggers are characterized by the persistence of positive output gap during the capital flows boom episode. Such persistence results from monetary policy constraints, due to the exchange rate regime. Fig. 7-13 shows the short-term interest rates in real terms for our sample. Countries with fixed exchange rates had real short term interest rates rather than floaters. In accordance with the impossible trinity, fixed exchange regimes constrain the ability of the central bank to raise its policy rates, insofar as raising domestic rates may attract more capital flows and, in turn, induce a pressure on the exchange rate. Specifically, many Emerging Europe countries have to ensure open financial account in order to respect rules defined in Copenhagen (the so-called “Copenhagen criteria”) to be eligible to join the European Union. In a similar way, the IMF (2008) finds that peggers set policy rates consistently below rates resulting from a Taylor rule. However, domestic authorities can try to curb capital inflows by allowing nominal appreciation of the currency. Indeed, nominal appreciation decreases the attractiveness of the country for international investors. On the one hand, nominal appreciation exerts a similar influence of the real economy than a restrictive monetary policy. Thus, future inflation and growth expectations tend to decrease. On the other hand, the immediate appreciation reduces future appreciations and, then, prospective returns. The behavior of nominal effective exchange rates, portrayed in Fig. 7-14, highlights the authorities’ reluctance to let currency appreciate, then losing a degree of freedom in the conduct of the monetary policy.

198

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hange rate Figure 7-13 Short-term reaal interest rates in fixed andd floating exch regimes

Source: Authhors’ estimatess. Data extracted from IMF, International Financial Statistics. Figure 7-14 N Nominal effectiive exchange raates in fixed annd floating exch hange rate regimes, 100 = 2010

In additiion, Allegret and a Sallenavee (2015) find tthat short-term m interest rates for thee sample counntries are sign nificantly influuenced by tho ose of the Euro area. T They report a higher h influen nce for peggerrs’ economies..

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m Bank for Intern national Settlem ments. Source: Data extracted from

The costt of exchange rate adjusstments und der fixed excchange rate reg gime Since thee seminal papper by Friedman (1953), it iis widely acceepted that the flexible exchange rate can play as a shock absoorber, insofar as larger movements in relative prrices - allowed d by floating regimes - briing to the smoother addjustment of output o to real shocks s under ffloating regim mes.4 This view has beeen challengeed by Calvo and a Reinhart (2001 and 20 002) who find that deppreciation leaads to contracttionary outputt in emerging g markets, insofar as exxchange rate crises in thesse countries ggo hand in han nd with a sudden stop of capital infflows. As a reesult, they suff ffer from reserrve losses and severe current accoount reversalss, explained bby a dramatiic fall in aggregate deemand. 4

On the emppirical side, see,, among others, Edwards and Levy-Yeyati (2 2003), and Broda (2004)).

200

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Case studies on Central Eastern and South-Eastern European countries, during the global financial crisis of 2008-2009, suggest that monetary policy in peggers has been more constrained to respond to the crisis than floaters (Gardó and Martin, 2010; Corozza et al., 2011). Cross-country analyses tend to confirm the initial conclusions by Friedman (1953), as they display a more mixed view on the advantages of floating exchange rates to respond to the financial crisis. The IMF (2010) found that emerging countries, with fixed exchange rate regime, experienced a weaker decrease in their interest rates, relative to floaters. Berkmen et al. (2012) show that countries with more flexible exchange rates exhibit smaller output declines. Adler and Tovar (2012) consider the “pure effect” of external financial shocks5 on output performance6. Their main result suggests that flexible exchange rate regimes smooth international financial shocks. Tsangarides (2012) obtained more nuanced conclusions than previous studies. On the one hand, during the crisis, countries with floating exchange rate regime experience no better performances than pegged regimes. As a result, floating regimes do not seem to provide an effective shock absorber mechanism. On the other hand, during the recovery period, peggers recover slower than floaters. Josifidis et al. (2013) analyzed adjustment mechanisms during the global financial crisis in some new European Union members, according to the exchange rate regimes (Czech Republic, Hungary, and Poland as flexible regimes group, and Estonia Latvia, and Lithuania for fixed regimes group). In order to assess differences in adjustment mechanisms to external shocks, vector autoregression (VAR) - or vector error correction models (VECM) - were estimated over the period from January 2004 to December 2010 and the crisis sub-period (January 2008December 2010). Following Blanchard et al. (2010), we estimate the effects of two international shocks: a trade shock proxied through an indicator of economic activity in the Group of seven countries, and a financial shock proxied through three indicators: (i) the VIX index; (ii) the EMBI+ indicator; and (iii) a banking shock by considering the external positions of reporting banks vis-à-vis all sectors in emerging Europe. Josifidis et al. (2013) showed that the weakest real exchange rate adjustment, during the crisis, was observed in countries with fixed exchange rate regimes. In addition, when real exchange rate adjustment

5

The international financial shock is represented by deviations of the VIX from its trend. The effects of the shock on output are estimated after controlling for trade shocks (such as deterioration in terms of trade and a drop in external demand). 6 Output performance captures the depth and duration of each crisis episode.

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occurs –withh lags for pegggers (Fig.7-15), underlyingg mechanismss differ in the two exchhange rate reggimes. hange rate Figure 7-15 Real effective exchange ratees in fixed andd floating exch regimes, 20100 = 100

m Bank for Intern national Settlem ments. Source: Data extracted from

Floaters countries adjust the reaal exchange rate mainly through nominal excchange rate movements m (F Fig. 7-16, left ft side), whilee peggers make the adj djustment via changes c in dom mestic prices (Fig. 8-16, rig ght side).

Floating ERR

Fix ERR

-2

0

-1

1

2

3

4

5

6

7

8

9

Source: Authors’ estimates. Data extracted from Bank for International Settlements and European Central Bank.

130 125 120 115 110 105 100 95 90 85 80

Chapter Seven

Figure 7-16 Nominal effective exchange rates and core inflation

202

01/01/2007 01/06/2007 01/11/2007 01/04/2008 01/09/2008 01/02/2009 01/07/2009 01/12/2009 01/05/2010 01/10/2010 01/03/2011 01/08/2011 01/01/2012 01/06/2012 01/11/2012 01/04/2013 01/09/2013 01/02/2014

2008-01 2008-05 2008-09 2009-01 2009-05 2009-09 2010-01 2010-05 2010-09 2011-01 2011-05 2011-09 2012-01 2012-05 2012-09 2013-01 2013-05

Floating ERR

Fixed ERR

2013-09 2014-01 2014-05 2014-09

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203

Table 7-3 shows, for the whole period, the percentage ratio of real effective exchange rate variations explained by the nominal effective exchange rate shock during 12 months.1 The nominal exchange rate shocks tend to have a higher influence on real exchange rate volatility in floaters countries (Poland (98%-90%), Hungary (93%-81%), and Czech Republic (84%-78%)). Table 7-3 Variance Decomposition of the Real Exchange Rate: Ratio of NEER Shocks to REER Variations 2004M1-2010M12, in percent Months 1 3 6 9 12

Czech Rep. Estonia Hungary 84.32 35.59 92.95 79.20 35.67 83.26 77.85 35.63 80.94 77.90 35.62 80.92 77.91 35.62 80.92

Latvia 0.56 5.06 13.55 20.08 24.68

Lithuania 51.92 61.25 60.80 60.79 60.79

Poland 97.65 92.74 90.59 90.40 90.38

Source: Josifidis et al. (2013).

At the opposite end, domestic price shocks exert a stronger influence on real effective exchange rate variance in peggers (Table 7-4). Thus, the share of the real exchange rate variance, explained by prices shocks, accounts for 39%-23% in Latvia; 32%-25% in Lithuania; and 28%-27% in Estonia. Table 7-4 Variance Decomposition of the Real Exchange Rate: The ratio of price shocks to REER variations 2004M1-2010M12 Months 1 3 6 9 12

Czech Rep. 9.44 11.38 12.26 12.23 12.23

Estonia Hungary 27.63 5.10 26.61 14.08 26.69 15.51 26.70 15.51 26.70 15.51

Latvia 39.22 27.28 23.58 23.17 22.99

Lithuania Poland 32.32 1.02 25.30 3.78 25.32 5.22 25.32 5.35 25.32 5.37

Source: Josifidis et al. (2013).

Real exchange rate adjustment is very costly in terms of output loss (see Fig. 7-8), and unemployment (Fig. 7-17), under fixed exchange rate

1

Crisis period does not change the results.

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regimes whhen prices annd wages arre sticky. Inddeed, compettitiveness improvemennt rests on inteernal devaluattion due to defflationary presssures. Figure 7-17 U Unemployment rates in fixed and a floating excchange rate regiimes

Source: Authhors’ estimatess. Data extracted from IMF, International Financial Statistics.

To w what extentt the currenccy mismatch h constraintts the reesponses of the t monetarry policy to fface the crissis? In line w with the fear of o floating liteerature, manyy studies sugg gest that a high domesttic liability doollarization maay lead to a feear of floating behavior by domesticc authorities. Specifically y, for examplle, 7 Latin American A countries, C Cavallo and Izzquierdo (200 09) have show wn that the higher h the domestic liaability dollariization, the higher h is the output loss following f exchange raate depreciatiion. For theirr part, Izquieerdo and Talv vi (2009) explain the stark contrasst, concerning g the monetarry policy resp ponses in Latin American countries in the afterm math of the R Russian crisiss of 1998 and the 2008-2009 globall financial crisis, by stressinng the reductiion in the

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degree of domestic liability dollarization in these countries. While the former Latin American countries suffered from a fear of floating behavior - limiting the size of the depreciation, and dramatically increased interest rates - in the latter crisis episode they allowed their currency to depreciate and decreased their interest rates. Two related papers used Taylor-type monetary policy rule in a panel data setting to assess the influence of currency mismatch on the adoption of counter-cyclical monetary policy. Hausmann and Panizza (2010) compared monetary policy responses to the Asian-Russian crises and the global financial crisis for a panel of 28 emerging markets; they found that the decrease, in the currency mismatch, allowed for the conduct of counter-cyclical monetary policy. Vegh and Vuletin (2012) included, in the Taylor rule, a fear of floating variables measured as the correlation between the cyclical component of the short-term interest rate, and the rate of depreciation of the exchange rate. Over the period 1960-2009, they identified a negative correlation between the degree of fear of floating and the adoption of countercyclical monetary policy. In other words, monetary policy is procyclical for high levels of fear of floating, and more countercyclical as fear of floating diminishes. In addition, Vegh and Vuletin (2012) showed that the fear of floating coefficient is particularly important for developing countries. Josifidis et al. (2014) analyzed the influence of the currency mismatch during crises episodes, for example, of 10 emerging European countries: Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Russia, and Turkey. Specifically, the authors studied monetary policy responses to common alternative financial shocks: EMBI shock; VIX shock2; and two volatility shocks in equities markets (the MSCI of G7 group and the MSCI of Emerging Markets. To assess to what extent these indicators are relevant to identify crises episodes, the Bloom (2009) approach was used. Thus, crises episodes are identified as deviations of each indicator from its HP trend. By applying such methodology, all financial indicators used in this study are relevant, insofar as they are able to identify the following financial crises episodes: (i) Mexican crisis 19941995; (ii) Asian and Russian crises 1997-1998 and Brazilian crisis 1999 (crises cluster around 1997-1999); (iii) ICT bubble and 09 / 11 bombing attack 2000-2001; (iv) Subprime crisis. Josifidis et al. (2014) distinguish two sub-periods: 1995:Q1-2001:Q4 in which crises are mainly driven by

2

The VIX measures market expectations of near term volatility conveyed by stock index option prices (S&P 500 index). VIX is often referred to as the "investor fear gauge".

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emerging countries; and 2002:Q1-2010:Q4 in which crises originate from advanced economies. The responses of macroeconomic variables to external financial shocks are identified with Structural Bayesian Vector Autoregressive (SBVAR) models. The model includes the real GDP as the response for the overall activity to the external shocks, and the financial account - excluding FDI as a ratio to GDP - as the external side of the domestic economy. Capital inflows are especially sensitive to international financial shocks. Three monetary policy variables are considered: the domestic short-term interest rates; the real effective exchange rates; and the foreign exchange reserves. To assess the influence of currency mismatch, two sub-groups of countries are distinguished according to the median value of the currency mismatch – estimated with the FLM ratio and the Ranciere et al. (2010) approach: -

the high currency mismatch group that includes Bulgaria, Estonia, Lithuania, Latvia, Croatia, and Hungary; the low currency mismatch group encompassing Czech Republic, Poland, Russia, and Turkey.

Josifidis et al. (2014) obtained two main findings. First, emerging European markets with high currency ratios have prevented depreciations of their real exchange rates in the aftermath of the external financial shocks. Second, in line with Aizenman and Sun (2012) and Aizenman and Hutchison (2012), a high currency mismatch ratio tends to be accompanied by a “fear of losing international reserves” in the aftermath of external financial shocks. In other words, financial vulnerability reduces the maneuvering room to adopt counter-cyclical policies. However, the results show that emerging European countries with high currency mismatch ratios suffer from both fear of floating and fear of losing reserves Allegret and Sallenave (2015) found that the level of currency mismatch exerted an influence on the determination of the short-term interest rates in emerging Europe, particularly during the crisis period (2007-2013). Their result suggests that countries with a high currency mismatch adopt procyclical monetary policy.

Conclusion This chapter investigated the macroeconomic impact of the boom-bust cycle in capital flows for a sample of 9 emerging European countries. As previous experiences in emerging economies, we show that the boom

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episode resulted in a credit boom and, in turn, in macroeconomic overheating. The contractionary impact of the bust in capital flows rested on a domestic deleveraging process. Specifically, the main finding of this study is to identify a clear relationship between the imbalance due to the boom-bust cycle, and the exchange rage regimes adopted by the sample countries. Indeed, we stress that economies with fixed exchange rate regimes face dramatic difficulties in managing both the surge and the sudden cessation in capital flows.

CHAPTER EIGHT MACROECONOMIC LINKAGES IN THE EUROPEAN UNION OSCAR BAJO-RUBIO AND CARMEN DÍAZ-ROLDÁN

Summary The European Union (EU) constitutes a particular and novel economic framework. More than half of her member countries form a monetary union, whereas the rest keep their national monetary policies. Regarding the external sector, the EU economies exhibit a high degree of openness and the European block plays a prominent role in international trade. In this chapter we will analyse the macroeconomic implications of these features, paying special attention to the linkages between domestic and external performance. In particular, under a theoretical approach, the relationship between the EU and the rest of the world can be explained by means of a two-country model. But, when considering the composition of the EU (i.e., Eurozone and non-Eurozone), relationships turn to be more complex and the model becomes a three-country one. In other words, we could say that macroeconomic linkages between the EU and the rest of the world can be described by a nested model in which the EU makes up a block versus the rest of the world, but also a two country model by herself. As far as we know there are no macroeconomic models describing such situation, in spite of being the current economic framework of one of the major economies worldwide. For that reason, the aim of this chapter would be to analyse the performance of the EU in the light of macroeconomic modelling.

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Introduction The relevance of choosing a particular exchange rate regime relies on the degree of openness of countries, and their particular monetary policy regime. Flexible exchange rates guarantees, through a simple monetary mechanism, the automatic adjustment of the balance of payments. The money supply is under control of monetary authorities, at the cost of losing direct control over exchange rates. On the contrary, in a regime of fixed exchange rates balance of payments deficits or surpluses would arise. There would not be uncertainty on the exchange rate, but the cost is that monetary policy will be aimed to sustain the exchange rate at the expense of subordinating domestic policy objectives. In last years, in a world characterized by a huge international capital mobility, where many countries are reluctant to adopt a system of flexible exchange rates (Calvo and Reinhart, 2002), the formation of a monetary union has proved to be an alternative to fixed exchange rate regimes. In other words, countries agree to adopt a common currency with one or more countries with which they have a particular relationship (financial, commercial, cultural and so on). Under this point of view, a monetary union is a particular case of a fixed exchange rate (see Obstfeld and Rogoff (1995) or De Grauwe (2006), among others). When a country joins a monetary union the national currency disappears, establishing an exchange rate irrevocably fixed with respect to the new currency. Put differently: neither fluctuation margins nor central parity changes will be allowed any more. In turn, the new currency adopted can be: (i) a newly created currency, of which the most important example is the euro, created in 1999 and currently used by 19 of the 28 member states of the European Union (EU); or (ii) the currency of another country, such as the adoption of the US dollar by some Latin American countries like Ecuador, El Salvador or Panama (dollarization) or the euro by some Eastern European countries such as Montenegro or Kosovo (euroisation). When joining a monetary union, the loss of an independent monetary policy would be a disadvantage for a country. Following the theory of Optimum Currency Areas pioneered by Mundell (1961), losing monetary policy would be less advisable the more important were the asymmetric shocks that the economy could suffer. Recall that an asymmetric shock is defined as one that requires a different optimal policy response in each country suffering the shock. Given that an asymmetric shock requires in each country different economic policies in order to be offset, a common monetary policy would not be the appropriate instrument to deal with

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asymmetric shocks. Therefore, the cost of losing monetary policy would be smaller the more integrated are the economies of the countries forming the monetary union. Within highly integrated countries the evolution of their economies would be much synchronized, and therefore less likely the occurrence of asymmetric shocks (Alesina and Barro, 2002). Following this argument, countries involved in an economic integration process (in principle, under a system of flexible exchange rates) or even joining an economic union should be in good conditions to evolving towards a monetary union. The key factor is the degree of synchronization of their economies and the risk of suffering from asymmetric shocks (Díaz-Roldán, 2013). The sequence of an economic integration process followed by an economic union and culminated by a monetary union, has been the way of construction of the current EU where 19 of her 28 member countries form a monetary union, whilst the rest keep their national monetary policies. The Economic and Monetary Union (EMU), started by 11 member countries of the EU on January 1st 1999, constitutes an example of this particular economic policy framework. The single monetary policy is the exclusive competence of an independent and supranational central bank, the European Central Bank (ECB). Fiscal and structural policies, as well as wage determination, remain the responsibility of the member states. In turn, the ECB’s monetary policy is aimed to respond to any symmetric shocks that might affect the Eurozone. When implementing monetary policy, the ECB follows a kind of monetary policy rule aimed to achieve the stability price as its unique objective. The formulation of monetary rules for open economies implies recognizing that neither the price level nor the money supply may be controllable by domestic monetary authorities under a fixed exchange rate regime. In that way, a monetary rule defining a target rate of growth of central bank credit can be formulated not only to achieve the inflation targeting, but also with the purpose of keeping the external balance (Bê Duc et al., 2008). In this economic policy framework, fiscal policy is the only demand policy aimed to achieve the stabilization goal. In line with the subsidiarity principle, national governments are in a position (subject to certain common rules) to deal with country-specific shocks. In EMU, fiscal policy is aimed to achieve output stabilization in the short run, through the use of discretionary changes in the government budget, and of automatic stabilizers. In the long run the fiscal policy should guarantee the sustainability of public finances, as well as to contribute to economic

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growth through the structure of revenues and expenditures, and public investment in physical and human capital (European Central Bank, 2004). In practice, the management of fiscal policy in EMU is constrained by the limits imposed to the deficit and the lack of a federal budget. Nevertheless, the EU budget should not be expected to play the same role than, for instance, US federal budget. In Europe, incorporating the insurance function into the EU budget would require reinforcing fiscal competencies at the EU level, given that the size of its budget is still relatively small. In fact, proposing structural reforms of the budget would require several institutional changes, such as reinforcing the role of the European Parliament, creating either a supranational authority on taxes or funds guaranteed by different budget rules, or establishing a joint decision mechanism for the coordination of fiscal policies (European Central Bank, 2013). As mentioned before, a monetary union such as EMU can be defined on the basis of achieving inflation targeting, as well as keeping external balance in the economy. On the one hand, the large risk posed by fiscal imbalances to the stability of any monetary area justifies closed rulesbased coordination of budgetary policies. With the exception of binding rules on deficits (addressed in the Stability and Growth Pact), macroeconomic coordination within the euro area is generally based on dialogue and consensus. But, on the other hand, the fiscal discipline imposed by the monetary agreements could limit the scope of stabilizing fiscal policies, and its implications on economic growth. In this chapter, we will develop a model describing the Eurozone macroeconomic framework, and its relationship with the rest of the EU and the rest of the world. The following section is devoted to present a model for a monetary union that would explain the relationships across the Eurozone member countries. Next, on the basis of such model, we will offer some considerations in order to account for the macroeconomic linkages between Eurozone members and the rest of the EU countries, as well as between the EU countries and the rest of the world. Finally, we will conclude with some policy implications of this economic framework regarding domestic and external performance.

A macroeconomic model of a monetary union The first attempt to extend the Mundell-Fleming model, incorporating a fully specified supply side, to the case of a monetary union, is BajoRubio and Díaz-Roldán (2011a). Specifically, starting from the standard two-country Mundell-Fleming model with perfect capital mobility

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(Mundell, 1964), extended to incorporate the supply side in a context of rigid real wages (Sachs, 1980), and allowing for a common money-market equilibrium condition, they analyse the effects of monetary, expenditure, supply-side and external, both common and country-specific, shocks in the novel macroeconomic framework given by a monetary union. In this section, we will modify the analysis in Bajo-Rubio and DíazRoldán (2011a) by replacing the traditional LM function by the assumption that the central bank follows a monetary policy rule. This can be justified on the grounds of the surge experienced by financial innovation, which makes highly unstable the demand for money, and hence the LM function. In that case, the intermediate target of monetary policy should be the interest rate rather than money supply, as already shown by Poole (1970). A macroeconomic model incorporating a monetary policy rule based on inflation targeting has been developed, at a textbook level, in Bajo-Rubio and Díaz-Roldán (2011b, 2013), which will be adapted here for the case of a small monetary union. This macroeconomic model would prove to be useful for describing the Eurozone countries’ interactions across her member countries.

The basic model The model is linear in logs for all the variables (except for the interest and unemployment rates, which denote their levels), Greek letters (all of them standing for positive values) denote the coefficients on the variables, and a star denotes a variable from the rest of the world; time subscripts are omitted for simplicity. The equilibrium condition in the goods market (i.e., the IS function) will be given by: y = íĮ'r + ȕy* í Jq + f where real output y depends negatively on the real interest rate r, and the real exchange rate q; and positively on foreign output y*, and a real, expansionary aggregate demand shock f. The real exchange rate, measured as the price of domestic goods in terms of foreign goods, is defined as e + p  p*, where e, p*, and p denote the nominal exchange rate and the foreign and domestic price levels, respectively. Finally, the variable f can include positive shocks to private consumption or investment, the trade balance, as well as expansionary fiscal policy changes. Assuming that the real exchange rate depends positively on the real interest rate differential with respect to the rest of the world r í r*,

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q = Ȝ(r í r*) the IS function becomes: y = íĮr + ȕy* + įr* + f

(1)

where r* denotes the foreign real interest rate, į = JȜ, and Į = Į' + į picks the effect of r via both private demand and the trade balance through q. As regards the money market, we assume that the central bank follows a monetary policy rule of the type proposed by Taylor (1993). Specifically, we assume a rule such as: i = (rҧ + ¨p) + İ(¨p í ¨pT) + Ș(y í yത) so that the nominal interest rate set by the central bank i, would be given by the sum of the equilibrium real interest rate rҧ, plus the current inflation rate ¨p; and this reference value should adjust along with deviations of the actual inflation rate from the target established by the central bank ¨pT, and of actual output from its potential level yത. Since the interest rate that affects the goods market is the real interest rate, we will present our monetary rule in terms of the latter. Recalling the definition of the real interest rate: r Ł i í ¨pE where ¨pE denotes the expected inflation rate, assumed to be given in the short run, the central bank will control indirectly the real interest rate. Accordingly, our equation for the monetary rule in terms of the real interest rate will be: r = U + İ(¨p í ¨pT) + Ș(y í yത) where U = rҧ + ¨p í ¨pE can include a risk premium1. Lastly, since our model has been developed taking as reference the Eurozone and the ECB is mostly concerned with the evolution of inflation, paying no attention to the evolution of output, we assume Ș = 0 and drop the term on the output gap y í yത, from

1

More strictly, the nominal market interest rate would be given by the sum of the nominal policy interest rate (i.e., that set by the central bank according to the rule) plus the risk premium; see, e.g., Sørensen and Whitta-Jacobsen (2010).

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the monetary policy rule. Hence, the equation for the monetary rule of the central bank, which will be termed MR function, becomes: r = U + İ(¨p í ¨pT)

(2)

and will be horizontal in the plane y-r, unlike the general case in which the MR function has a positive slope. We complete the model by developing the supply side. Our analysis of the aggregate supply is based on imperfect competition assumptions, where wages are set through a bargaining process between workers and firms, and prices are then set by firms. This modelling of aggregate supply, widely used in the analysis of unemployment in the European economies, follows Layard, Nickell and Jackman (1991). Such a framework allows us to stress the role of institutional aspects in economic evolution, as well as to account for the presence of involuntary unemployment. The supply side of the model includes a wage equation, a price equation, and a relationship between output and employment2: ¨w = ¨pEC – ࢥu + ¨prod + zw ¨p = ¨w – ¨prod + zp n = y – prod

(3) (4) (5)

According to equation (3), the change in the nominal wage w, is fully indexed to changes in the expected value of the consumer price index pEC , and depends negatively on the unemployment rate u, and positively on the change in labour productivity prod and some wage pressure factors summarized in zw. In turn, equation (4) sets prices as a mark-up over average variable costs, where the only variable factor is labour, and the mark-up covers any fixed costs and is assumed to depend on the variables summarized in zp. Lastly, equation (5) defines employment n, as the difference between real output and productivity. Notice that the variables zw and zp would pick the effect of labour market taxes, as well as the market power of workers and firms, respectively. Regarding price expectations, our assumption of nominal inertia means that it takes some time for prices and wages to adjust to a shock. Specifically, expected inflation of the consumer price index will be given by: 2

As usual, the coefficients on the productivity variable are the same in the wage and price equations in order to prevent an effect of productivity on unemployment in the long run; see Layard, Nickell and Jackman (1991).

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¨pEC = ¨pC,–1 where the subscript –1 denotes the value of a variable at the beginning of the period of analysis. This kind of assumption will allow us to separate the short- and long-run effects of shocks, the latter occurring when prices and wages have fully adjusted. This specification of expectations appears to be consistent with the standard stylized facts about the dynamic effects of monetary policy (Mankiw, 2001); and, as noticed by Ball (2000), such backward-looking expectations can be interpreted as a “near-rational rule of thumb” in the sense of Akerlof and Yellen (1985), given the costs of gathering and processing the information needed for fully rational inflation forecasts. To complete the supply side of the model, two definitions are required. The first is the consumer price index, which is a weighted average of domestic and foreign prices, with the latter denominated in domestic currency: pC Ł ıത p + (1 í ıത )(p* í e) or, recalling that q Ł e + p  p*: pC Ł p í (1 í ıത )q where ıത > 0 denotes the weight of domestic prices. The second is the rate of unemployment, that is, the difference between labour force l and employment: uŁl–n Hence, from (3) to (5), and taking into account the assumption on expectations and the two above definitions, we can derive the aggregate supply equation or AS function: ¨p = ¨pି1 í (1 í ıത )¨qି1 + ࢥy + s

(6)

where s is a contractionary supply shock capturing all the possible supply shocks considered before (i.e., pressures on wages and prices, and shocks to labour force and productivity): s Ł (zw + zp) – ࢥ(l + prod)

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In turn, the long-run aggregate supply equation is given by: yത =

(1 –ıത )

s

ࢥ

ࢥ

¨q –

(6')

In this way, our basic model is made up of equations (1), (2) and (6) for the short run; with (6) replaced by (6') in the long run, i.e., when ¨p = ¨pି1 and ¨q = ¨“ି1 . As noted earlier, the advantage of this specification is that it will allow us a separate examination of the immediate or impact effect of a shock, and its final effect, once all prices have fully adjusted.

The model for a monetary union Next, we will assume that, rather than a single country, the above model describes a monetary union. We define a monetary union as a group of countries that have decided to abolish their national currencies to adopt a new currency, common to all of them, assuming a flexible exchange rate with the rest of the world. Under the framework developed before, every equation in the monetary union model can be written in terms of every member country. To keep things as simple as possible, we will assume that the monetary union is made up of two identical countries, denoted by the subscripts 1 and 2; and that each variable of the union is a weighted average of the 1

corresponding variables of countries 1 and 2, with the weights equal to . 2 Specifically, for any variable x: 1 2

x = (x1 + x2 ) We will make the additional assumption that, the consumption price index of each member country is defined such that its own prices have greater weight than those of the other country. Specifically: ıത ൌı + ı', ı > ı', so that: pC1 Ł ıp1 + ı'p2 + (1 – ı í ı')(p* í e) pC2 Ł ıp2 + ı'p1 + (1 – ı í ı')(p* í e) or, defining the real exchange rates of countries 1 and 2 as q1 Ł e + p1  p*, q2 Ł e + p2  p*:

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pC1 Ł (1 í ı')p1 + ı'p2 + (1 – ı í ı')q1 pC2 Ł (1 – ı')p2 + ı'p1 + (1 – ı í ı')q2 1

where (1 í ı') > ı' if ı' < . 2 The equilibrium conditions in the goods market or IS functions for countries 1 and 2 would be: y1 = íĮ'r1 + ȕy* + ȕ(y2 –y1 ) í Jq1 í J(p1 –p2 ) + f1 y2 = íĮ'r2 + ȕy* + ȕ(y1 –y2 ) í Jq2 í J(p2 –p1 ) + f2 where, in the equation for each country, two terms have been added: (i) the output of the other country relative to its own output, and (ii) the relative prices versus the other country, which amount to the real exchange rate against the partner country (once that the nominal exchange rate between the two countries has disappeared). These two terms affect the trade balance between the two member countries of the union, which cancel each other at the union level. Assuming again that the real exchange rate of each country depends positively on its real interest rate differential with respect to the rest of the world, the IS functions become: y1 = íĮr1 + ȕy* + ȕ(y2 –y1 ) í J(p1 –p2 ) + įr* + f1 y2 = íĮr2 + ȕy* + ȕ(y1 –y2 ) í J(p2 –p1 ) + įr* + f2

(7) (8)

where, as before, Į = Į' + į. On the other hand, since the two member countries of the union have a common central bank, the nominal interest rate and hence the monetary policy rule in terms of the latter will be the same for both countries. Nevertheless, the real interest rates will be different, because inflation rates might not be the same in the two countries. Therefore, the MR functions for countries 1 and 2 are: İ–1

r1 = ȡ1 + ቀ

2 İ–1

r2 = ȡ2 + ቀ

2

1+İ

ቁ¨p1 + ቀ ቁ¨p2 + ቀ

2 1+İ 2

ቁ¨p2 í ݨpTU

(9)

ቁ¨p1 í ݨpTU

(10)

where the inflation target set by the central bank of the union is denoted by ¨pTU , and ȡ1 = rҧ + ¨p1 í ¨pE1 and ȡ2 = rҧ + ¨p2 í ¨pE2 . Notice that the coefficients on the inflation rates of each country are different in the MR

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functions: while an increase in the inflation rate in any of the countries leads to an increase in the nominal interest rate of the union through the monetary rule (by (1 + İ)/2, since each country’s inflation rate is one half of the union’s inflation rate), an increase in the inflation rate in a country lowers her real interest rate in the same proportion, but does not affect the other country’s real interest rate. We will assume hereafter that a country would agree joining a monetary union only if the monetary policy of the union is anti-inflationist enough, so that an increase in her inflation rate raises the real interest rate; in other words, if İ > 13. Regarding the supply side, from the equivalents of equations (3) to (5) for the two countries, and given our assumption on expectations and the definitions of the unemployment rate and the consumption price indices of the two countries, the AS equations for each country would be: ¨p1 = (1 í ı')¨p1,ି1 + ı'¨p2,ି1 – (1 – ı í ı')¨q1,ି1 + ࢥy1 + s1 (11) ¨p2 = (1 í ı')¨p2,ି1 + ı'¨p1,ି1 – (1 – ı í ı')¨q2,ି1 + ࢥy2 + s2 (12) which, in the long run, once all prices have fully adjusted, should be replaced by: ı'

(1 – ı – ı')

s1

ࢥ ı'

ࢥ (1 – ı – ı')

ࢥ s2

ࢥ

ࢥ

ࢥ

yത1 = (¨p1 –¨p2) + yത2 = (¨p2 –¨p1 ) + p

¨q1 – ¨q2 –

(11') (12')

p

where s1 Ł (zw1 + z1 ) – ࢥ(l1 + prod1 ) and s2 Ł (zw2 + z2 ) – ࢥ(l2 + prod2 ). Hence, equations (7) to (12) make up our macroeconomic model of a monetary union for the short run; with (11) and (12) replaced by (11') and (12') in the long run. As can be easily proved, from the weighted sum of equations (7) and (8), (9) and (10), (11) and (12), and (11') and (12'), we can obtain equations (1), (2), (6), and (6'), respectively, i.e., the corresponding equations for the union as a whole. Notice that we are assuming that the rest of the world’s variables, i.e., y* and r*, are exogenous, so the model represents the case of a small monetary union. The equations of the model are shown in Table 8.1.

3

This assumption, on the other hand, is necessary for the aggregate demand functions of the two countries to be negatively-sloped; see below.

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Table 8.1 A macroeconomic model of a monetary union y1 = íĮr1 + ȕy* + ȕ(y2 – y1 ) í J(p1 – p2 ) + įr* + f1 y2 = íĮr2 + ȕy* + ȕ(y1 – y2 ) í J(p2 – p1 ) + įr* + f2 İ–1

r1 = ȡ1 + ቀ r2 = ȡ2 + ቀ

2 İ–1 2

(IS1 ) (IS2 )

(7) (8)

ቁ¨p2 í ݨpTU

(MR1 )

(9)

ቁ¨p1 í ݨpTU

(MR2 )

(10)

1+İ

ቁ¨p1 + ቀ

2 1+İ

ቁ¨p2 + ቀ

2

¨p1 = (1 í ı')¨p1,ି1 + ı'¨p2,ି1 – (1 – ı í ı')¨q1,ି1 + ࢥy1 + s1 (AS1 ) ¨p2 = (1 í ı')¨p2,ି1 + ı'¨p1,ି1 – (1 – ı í ı')¨q2,ି1 + ࢥy2 + s2 (AS2 )

(11) (12)

in the long run: ı'

(1 – ı – ı')

s1

ࢥ ı'

ࢥ (1 – ı – ı')

ࢥ s2

ࢥ

ࢥ

ࢥ

yത1 = (¨p1 –¨p2) + yത2 = (¨p2 –¨p1) +

¨q1 – ¨q2 –

(long run AS1 )

(11')

(long run ASʹ )

(12')

We can also derive the aggregate demand equations or AD functions for each country, after replacing (9) and (10) into (7) and (8) for countries 1 and 2, respectively: 1 İ–1 1+İ ൤െĮȡ1 – Į ൬ ൰ ¨p1 – Į ൬ ൰ ¨p2 + ĮݨpTU + ȕy* + ȕy2 1+ȕ 2 2 (AD1 ) (13) –J(p1 – p2 ) + įr* + f1 ൧ 1 İ–1 1+İ * y2 = ൤െĮȡ2 –Į ൬ ൰ ¨p2 –Į ൬ ൰ ¨p1 + ĮݨpTU + ȕy + ȕy1 1+ȕ 2 2 (AD2 ) (14) – J(p2 –p1 ) + įr* +f2 ൧

y1 =

where the weighted sum of equations (13) and (14) would give the aggregate demand equation or AD function of the union, which can be also found by replacing (2) into (1): y = íĮU í Įİ(¨p í ¨pT) + ȕy* + įr* + f

(15)

The model can be represented graphically using the functions IS and MR, which are decreasing and horizontal, respectively, in the plane y-r; and the functions AD and AS, which are decreasing and increasing, respectively, in the plane y-¨p.

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The effects of shocks in the model of the monetary union In this section, we examine the effects of different shocks on the endogenous variables of the model presented above. First, notice that our modelling framework for a monetary union allows us to distinguish two kinds of shocks: a) When the shock occurs simultaneously in all member countries of the monetary union, we have a common shock. The effect of a common shock is the same for both the union as a whole and each of the member countries. b) When the shock occurs in just one of the member countries of the monetary union, but not in the other, we have a country-specific shock. The effect of a country-specific shock is different for the country of origin of the shock and for the country to which the shock is transmitted (in both cases, regardless of the country); and will be smaller in size, in absolute terms, in the latter than in the country of origin of the shock. In turn, the effect of the shock on the union as a whole will be the weighted sum of the effect on each member country, and will have the same sign as in the country of origin of the shock. In addition, shocks can be also characterized as usual: a) When the shock occurs in the money market, we have a monetary shock. Monetary shocks include monetary policy actions, through changes in the inflation target set by the central bank of the union, ¨pTU , and shocks to the risk premium, incorporated in ȡ1 and ȡ2 . While the former are always common shocks, the latter can be either common or specific. b) When the shock occurs in the goods market, we have an expenditure (or aggregate demand) shock. Expenditure shocks include fiscal policy actions, and shocks to private consumption, private investment and the trade balance, and show up as changes in f1 and f2 . Expenditure shocks can be either common or specific. c) When the shock occurs in the supply side, we have a supply shock. Supply shocks include pressures on wages and prices and shocks to labour force and productivity, and show up as changes in s1 and s2 . Supply shocks can be either common or specific.

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d) When the shock occurs in the rest of the world, we have an external shock. External shocks include shocks to foreign output, y*, and foreign interest rate, r*, and are always common shocks4. On the other hand, the effects of common shocks on the whole union (which coincide with those on every member country, as mentioned above) match the results in the model of reference, in this case the smallcountry open economy model. In particular5: x An expansionary monetary policy, through an increase in the inflation target set by the central bank of the union (or, alternatively, a decrease in the risk premium common to the two member countries) raises output in the short run, via both a lower real interest rate and the resulting real exchange rate depreciation. In the long run, however, potential output remains unchanged, only increasing the inflation rate. x A common expansionary expenditure shock (through an expansionary fiscal policy, an exogenous increase in private consumption or investment, or an exogenous improvement in the trade balance) leads to an increase in output in the short run, which is only partially crowded out via a higher real interest rate. In the long run, the higher real interest rate (due to the higher initial inflation) and the resulting real exchange rate appreciation, leads to a fall in output, even though potential output is higher than in the starting equilibrium, with an ambiguous effect on inflation. x A common supply shock that lowers the inflation rate (through an exogenous decrease in wages or prices, or a positive shock to labour force or productivity) gives rise to a higher level of output in the short run, due to the fall in the real interest rate and the resulting real exchange depreciation; with an additional increase in potential output in the long run. x Finally, regarding external shocks, an increase in foreign output is equivalent to an expansionary expenditure shock. In turn, the effects of an increase in the foreign interest rate resemble those of the 4

Notice that, if the model is applied to the Eurozone, the rest of the world would include both the rest of the EU and those countries outside the EU. 5 See Bajo-Rubio and Díaz-Roldán (2011b, Chapter 10) for details. Unlike there, we have assumed in this chapter a horizontal MR function, which would result in stronger output effects in the short run. The reason would be the absence of a crowding-out effect, since the interest rate would be kept unchanged following the initial change in output.

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expansionary monetary policy, with some differences. So, the initial increase in output in the short run is smaller, just following from the depreciation of the real exchange rate since the union’s real interest rate does not change. But the higher inflation rate leads to a rise in the union’s real interest rate and a partial real exchange rate appreciation, resulting into a lower potential output in the long run. More interesting are the effects of country-specific shocks on the member countries of the union; recall that their effects on the union as a whole match those of common shocks: see above. In the rest of this section we will discuss the effects of country-specific shocks using the AS and AD functions for the two member countries of the monetary union (i.e., equations (11) and (13) for country 1, and (12) and (14) for country 2), and assuming that the shock occurs in the first country (the results would be symmetrical if the shock would occur in the other country). We begin with the effects of a country-specific decrease in the risk premium in country 1, which is shown in Figure 8.1. Starting from the points labelled 1, this shock means an aggregate demand expansion in the short run in country 1 due to the fall in the real interest rate, which is accompanied by a real exchange rate depreciation; the AD1 function shift to the right and country 1 stays at point 2 in the figure. Aggregate demand also expands in country 2 due to the positive transmission of the shock through higher output in country 1; AD2 shifts to the right and country 2 stays at point 2. Next, the inflation rate increases in both countries due to the higher wage demands, moving to points 3 in the figure. The higher inflation rates raise the real interest rate through the monetary policy rule, which tends to appreciate the real exchange rate, and aggregate demand contracts in the two countries; the AS1 and AS2 functions shift upwards (following higher inflation in both countries), and AD1 and AD2 shift leftwards (due to the lower output and higher inflation in countries 2 and 1, respectively). In the end, countries 1 and 2 move to points 4 in the figure so that, in the long run, the increase in potential output in country 1 fully matches its decrease in country 2, keeping unchanged potential output in the whole union; inflation increases in both countries.

Figure 8.1: A country-specific decrease in the risk premium in the model of the monetary union

Macroeconomic Linkages in the European Union 223

224

Chapter Eight

The case of a country-specific expansionary expenditure shock in country 1 is depicted in Figure 8.2. Aggregate demand expands in both countries: as a direct result of the shock in country 1, and following the positive transmission of the shock through higher output to country 2. In terms of the figure, the AD1 and AD2 functions shift to the right and countries 1 and 2 move from points 1 to points 2. Then, the higher inflation rate in both countries following higher wage demands (which make both countries move to points 3 in the figure), leads to an increase in real interest rates through the monetary policy rule, and hence a real exchange rate appreciation, which reduces aggregate demand in the two countries. Although the AD2 function shifts to the left (due to the lower output and higher inflation in country 1), the change in AD1 would be indeterminate (given the ambiguity of the results on output and inflation in country 2), and the effect on AS1 and AS2 would be also ambiguous, with higher inflation and the appreciation of the real exchange rate tending to shift them upwards and downwards, respectively. We have assumed in Figure 8.2 that both functions shift upwards, with the two countries moving to points 4 in the long run. In the final situation, potential output and inflation rise unambiguously in country 1 and, given the relative shifts of the functions in the figure, also in country 2; potential output increases in the union as a whole. Finally, Figure 8.3 shows the case of a country-specific aggregate supply shock that lowers the inflation rate in country 1. The fall in inflation in country 1 means that the real interest rate also falls in both countries through the monetary policy rule, which depreciates their real exchange rates. Accordingly, output rises in the two countries, inflation falls in 1 and rises in 2, and AS1 and AD2 shift downwards and rightwards, respectively, with countries 1 and 2 moving from points 1 to points 2 and 3. Later on, lower inflation in country 1, on the one hand, and higher inflation in country 2 and the exchange rate depreciation, on the other hand, have conflicting effects on the AS functions; assuming that the own-inflation effect prevails, in Figure 8.3 AS1 shifts downwards and AS2 upwards. In addition, AD2 shifts to the right (due to the higher output and lower inflation in country 1), and the effect on AD1 is indeterminate (following both higher output and inflation in country 2). In the end, we move to points 4 in the figure, where potential output is higher for the two countries, which is accompanied by a lower and higher inflation in countries 1 and 2, respectively.

Figure 8.2: A country-specific expansionary expenditure shock in the model of the monetary union

Macroeconomic Linkages in the European Union 225

Figure 8.3: A country-specific supply shock that lowers the inflation rate in the model of the monetary union

226 Chapter Eight

Macroeconomic Linkages in the European Union

227

The effects of all possible shocks on the main endogenous variables (output, inflation and the real interest rate) in the model of the monetary union are summarized in Table 8.2. We show the effects for the countries and for the union as a whole, the variables for the latter denoted by the subscript U. To conclude, notice that the adjustment process towards the long run through changes in the inflation rate might not work properly if there is a zero lower bound to the value of the nominal interest rate. This is which Keynes termed “liquidity trap”, a situation that hinders the capacity of the central bank to manage the economy. Such a problem returned to the forefront with Japan’s experience during the 1990s, and more recently with the current crisis (Krugman, 2000). In terms of our model, assuming the minimum value that the nominal interest rate can take is zero, and recalling the definition of the real interest rate and our assumption on expectations, when the zero lower bound is binding the MR function would be given by: r = –¨pെͳ and the resulting AD function by: y = Į¨pെͳ + ȕy* + įr* + f so that both schedules would become horizontal and vertical, respectively. Now, unless the “normal” case, a higher (lower) inflation rate would shift MR downwards (upwards), and AD rightwards (leftwards); in both cases with a lag, and due to the fall (rise) in the real interest rate. In particular, in the presence of a liquidity trap, a contractionary expenditure shock that lowers the inflation rate shifts downwards the AS function as before, but now shifts also leftwards the AD function; which, as well as worsening the effects of the shock, moves the economy away from the long-run equilibrium. On the contrary, a large enough expansionary expenditure shock (as, e.g., an expansionary fiscal policy), might be more effective than in the general case, by moving the economy away from the liquidity trap6.

6

See Bajo-Rubio (2014) for an analysis of how the existence of a liquidity trap affects the performance of this kind of models.

228

Shocks

í

í

+

+

+

í

í

+

+

+

+

+

ȡ1

ȡ2

f1 & f2

f1

f2

*

*

r

+

+

í

í

ȡ1 & ȡ2

y

+

y2

+

y1

¨pTU

+

+

+

+

+

í

í

í

+

yU

+

+

+

+

+

í

í

í

+

+

+

+

+

+

í

í

í

+

+

+

+

+

+

í

í

í

+

short run ¨p1 ¨p2 ¨pU

0

0

0

0

0

0

+

+

í

r1

0

0

0

0

0

+

0

+

í

r2

0

0

0

0

0

+

+

+

í

rU

í

+

?

+

+

+

í

0

0

y1

í

+

+

?

+

í

+

0

0

y2

Endogenous variables

í

+

+

+

+

0

0

0

0

yU

+

?

?

+

?

í

í

í

+

+

?

+

?

?

í

í

í

+

+

?

?

?

?

í

í

í

+

long run ¨p1 ¨p2 ¨pU

+

+

+

+

+

í

+

0

0

r1

Table 8.2 Effects of shocks on endogenous variables in the model of the monetary union

Chapter Eight

+

+

+

+

+

+

í

0

0

r2

+

+

+

+

+

0

0

0

0

rU

í

í

í

í

s1 & s2

s1

s2

í

í

yU í í

+

¨p1 + +

í +

+

short run ¨p2 ¨pU + + +

+

r1 + +

+

r2 + +

+

rU + í

í

y1 í í

í

y2 í

Endogenous variables

Table 8.2 (continued)

í

í

yU í

Macroeconomic Linkages in the European Union

í

+

¨p1 + +

í

+

+

long run ¨p2 ¨pU + +

+ denotes that the change in the endogenous variable has the same sign that the shock. í denotes that the change in the endogenous variable has the opposite sign that the shock. 0 denotes that the endogenous variable does not change following the shock. ? denotes that the change in the endogenous variable has an ambiguous sign following the shock. & denotes the occurrence of a common shock.

y2 í

y1 í

Notes: (a) (b) (c) (d) (e)

Shocks

+

+

r1 +

+

+

r2 +

+

+

rU +

229

230

Chapter Eight

The macroeconomic performance of the European Union In this chapter, we have tried to analyse on theoretical grounds the particular and novel macroeconomic framework of the EU after EMU, which can be described by a two-country model, i.e., the Eurozone versus non-Eurozone members, the latter comprising both the rest of the EU and the rest of the world. As far as we know, there are no macroeconomic models describing such a situation, in spite of being the current economic framework of one of the major economies worldwide. We have assumed in our model that the central bank follows a monetary policy rule. And, since the latter took as reference the case of the ECB, mostly concerned with the evolution of inflation and paying no attention to the evolution of output, we have assumed a monetary rule of the central bank designed only in terms of the deviations from the inflation target. Regarding the supply side, aggregate supply is based on imperfect competition assumptions, allowing for nominal inertia. The advantage of this specification is that it allows for a separate examination of the immediate or impact effect of a shock, and its final effect once all prices have fully adjusted. When developing the model for a monetary union, we have assumed that the monetary union is made up of two symmetric countries, and every equation has been written in terms of every member country, differentiating between common and country-specific shocks. In the case of common shocks, the results for the monetary union match those results in the model of reference, in this case the small-country open economy model. Specifically, a common expansionary monetary shock does not change potential output in the long run, leading only to higher inflation; whereas a common expansionary expenditure shock increases potential output in the long run (by less than the initial increase in aggregate demand), with an ambiguous effect on inflation. On the other hand, a common supply shock that lowers the inflation rate raises output in the short run, leading to an additional increase in potential output in the long run. Finally, the effects of an increase in foreign output are equivalent to those of an expansionary expenditure shock; and the effects of an increase in the foreign interest rate are similar to those of an expansionary monetary policy, even though resulting into a lower potential output in the long run. In turn, country-specific shocks have different effects depending on their country of origin. So, a country-specific decrease in the risk premium in country 1 leads to an unchanged potential output in the whole union in the long run, with the increase in country 1 fully matching the decrease in country 2; inflation increases in both countries. In the case of a countryspecific expansionary expenditure shock in country 1, potential output raises

Macroeconomic Linkages in the European Union

231

in the long run both in the union and in country 1, with an ambiguous effect in country 2; inflation also rises in country 1, but the effects in country 2 and the union as a whole are ambiguous. Lastly, a country-specific supply shock that lowers the inflation rate in country 1 leads in the long run to higher potential output in the two countries and the union as a whole; inflation falls in the union and in country 1, but rises in country 2. The above paragraphs describe the kind of disturbances derived from the interactions across the Eurozone member countries, according to the model for a monetary union developed in this chapter. Those interactions determine the effects of the shocks on the endogenous variables of the model, i.e., output, inflation and the real interest rate. Recall that, in the case of the (always common) external shocks, these would include both those originated in the rest of the Eurozone, and those originated outside the EU. As stressed before, the new macroeconomic framework given by the Eurozone, and her relationship with the rest of the EU and the rest of the world, represents a novel and particular scenario. Before EMU, we could say that the EU and the rest of the world were described by a standard open-economy macroeconomic model. However, after EMU, the results change for the Eurozone members, in particular regarding the case of country-specific shocks. If we look at the consequences of countryspecific shocks on EMU as a whole, the effects are the same than in the standard model; but, when looking at the results in each particular country, we can see how they depend on the country of origin of the shock. Summing up, for the whole union the results are those expected according to the model of reference, but for individual countries there is a redistribution of the effects: sometimes with an opposite sign and offsetting them, and sometimes with ambiguous effects on the other country. This could lead to a debate on how the effects of economic policies aimed to deal with country-specific shocks in the Eurozone are actually allocated across member countries.

References Akerlof, G.A. & Yellen, J.L. 1985. Can small deviations from rationality make significant differences to economic equilibria? American Economic Review. 75(4):708-720 Alesina, A. & Barro, R.J. 2002. Currency unions. Quarterly Journal of Economics. 117(2):409-436 Bajo-Rubio, O. 2014. La crisis económica en los modelos macroeconómicos (The economic crisis in macroeconomic models). epública. 15:1-14

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Bajo-Rubio, O. & Díaz-Roldán, C. 2011a. Macroeconomic analysis of monetary unions: A general framework based on the Mundell-Fleming model. Berlin: Springer Bajo-Rubio, O. & Díaz-Roldán, C. 2011b. Teoría y política macroeconómica (Macroeconomic Theory and Policy). Barcelona: Antoni Bosch editor Bajo-Rubio, O. & Díaz-Roldán, C. 2013. Open economy Keynesian macroeconomics without the LM curve. Available at SSRN: http://ssrn.com/abstract=2241850 Ball, L. 2000. Near-rationality and inflation in two monetary regimes. National Bureau of Economic Research: Working Paper 7988 Bê Duc, L., Mayerlen, F. & Sola, P. 2008. The monetary presentation of the Euro area balance of payments. European Central Bank: Occasional Paper 96 Calvo, G.A. & Reinhart, C.M. 2002. Fear of floating. Quarterly Journal of Economics. 117(2):379-408 De Grauwe, P. 2006. What have we learnt about monetary integration since the Maastricht Treaty? Journal of Common Market Studies. 44(11):711-730 Díaz-Roldán, C. 2013. Macroeconomic shocks in Latin American countries: Implications on the economic integration and development processes. Paper presented at the I Ibero-American Regional SocioEconomics Meeting of the Society for the Advancement of SocioEconomics (SASE), México DF European Central Bank 2004. Fiscal policy influences on macroeconomic stability and prices. Monthly Bulletin. April:45-57 —. 2013. The importance and effectiveness of national fiscal frameworks in the EU. Monthly Bulletin. February:73-88 Krugman, P. 2000. Thinking about the liquidity trap. Journal of the Japanese and International Economies. 14(4):221-237 Layard, R., Nickell, S. & Jackman, R. 1991. Unemployment: Macroeconomic performance and the labour market. Oxford: Oxford University Press Mankiw, N.G. 2001. The inexorable and mysterious tradeoff between inflation and unemployment. Economic Journal. 111(471):C45-61 Mundell, R.A. 1961. A theory of optimum currency areas. American Economic Review. 51(4):657-665 —. 1964. A reply: Capital mobility and size. Canadian Journal of Economics and Political Science. 30(3):421-431 Obstfeld, M. & Rogoff, K. 1995. The mirage of fixed exchange rates. Journal of Economic Perspectives. 9(4):73-96

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Poole, W. 1970. Optimal choice of monetary policy instruments in a simple stochastic macro model. Quarterly Journal of Economics. 84(2):197-216 Sachs, J. 1980. Wages, flexible exchange rates, and macroeconomic policy. Quarterly Journal of Economics. 94(4):731-747 Sørensen, P.B. & Whitta-Jacobsen, H.J. 2010. Introducing Advanced Macroeconomics: Growth and Business Cycles (2nd edition). New York: McGraw-Hill Taylor, J.B. 1993. Discretion versus policy rules in practice. CarnegieRochester Conference Series on Public Policy. 39(1):195-214

LIST OF ABBREVIATIONS AND ACRONYMS

AA: Association Agreement AAS: African Associated States AASM: Associated African States and Madagascar ABC: Agência Brasileira de Cooperação ABS: Asset-Backed Securities ABSPP: Asset-Backed Securities Purchase Programme ACP: African, Caribbean and Pacific states ADA: Austrian Development Agency AECID: Spanish Agency for International Development Cooperation (Agencia Española Cooperación Internacional para el Desarrollo) AF: African Union AFD: French Agency for Development (Agence Française de Dévelopement) ALA: Latin America and Asia (French: Amérique Latine et Asie) AMG: Advisory Monitoring Group ATI: Aid Transparency Index BAM: EU Border Assistance Mission BoE: Bank of England BRICS: Brazil, Russia, India, China and South Africa BMZ: German Ministry for Economic Cooperation and Development (Bundesministerium für Wirtscaftliche Zusammenarbeit und Entwicklung) CAP: Common Agricultural Policy CBPP: Covered Bond Purchase Programme CCP: Common Commercial Policy CEEC: Central and Eastern European Countries CET: Common External Tariff CFSP: Common Foreign and Security Policy CICL: Cooperation and Language Institute CISS: Composite Indicator of Systemic Stress CSDP: Common Security and Defense Policy CUs: Customs unions CzDA: Czech Development Agency DAC: Development Assistance Committee DANIDA: Denmark Foreign Ministry

The European Union and the Challenges of the New Global Context

DCFTA: Deep and Comprehensive Free-Trade Agreement DEVCO: Directorate General for Development and Cooperation DFID: Department for International Development (UK government) DGCD: Direction Générale Coopération au Développement et Aide Humanitaire (Belgium) DG DEVCO: Directorate General Development and Cooperation – EuropeAid (European Commission) DGS: Deposit Guarantee Schemes DRP: Democratic Republic of Congo EAs: Europe Agreements EAST: Eastern countries EBA: European Banking Authority EC: European Community ECB: European Central Bank EEC: European Economic Community ECHO: Humanitarian Aid and Civil Protection Department (European Commission) ECSC: European Coal and Steel Community EDC: European Defense Community EDF: European Development Fund EEA: European Economic Area EEAS: European External Action Service EEC: European Economic Community EFSF/ESM: European Financial Stability Facility/European Stability Mechanism EFTA: European Free Trade Association EIB: European Investment Bank ELA: Emergency Liquidity Assistance Programme EMU: Economic Monetary Union ENP: European Neighborhood Policy EONIA: Euro Overnight Index Average EP: European Parliament EPAs: Economic Partnership Agreements ERM II: Exchange Rate Mechanism II ESDP: European Security and Defense Policy ESM: European Stability Mechanism ESRB: European Systemic Risk Board ESS: European Security Strategy EU: European Union EUR: Euro FCO: Foreign and Commonwealth Office (UK government)

235

236

List of Abbreviations and Acronyms

FDI: Foreign Direct Investment FPI: Foreign Policy Instruments Service (European Commission) FR: Federal Reserve FTA: free trade agreement FYROM: Former Yugoslav Republic of Macedonia GATT: General Agreement on Tariffs and Trade GDP: Gross Domestic Product GIZ: German Agency for International Cooperation (Gesellshaft für Internationale Zusammenarbeit) GNI: gross national income GSP: General System of Preferences IMF: International Monetary Fund IPA: Instrument for Pre-accession Assistance KfW: German government-owned development bank (Kreditanstalt für Wiederaufbau) LDC: Less developed countries LTRO: Long-Term Refinancing Operations MAE: Ministry of Foreign Affairs (le Ministère des Affaires Etrangères – French government) MAEC: Spanish Ministry of Foreign Affairs and Cooperation (Ministerio de Asuntos Exteriores y de Cooperación) MBS: Mortgage-Backed Securities MDG: Millennium Development Goals MED: Mediterranean Region MENA: Middle East and North Africa MFA: Ministry of Foreign Affairs MFN: most favoured nation treatment MIC: Monitoring and Information Centre (European Commission) MINEFI: Ministry of Economy, Finance and Industry (le Ministère de l’Économie et des Finances – French government) MOD: Ministry of Defense (UK government) MRO: Main Refinancing Operations NATO: North-Atlantic Treaty Organization NTBs: Non-Tariff Barriers NGOs: Nongovernmental Organizations OCTs: Overseas Countries and Territories ODA: Official Development Assistance OECD: Organization for Economic Cooperation and Development OMT: Outright Monetary Transactions OSCE: Organization for Security and Cooperation in Europe QE: Quantitative Easing

The European Union and the Challenges of the New Global Context

PCA: Partnership and Cooperation Agreement PSA: Process of Stabilisation and Association PTAs: Preferential trade agreements RTAs: regional trade agreements QMV: qualified majority voting SAIDC: Slovak Agency for International Development Cooperation SSC: South-South Cooperation SEA: Single European Act Sida: Swedish International Development Cooperation Agency SMEs: Small and Medium Enterprises SMP: Securities Markets Programme SPS: sanitary and phyto-sanitary standards SRF: Single Resolution Fund SRM: Single Resolution Mechanism TFEU: Treaty on the Functioning of the European Union UK: United Kingdom UN: United Nations USA: United States of America

237

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CONTRIBUTORS

x Jean-Pierre Allegret, Professor of Economics, Deputy director EconomiX, research center in economics operated by the CNRS and the University of Paris Ouest Nanterre La Défense x Oscar Bajo-Rubio, Professor of Economics, Universidad de CastillaLa Mancha, former President of the Spanish Association of International Economics and Finance x Carmen Diaz-Roldan, Associate Professor of Economics, Universidad de Castilla-La Mancha, President of the Spanish Association of International Economics and Finance x Vicente Esteve, Professor of Economics, Universidad de Valencia and Research Associate, Universidad de Alcalá and Universidad de La Laguna x Elzbieta Kawecka-Wyrzykowska, Professor of European Integration and EU Common Policies, Ad Personam Jean Monnet Chair in Warsaw School of Economics x Dirk Lehmkuhl, Professor of European Politics at the University of St. Gallen, coordinator of the EU FP7 project “ISSICEU – Intra-and Inter-Societal Sources of Instability in the Caucasus and EU Opportunities to Respond” x Nicolae Marinescu, Associate Professor of International Trade, Transilvania University of Brasov, Romania, Coordinator of Jean Monnet Module “The Evolution of European Integration” x Maria A. Prats, Associate Professor of Economics, Universidad de Murcia, Member of the Executive Board of the Asociación Libre de Economía (Spanish Chapter of the International Economic Association) x Audrey Sallenave, Associate professor, LEAD and University of Toulon and Research Associate, EconomiX, CNRS and University of Paris Ouest Nanterre La Défense x Mariia Shagina, PhD Candidate at the University of Lucerne and at the NCCR Democracy, University of Zürich x Ileana Tache, Professor of European Integration and EU Economic Policies, Transilvania University of Brasov, Ad Personam Jean Monnet Chair

INDEX

A Abkhazia 13, 64 African, Carribean and Pacific (ACP) countries 91, 94, 218, 246 Annexation 22, 63, 74, 75, 76, 77, 79, 85, 93, 101 arms embargos 63, 80, 85 asset freezes 55, 58, 61, 63, 74, 75, 76, 80, 83, 84, 85 Association Agreement 1,22, 74, 90, 91, 92, 93, 95, 101, 107, 108, 120, 121, 123, 125, 126, 218, 232, 234, 246 asymmetric shock 196, 197 Austria 8, 32, 42, 78, 85, 173, 218, 231 B Belarus 3, 22, 54, 57, 60, 61, 62, 63, 64, 65, 76, 81, 83, 91, 93, 113, 125, 128, 224, 226, 230, 234, 236, 239, 241, 242, 243 Brazil 7, 27, 33, 47, 48, 49, 50, 52, 92, 172, 175, 176, 181, 193,218 Bulgaria 2, 13, 32, 76, 77, 78, 80, 85, 124, 128, 170, 172, 174, 175, 181, 192, 193, 231 C capital inflows 8, 169, 170, 174, 177, 186, 187, 193 Central and Eastern European countries 218, 246 China 7, 27, 47, 50, 51, 52, 70, 109, 110, 113, 114, 115, 127, 128, 129, 131, 132, 218, 227, 228, 229

Common Agricultural Policy 28, 114, 218 Common Commercial Policy 111, 113, 114, 218 Common Foreign and Security Policy 4, 5, 6, 7, 10, 20, 22, 24, 30, 31, 54, 56, 111, 218, 233, 237 common position 5, 7, 10, 61, 66, 71, 72, 77, 82, 113, 116, 241 common shock 181, 206, 207, 215, 216 Cotonou Agreement 27, 29, 35, 36, 43, 45, 51, 52, 92 country-specific shock 197, 206, 207, 216, 217 credit boom 171, 174, 176, 179, 180, 183, 194 Crimea 22, 74, 75, 76, 77, 79, 85, 93, 101, 127, 128, 223, 226, 229, 230, 242, 243 currency mismatch 169, 170, 174, 175, 192, 193, 194, 233 Customs Union 22, 88, 89, 124, 125, 218, 222, 231 Czech Republic 32, 42, 73, 78, 80, 84, 85, 128, 161, 175, 188, 190, 192, 193 Cyprus 9, 32, 68, 76, 78, 80, 84, 85, 123, 143, 157, 229 D Deep and Comprehensive Free Trade Agreement 7, 86, 94, 103, 107, 228 Democracy 5, 17, 20, 36, 50, 54, 56, 58, 59, 62, 93, 101, 112, 122, 236, 245 Denmark 2, 8, 32, 33, 34, 42, 64, 73, 78, 83, 84, 105, 218

Challenges of EU’s Foreign and Security Policy in a Rapidly developing countries 27, 31, 34, 35, 45, 46, 51, 52, 94, 99, 100, 107, 123, 192 development-aid policy 1, 7, 26, 27, 28, 31, 32, 43, 45, 51 Development Assistance Committee (DAC) 3, 42, 47, 48, 50, 51, 218 E Economic Partnership Agreements 30, 91, 94, 219, 224 economic sanctions 21, 62, 63, 75, 76, 78, 85, 234, Egypt 7, 17, 39, 54, 91, 94, 228, 229 emerging Europe 2, 7, 8, 169, 170, 171, 173, 174, 176, 179, 180, 181, 184, 185, 188, 192, 193, 194, 222, 223 enlargement 1, 4, 6, 8, 9, 34, 35, 37, 55, 57, 68, 93, 107, 108, 121, 124, 177, 226, 237, 239 European Central Bank 133, 134, 135, 145, 190, 197, 198, 219, 222, 223, 224, 226, 231, 234, 235 European Commission 6, 9, 15, 25, 26, 30, 31, 32, 36, 38, 52, 59, 62, 67, 88, 90, 92, 95, 96, 98, 101, 109, 112, 113, 115, 129, 135, 145 European debt crisis 184 European Defense Agency 14 European Development Fund 36, 98, 219 European Economic Area 89, 91 European External Action Service 9, 11, 31, 38, 52 European Investment Bank 32, 39, 76, 116, 219 European Security and Defense Policy 8, 11, European Security Strategy 4, 7 Eurozone 132, 133, 134, 135, 136, 140, 141, 143, 144, 149, 150, 153, 155, 156, 157, 160, 161, 195, 197, 198, 199, 200, 216, 217

263

exchange rate regimes 163, 164, 169, 170, 173, 174, 176, 189, 180, 182, 183, 186, 187, 188, 189, 191, 194, 196, expectations-capability gap 82 expenditure shock 213, 216, 217 external shock 170, 188, 193, 206 extra-EU trade 113, 160

F financial sanctions 76, 78, 85, 128 foreign and security policy 20, 22, 23, 24, 30, 31, 38, 54, 111 Fouchet Plan 2 France 19, 21, 28, 32, 34, 42, 65, 68, 73, 78, 89, 81 Free Trade Agreement 94, 95, 98, 103, 130 frozen conflict 66, 68, 69 G General System of Preferences 29 Germany 73, 76, 77, 78, 81, 110, 118, 135, 144 global financial crisis 167, 174, 179, 180, 183, 184, 188, 192 Greece 8, 9, 68, 76, 78 H High Representative for Foreign Affairs and Security Policy 9, 15, 59 human rights 36, 50, 54, 56, 58, 61, 62, 63, 71, 73 Hungary 33, 64, 78, 80, 128, 161, 170 I India 27, 28, 47, 48, 49, 52, 92 interest rate 137, 139, 141, 145, 146, 147 Iran 21, 124 Italy 8, 10, 14, 28, 33, 42, 64

264 L Latvia 32, 33, 64, 65, 78, 128, 170 Lehman Brothers 134, 170, 180, 181, 184 Lithuania 33, 63, 64, 78, 128, 172 Libya 7, 18, 28, 91 liquidity trap 213 Lisbon Treaty 31, 60, 112 Lomé Conventions 27, 29, 44, 45, 51, 52 Luxembourg 10, 14, 33, 34, 42, 76, 78, 156 M Maastricht Treaty 10, 30, 111, 117 Malta 112, 157 Middle East 16, 17, 20, 23, 24, 25, 101, 132, 161 Millennium Development Goals 31, 35 Moldova 62, 65, 66, 67, 68, 69, 70 ,71 monetary policy 133, 135, 136, 137, 139, 146, 152, 153, 169, 170, 171 monetary rule 197, 200, 203, 216 monetary shock 203, 216 monetary union 133, 145, 195, 196, 197, 198, 199, 204, 208 Mundell-Fleming model 198, 199 N NATO 2, 3, 4, 6, 7, 8, 9, 10, 12, 45 non-tariff barriers 114, 120, 123 O Official Development Assistance 34, 41, 42 P Partnership and Cooperation Agreement 61, 93, 126 Petersberg Declaration 4, 10 Petersberg tasks 10, 11, 14 Poland 63, 64, 73, 77, 78

Index Policy Coherence for Development 30, 31 Portugal 65, 68, 76, 78, 81 Preferential Trade Agreements 7, 45, 86, 87, 89 R regional power 47, 57, 60 Regional Trade Agreements 87, 115 restrictive measures 54, 58, 61, 63, 66, 67, 68, 69 Romania 2, 9, 13, 32, 33, 68, 66, 124, 173, 175, 181 rule of law 36, 54, 56, 58, 62, 93, 95 Russia 17, 21, 22, 23, 24, 39, 52, 56 S sanctions 21, 22, 23, 54, 55, 56, 58, 65, 66, 68 Slovenia 32, 33, 42, 64, 157 South Ossetia 13, 63 Spain 42, 64, 68, 73, 76, 78 supply shock 202, 206, 207, 210, 216, 217 Sweden 8, 33, 34, 42, 64, 73, 77, 78 Syria 19, 54, 91, 124 T trade sanctions 76, 129 Transatlantic Trade and Investment Partnership 92, 120 Transnistria 57, 60, 65, 66, 67, 68, 69, 70, 71, 81 travel bans 22, 54, 58, 61, 62, 63, 66, 67, 71, 74, 76 travel restrictions 61, 62, 63, 65, 66 Treaty of Rome 2, 28, 36 Tunisia 16, 17, 28, 39, 54, 91, 94 U UK 4, 29, 33, 81 Ukraine 119, 125, 126, 127, 132, 223 unconventional monetary policy 167 United Nations 5, 8, 35, 71, 116

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Uzbekistan 60, 71, 72, 73, 81 V visa bans 63, 72, 80 visa liberalization 74 Z zero lower bound 213

W World Trade Organization 86, 100, 112 Y Yaoundé Conventions 28