by Katinka Barysch

Christine Lagarde, the French finance minister, threatens to walk out of the London G20 summit unless France gets its way on tougher financial regulation. The toppled Czech Prime Minister, Mirek Topolanek, who happens to hold the EU presidency, describes the US fiscal stimulus as “the road to hell”. Not one EU leader deems it necessary to support Gordon Brown publicly when he tries to drum up support for a more concerted international effort to revive the global economy. The Dutch and the Spaniards are turning the G20 itself into a misnomer by insisting on their own place at the table, and raising the number of the already over-represented Europeans (The fact that there will be six European governments represented, plus the Czech presidency, plus the European Commission, not counting the European heads of the World Trade Organisation and the International Monetary Fund, attracts deserved ridicule from other countries).

So is the G20 just another opportunity for the Europeans to show how weak, divided and status-conscious they are?

In fact, the Europeans have not done as badly in the run-up to the summit as some media reports (and occasional outbursts by stressed prime ministers) suggest.

EU leaders managed to thrash out a reasonably coherent position at their spring summit on 20th -21st March. The meeting’s final communiqué has a special section on the agreed line for the London summit. The words in this section are vague but represent a workable compromise which could allow the Europeans to speak with one voice at the G20.

G20 finance ministers had already reached a kind of truce on the issue of more fiscal stimuli at their meeting on March 14th. Not surprisingly, EU leaders, at their spring summit a week later, also rejected calls for an immediate increase in budgetary spending. So why some commentators are still speculating whether the G20 may come up with a new, co-ordinated package is a bit of a mystery. There needs to be a firm pledge from all G20 countries to assess critically the fiscal efforts they have made so far, and then to revisit the issue of a co-ordinated stimulus at their next summit, probably later this year.

At the March 20th–21st summit, EU leaders called only for swift implementation of those packages already announced. This, and the fact that the communiqué also calls on the EU countries to prepare for “an orderly reversal of macro-economic stimuli” and to “ensure consistency with longer term objectives such as sustainable public finances” represents a victory for Berlin and other capitals worried about inflationary pressures and the stability of the euro.

The Europeans supported global efforts to make more money available for the poorer and more vulnerable countries around the world. They started at home, by doubling the size of the EU’s own emergency fund for Central and Eastern Europe to €50 billion. The Europeans also agreed to raise an additional €75 billion as their contribution to a significant increase in the IMF’s war chest, to at least $500 billion. Since Japan had already pledged $100 billion, the onus is now on the US and China to chip in.

China, of course, will be cautious about committing money to an unreformed IMF. Here the EU’s position is lame. The communiqué only calls for a “reform of the IMF so that it reflects more adequately relative economic weights in the world economy”. The Europeans should have made it clearer that they are prepared to decrease their own voting shares and representation on the IMF’s management board. But diplomats say that the strongest opposition to thorough IMF reforms currently comes from the US – reluctant to give up its de facto ability to veto IMF decisions – rather than Europe.

On financial market regulation, the EU’s position is quite far advanced, much more so than the American one. The EU summit communiqué list all the measures that the EU wants to take – on regulating credit agencies, hedge funds, credit default swaps and so forth – and attaches deadlines to each. There has been a great deal of convergence within Europe, chiefly between Germany, France and others that want to see tighter rules and supervision of financial markets, and the UK, which has abandoned its belief in ‘light touch’ regulation. There are a lot of similarities between the recommendations of the recent reports from Jacques de Larosiere, which the EU wants to use as a basis for its legislative programme, and Adair Turner, head of the UK’s Financial Services Authority. Both, for example, call for more co-ordination between the supervision of individual banks and the monitoring of the stability of the financial system as a whole. The emerging US position as presented by US Treasury Secretary Timothy Geithner on March 26th also calls for more centralised supervision of US financial services, as well as a reform of capital adequacy and accountancy rules (in line with EU demands). Geithner for the first time acknowledged that hedge funds and other hitherto lightly regulated but systemically important finance vehicles need at least some supervision.

Of course the devil is in the detail and the London summit cannot and will not agree on more than the broad principles of further regulation and supervision. The debate about a new supervisory system in the US is only just beginning. It will be long and politicised. The EU’s deadlines for new legislation run from May until the end of 2009. Since the European Parliament will be re-elected in June and the European Commission will step down in October (although it could be extended to the end of the year), comprehensive new rules are unlikely before 2010.

The EU has looked weak and divided in the run-up to the G20 summit. Its reluctance to make more commitments to increase fiscal stimuli is rightly open to criticism. But the Europeans have actually managed to agree a reasonably coherent position and in many respects, their positions are as, or more, polished than the US ones.

Katinka Barysch is deputy director of the Centre for European Reform.

by Katinka Barysch

Russia’s economy has been hit hard by a triple whammy of capital outflows, collapsing oil prices and falling global demand. In the first three months of the year, output was down by 10 per cent compared with a year earlier. The retail boom that had fuelled growth in recent years has turned into a slump. The output of the manufacturing sector is contracting at a rate of over 20 per cent year on year. Construction is in deep recession. The current-account surplus has melted away.

However, the latest economic indicators suggest that the economic contraction is at least slowing. The oil price has recovered to over $70 a barrel. Surveys show that credit conditions are easing and managers are a bit less gloomy. Capital outflows have slowed. So has inflation, which has allowed the central bank to finally cut rates. International reserves, although down from 2008 peaks, still stand at $410 billion. The government is making plans for recapitalising some of the country’s banks.

Investors still remember the rapid, V-shaped recovery that followed Russia’s last financial crash in 1998. In the following nine years, the Russian economy grew by an average of 7 per cent a year. Will Russia be able to pull out of trouble this quickly again?

On the plus side, Russia’s government finances are in incomparably better shape than they were ten years ago. Back then, it was short-term public borrowing that triggered the crisis, ultimately forcing the government into default. Since then, the budget has shown a healthy surplus, allowing the government to stash away $140 billion in a reserve fund. So although revenue has collapsed (half of it comes from the oil and gas sector), the authorities have room for fiscal manoeuvre. Public spending will also have a bigger impact on the economy, simply because the Russian state is much bigger than it used to be (federal budget revenue was 13 per cent of GDP back in 1998, today it is over 20 per cent, according to Erik Berglőf from the European Bank of Reconstruction and Development).

Also, in 1998 the Russian economy had only just returned to growth, following years of severe post-transition recession. Now, after ten years of uninterrupted expansion, fewer Russians are living hand to mouth and many should be able to draw on savings to tide them over the most difficult period.

However, there are also reasons to expect the current crisis to be more severe and drawn-out. The 1998 crisis mainly affected emerging markets. This time, the recession is global, which means that no country will be able to export its way out of trouble. (Russia exports mainly raw materials, as well as some metals, timber and heavy industrial goods. But it is the collapse in demand for non-oil exports, such as steel products, that is causing the most trouble since these are often produced in isolated one-industry towns.)

Depressed global demand also means that the rally in oil prices is likely to be short-lived. After 1998, the oil price climbed steadily from around $10 a barrel to a peak of $140 last summer. Many forecasters expect oil prices to linger around $50-60 this year and next – not disastrously low but not enough to fuel a strong Russian recovery either. Moreover, Russia’s economy today is much more dependent on oil and gas sales than it was in 1998. Back then, oil and gas sales accounted for 44 per cent of export revenue, now the share is over two-thirds. Many manufacturing and services industries are directly or indirectly linked to the resource sector.

Perhaps the biggest difference lies in the role of banking and borrowing. Although both crises originated in the financial sector, in 1998 this sector was still so small that its collapse barely affected the wider economy. Then, credit to firms and households stood at 9 per cent of GDP; today it is over 40 per cent.

In recent years, much more of that borrowing came from abroad so the drying up of global liquidity in 2008 hit Russia hard. The World Bank estimates that in 1998-99, the reversal in foreign capital flows amounted to less than 2 per cent of Russian GDP. In 2008-09, it was close to 12 per cent of GDP.

Domestic banks cannot take up the slack because a rising share of bad loans will constrain their ability to start lending again. The health of the banking sector is difficult to assess. Official numbers show that the share of non-performing loans has climbed from 1 per cent at the start of the year to 4 per cent today. Given the sorry state of Russian industries, this is still an implausibly low number. Independent assessments put the share of bad loans at anywhere between 10 and 20 per cent.

As a result of these factors, the Russian economy is likely to take longer to come out if its slump than it did ten years ago. The World Bank predicts a contraction of almost 8 per cent this year, but some forecasters thinks even this is too optimistic and they question whether Russia will be able to make even timid recovery in 2010. Most economists agree that Russia stands little or no chance of returning to the 7-8 per cent growth rate that it enjoyed before the crisis struck

The big question is what the changed growth outlook will mean for Russia’s internal stability and the government’s willingness to implement economic reforms. In 1998 Russians expected very little from their leaders in Moscow. They were positively surprised when the Putin administration after 2000 started to implement some useful reforms, such as simplifying the tax system and cleaning up regulations.

Since then, Putin’s muscular rhetoric, combined with Alexei Kudrin’s sound macro-economic management, have raised expectations. The people that took to the streets in Russian cities in recent weeks and months did not so much protest against government policies as demand government help. The government could react either by getting serious about modernising and diversifying the economy. Or it could resort to economic nationalism and populist spending increases. So far, there is more evidence of the latter than the former. Prime Minister Putin has personally instructed companies to clear wage arrears and criticised shops for overcharging struggling families. On June 29th, he told the managers of Russia’s biggest banks that they should not go on summer holiday before they have significantly increased lending to the corporate sector (he even gave them a numerical target of $16 billion). With this kind of crises response, Russia’s growth prospects could end up being lower not only in the short term, but for many years to come.

Katinka Barysch is deputy director of the Centre for European Reform.

by Clara Marina O'Donnell

European countries have long declared their ambition to turn the EU into a global player in security – in order to tackle common threats and strengthen their voice on the global stage. But they still cannot agree on the main threats to their security or the best way to tackle them. Their views are so diverse that it is a wonder EU countries have managed to agree on any common action at all. But member-states need to strengthen their efforts to develop a common approach to security if the EU is to become a serious player.

For the past two decades, the EU has been developing a profile in foreign and security policy. It has agreed common security strategies, deployed over 20 peacekeeping and crisis management missions, led negotiations with Iran on the latter’s nuclear programme and negotiated a ceasefire to the Russia-Georgia war. However, as was brought into focus at a recent EUISS seminar, EU countries do not always share the same threat perceptions, or agree how these should be tackled.

Some European countries, such as Ireland and Austria, do not believe they face any serious ‘hard’ threats. Others fear for their territorial integrity, including the Baltics, Poland and the Czech Republic. Greeks and Cypriots worry mainly about the prospect of renewed military conflict with Turkey. So while Cyprus is still partly militarily occupied and Greek and Turkish military aircraft tail each other on a daily basis, the Viennese worry mainly about the level of burglaries in their city.

While the UK considers the threat of transnational terrorism as the most pressing threat to Europe as a whole, and a key priority to be tackled at home and abroad, most other countries feel largely unaffected. Russia is seen as a close partner to some countries, including Italy and Germany, while the Baltic states see it as an existential threat. Some member-states believe it is important to have a global outlook on security, in particular France and the UK, while others, such as Malta, believe their main security challenge is managing migration flows.

Different views also exist on how to tackle security threats. For many member-states a UN mandate is essential in order to participate in a military mission abroad, while for others, like the UK, it is only desirable. Some believe the US and NATO are cornerstones of their security (in particular the UK and the eastern countries), while others view NATO with suspicion – and resent the UK for having sided with the US during the war in Iraq. Some EU member-states have long traditions of intervention in conflicts across the world and accept the possibility of casualties within their armed forces, in particular France and the UK. Others are averse to the use of military force, most notably Germany.

Various member-states (Sweden, Austria, Finland and Ireland) have a long history of neutrality and are grappling to make their stance compatible with growing EU co-operation in security and defence (Ireland is finding it the hardest to accept EU defence co-operation. Due to public concern, it will have its military neutrality enshrined in an EU treaty for the first time if the Lisbon treaty comes into force). For their part, the UK and France are insistent on the need to develop expeditionary capabilities to allow the EU to fulfil its ambitions abroad. Some member-states, such as Sweden, have transformed their military forces, but many others have so far resisted.

In light of their very different histories, traditions and cultures, it is no mean achievement that EU countries have agreed to work together to provide peacekeeping and crisis management to conflicts zones in need, and to cooperate on wider security issues such as Iran and the Arab-Israeli conflict. In addition, with time the EU is likely to become further involved in security, by tackling ‘soft’ threats (such as protective measures against cyber attacks), or certain aspects of ‘hard’ threats (such as monitoring the cross-border transfer of dangerous products which could be used in chemical or biological attacks).

But member-states’ different interests and approaches limit the EU’s effectiveness as an external actor, as demonstrated by the difficulties in finding helicopters for the EU’s peacekeeping mission to Chad, the UK’s refusal to send a battlegroup to the Democratic Republic of Congo in 2008, or the difficulties the EU has in agreeing a common position on Russia or energy security.

Perhaps the biggest problem for the EU is the division between its western and eastern members. While many member-states feel they cannot trust their partners to guarantee their security (within the EU or NATO), it is difficult to talk of a common security culture. If threat perceptions within eastern European countries worsened, their anxieties could define their foreign policies, hampering the EU’s work at home and abroad (and NATO). For the EU and NATO to remain credible security providers to their members, and for the EU to become a serious player in global security, European countries must overcome the current mistrust and strengthen their efforts to develop a stronger common strategic culture.

Clara Marina O'Donnell is a research fellow at the Centre for European Reform

by Tomas Valasek

When the EU's first 'foreign minister', Cathy Ashton, starts work on December 1st, she will find Iran on top of her 'to do' pile. Earlier this week, Tehran turned down a proposal from the International Atomic Energy Agency (IAEA) that would have seen a large part of the country's stock of uranium moved out of the country for further enrichment. Barring a last-minute change of heart in Tehran, the US, UK, France and Germany will soon move to tighten UN sanctions on Iran. This could set the scene for a confrontation with Russia and China, which are unconvinced that tough sanctions would work.

It will fall to Ashton to try to get Iran to reconsider. The country's government has not rejected the IAEA proposals outright; it has offered a counter-proposal, which US and European officials deem unacceptable. The Iranians may simply be buying time but there is a small hope that they are open to compromise. Before the UN Security Council imposes further sanctions, the EU needs to be absolutely sure that Iran does not want a deal.

The trouble is that the chances of a negotiating breakthrough with Iran, never high, have diminished since the fraudulent elections in Iran in June 2009 and their bloody aftermath. For the past five months, the country has been mired in twin crises: one within the regime (a band of clerics versus the former Revolutionary Guard commanders grouped around President Mahmoud Ahmadinejad) and another one between the regime and the people. The government appears to have become dysfunctional. Tehran wavered for weeks over the recent Western proposals before rejecting them. It is not obvious that in a country as unstable as Iran is today, any centre of power has the courage to push for a compromise with the West (though some Iran watchers have warned that Tehran could be faking indecision while it buys time to develop further its nuclear programme).

It had been hoped that Barack Obama's entry into the nuclear talks would strengthen the EU's negotiating hand. In the past Iran had made clear to EU diplomats that it would not accept any agreement that did not involve the US. But Obama's charm offensive has had a limited effect. True, it “empowered advocates of engagement inside Iran and transferred the onus of co-operation from the US to Iran”, one Iran expert told a recent gathering of foreign policy thinkers and officials convened by the CER and other think-tanks in Stockholm. Obama's efforts have also made it more likely that Russia will support sanctions. But even after the US had joined the Iran talks and Obama had offered “dialogue without preconditions”, Tehran decided to reject the recent IAEA package.

High Representative Ashton and other western diplomats have few effective tools left to pressure Iran into changing its position, so the world's attention is shifting towards negotiating a new sanctions regime. The EU used to be divided on further sanctions, with France and the UK strongly in favour and Germany more sceptical. But Chancellor Angela Merkel's recent tough language on Iran (in a speech to a joint session of the US Congress) suggests that the new centre right-liberal coalition views sanctions more favourably (this was confirmed by senior German diplomats at the Stockholm event).

The key critics of tighter sanctions are Russia and China, whose top officials have argued on many occasions not only that sanctions would fail to stop Iran's nuclear programme, but also that they would boost the position of radicals within the country. They are right that sanctions are a very blunt instrument. Tougher sanctions almost certainly would strengthen the Revolutionary Guards' stranglehold on the economy and thus, paradoxically, empower the most authoritarian of Iranian political forces and set back the cause of Iran's liberalisation. Sanctions could also prompt Iran to kick out the IAEA inspectors who monitor Iran's nuclear facilities; this would leave the world blind to Iranian nuclear intentions.

But the case for sanctions, on balance, seems somewhat stronger. They discourage other states in the region from following Iran down the nuclear path, and they give the US and - crucially - Israel an alternative to the use of force. Existing sanctions have worked to the extent that they have deprived Iran of some needed technology; the centrifuges used to enrich uranium are said to be crashing frequently. And contrary to what Russia and China say, precedents suggest that sanctions can, under the right circumstances, bring weapons programmes to halt. As one US participant at the Stockholm meeting pointed out, “sanctions against Iraq in the 1990s and early 2000s worked so well that they made the invasion of that country completely unnecessary”. It transpired after the war that Iraq had given up its nuclear and biological programmes years before the US invasion, in large part because it could not obtain the necessary technology.

The two European members of the UN Security Council, France and the UK, along with Germany and the US, will lead negotiations at the UN on further sanctions. But Ashton will still have an important role to play. Sanctions are not meant to replace talks but to complement them; the idea is to inflict hurt on Iran's economy and political classes in order to get the government to accept nuclear proposals from the IAEA. So Cathy Ashton, like Javier Solana before her, will be expected to keep up talks with Iran while the UN debates sanctions, and after the UNSC agrees a new regime. The UNSC is likely to do so: President Dmitri Medvedev has hinted that Russia will swallow somewhat tougher sanctions, while China rarely vetoes UNSC resolutions alone (unless they concern Tibet or Taiwan).

But one wonders if this is the EU's last hooray on Iran. If the combination of sanctions and talks fail, the remaining options would seem to leave little room for EU diplomacy. If Israel strikes Iran's nuclear facilities, Tehran will certainly call off the EU-led talks. The other choice before the world is to start preparing for a nuclear Iran. A strategy of containment would require western governments to focus on making Iran's neighbours feel secure, so as to discourage them from building nuclear weapons themselves. But this will almost certainly be a job mainly for the US, rather than the EU. So while Baroness Ashton will spend a lot of time on Iran at the beginning of her term, the EU may gradually lose its leading role.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.