What to expect from the EU in 2013

December 2012 By Mats Persson & Raoul Ruparel

Copyright 2012 Open Europe Open Europe 7 Tufton Street London SW1P 3QN Tel: 0207 197 2333 Fax: 0207 197 2307 www.openeurope.org.uk

Contents Executive Summary Section 1: The Eurozone crisis is the worst behind us? Spain: further assistance needed? Italy: political uncertainty remains the Achilles heel Germany: will the paymaster continue to cough up? Austrian elections: an unexpected flashpoint? France: Hollandes twin challenges Greece: will Grexit return? Ireland: Bouncebackability? Portugal, Slovenia and Cyprus: yet more bailouts? The pain continues: Eurozone-wide recession almost guaranteed Section 2: Will a Banking union be completed in 2013? Disagreements over the resolution fund Approval by European Parliament (EP) and some national parliaments Section 3: Britain in the EU a mid-life crisis or full divorce? Camerons big Europe speech Can Cameron deliver on the EU budget? How many EU crime and policing laws will the UK ditch? Will the UK be able to manage the banking union? 7 6 2 3

Executive Summary Section 1: The eurozone crisis survival but stagnation If 2012 saw a full on crisis in the eurozone, 2013 is likely to be a year of economic stagnation and political uncertainty, with low growth and high unemployment continuing to plague many countries. There will be fewer threats to the eurozones existence than in 2012, but the fundamental flaws in the structure of the eurozone remain, and progress towards solving them is likely to continue to be slow. Italy, Spain and France face funding costs of 332bn, 195bn and 243bn respectively, which will keep markets on edge. On this front, liquidity from the ECB and the potential activation of its bond buying programme, the OMT, will help soothe fears in the first half of the year at least. However, politics will be the name of the game. In order to get to the OMT, Spain and others will have to go through the ESM, meaning approval by parliaments in several creditor countries including Germany. This could trigger unexpected delays and tensions. Italy, Germany and Austria are also facing important elections, with it being far from clear that the Italian elections, in particular, will produce a stable, pro-reform government. In addition, Portugal, Slovenia and Cyprus could also be forced to seek more financial aid, while the Greek political scene remains very fragile amid growing austerity-fatigue. In combination, political tensions, particularly between the creditors and recipients, could suddenly flare up. Verdict: A calmer, but still painful year for the eurozone, with several political flashpoints that could quickly trigger a fresh flare-up in the crisis. The eurozone is unlikely to fully turn the corner. Section 2: Banking union slow or even slower? As the eurozones flagship solution to the crisis, the banking union will continue to be at the forefront of discussions and disagreements in 2013. The set timetable which includes a decision on the resolution fund in 2013 will likely fall foul of political wrangling, with direct recapitalisation of eurozone banks by the ESM already pushed back until after the German elections. Verdict: A decision on the second step of the banking union a joint fiscal backstop is unlikely to be taken amid continued disagreements and domestic pressures. Section 3: Britain in the EU a mid-life crisis or full divorce? On 1 January, the UK will have been an EU member for 40 years, but the relationship is becoming increasingly complicated. A British exit from the EU became a topic of mainstream discussion in 2012 and will continue to be a front-page issue in 2013, with UKIP on the rise and European elections approaching. Though Cameron may not have to seek parliamentary approval for any major EU issue in 2013, there will be tense discussions both within the Coalition and the Conservative party about how to tackle demands for a new relationship with Europe. In his forthcoming Europe speech scheduled for mid-January Cameron could well frame the choice for Britain in Europe as one between renegotiation and Brixit, though may still shy away from promising a concrete referendum. The two issues to watch are how many EU crime and policing laws the UK will remain signed up to, which could be decided next year, and whether Cameron can present a deal on the long-term EU budget as a success. Verdict: No fundamental changes to the relationship, but positioning and political manoeuvring will set the stage for the 2014 and 2015 elections that in turn could decide the exact nature of the EU-UK relationship in the future.

Section 1: The Eurozone crisis is the worst behind us? Between the Outright Monetary Transaction (OMT), the Greek deal and an agreement on the EU banking union, the end of 2012 turned out to be less volatile than many expected. Heading into 2013, many politicians have asserted that the worst of the crisis is behind Europe. Below, we assess the issues to watch with respect to individual countries. Spain: further assistance needed? Aid Request: A Spanish request for aid from the ESM/OMT still looks likely, possibly in the first quarter of 2013. ECB President Mario Draghis visit to the Spanish Parliament to explain the exact OMT conditions in January or February might be a stepping stone towards this.1 Banking sector remains problematic: The Spanish bad bank plan continues to be riddled with uncertainty, with success largely depending on the level at which the assets are transferred to the bad bank.2 The early indications are not encouraging large amounts of funding for nationalised banks and limited funds for others suggests large write-downs for the first group and lesser write downs for the second group. The lack of foreign investors also raises serious concerns. All this combined with the massive overhang of real estate supply and unused capacity (it is thought that there is an oversupply of between 1 2 million units in the Spanish real estate market, with banks already owning land to create a further 4 million units) means that real estate prices will continue to be distorted and still have some way to fall.3 Huge funding needs: Spain has 134.6bn (74.2bn bills and 60.4bn bonds) in debt maturing in 2013, around 13% of its GDP. This, combined with a deficit estimated to be around 60bn (5.6% of GDP) gives a massive total funding need of 195bn. This is substantially up from 2012. On top of this Spain has nearly 100bn in unpaid bills, often to domestic businesses, which will need to be wound down, particularly as part of an ESM programme.4 Spanish regions remain a thorn in the governments side: It remains to be seen whether Spanish regions will manage to meet their overall deficit target of 1.5% of GDP for 2012. No less than six regions have already announced that they will tap the Spanish governments own bailout fund again next year, with a further three considering doing so. The impact on Spains finances is likely to remain limited but the governments international credibility could be negatively affected, particularly if it continues missing its fiscal targets. What next in Catalonia? Catalonias two largest nationalist parties have wrapped up a deal which will see Artur Mas have a second term as Catalan President. They have also agreed that a referendum on Catalonias independence should take place in 2014. It remains to be seen how these two parties will get along until then, as they clearly do not see eye-to-eye on a number of key issues, including fiscal consolidation and social policies. Italy: Political uncertainty remains the Achilles heel Elections Can a stable coalition government be formed? Italians are expected to vote on 24 February. The official electoral campaign has yet to kick off, but political parties are already clearly divided into two broad camps: those pledging to continue with Mario Montis reform agenda (including the centre-left Democratic Party, the front-runner according to all opinion polls) and those pledging to overturn the current economic policies (including Berlusconis party, Lega Nord and comedian Beppe Grillos Five-Star Movement). Opinion polls show that the parties supportive of Montis reforms would, together, have the numbers to form a stable government but given movements in opinion polls and the fragmented political spectrum, this cannot be taken for granted.5 3

Will Monti run? Monti has not yet decided what to do, adding further uncertainty. He may stay out of the race while openly endorsing a group of centre parties supportive of his reforms and then facilitate an alliance between those and the Democratic Party. Alternatively, he may create his own list of candidates. Whichever form of participation he opts for, if Monti decides to get involved in the electoral race that could shift votes towards the parties he chooses to endorse or run with. However, it is too early to tell how big an impact he would have not least because he is clearly not as popular among Italian voters as he was when he entered office last year.6 Large funding needs: Although Italys funding needs are likely to be down in 2013 compared to 2012 and do not look as bad as Spains they are still substantial. In total, Italy has funding needs of 332bn.7 Germany: will the paymaster continue to cough up? A quantum leap towards more integration? The question on everyones mind is whether a post-election German government will press ahead with further eurozone integration, including measures that have so far been postponed most importantly the possible recapitalisation of banks via the ESM, a resolution fund for banks and a common eurozone budget. Any moves towards anything resembling debt pooling will cause significant unrest among the more fiscally conservative CDU MPs, the CDUs Bavarian sister party, the CSU and among the public. Conversely, a new German government might be more inclined to try to force Greece out should its political situation deteriorate significantly. A new German government will be restrained by other deep-rooted forces: Although theres huge political momentum for further eurozone integration, the next German government will also find its room for manoeuvre considerably restricted by many of the other centres of power in Germanys complex and decentralised political model. The Constitutional Court has indicated further moves towards eurozone integration such as debt pooling would exceed to limits of the present Constitution, and that any changes would need to be legitimised via a referendum, while the Bundesbank is deeply sceptical of the ECBs OMT bond buying programme and the form of the proposed banking union.8 Is a Grand Coalition inevitable? The make-up of the new German government may have some bearing of the direction of travel in Europe, but arguably less than is often assumed. Current polls suggest that neither SPD nor CDU will win an outright majority, and absent a major surge for either the FDP or the Greens, a Grand Coalition looks likely. It remains to be seen how vigorously the two parties will campaign against one another and how radically different their pre-election commitments on Europe policy will be. Beyond party politics, the leaderships of the two parties have a broadly similar approach to the eurozone crisis, although the SPD has indicated that it is more relaxed about pushing ahead with debt pooling. However, this could well change should the party find itself in power. Bavarian elections will test the strength of the anti-bailout mood: The Bavarian elections are scheduled to take place just a week before the federal election, and could provide an indication as to the strength of anti-bailout sentiments in Germanys biggest creditor Lnder. The CSU has adopted a more hawkish stance on the eurozone crisis than the CDU and may seek to tap into the anti-bailout mood during the election campaign, particularly if it feels the need to shore up its right flank against attacks from smaller parties, such as the Freie Whler.

Can Germany afford to carry the eurozone? With mixed economic data suggesting that the crisis will hamper German economic growth, and with the country facing longer term structural challenges such as an ageing population and high pension liabilities, next year could also see an intensified debate as to whether or not it can actually afford to underwrite the eurozone. This, too, could play a role in the two election campaigns.9 Austrian elections: an unexpected flashpoint? With the Austrian economy looking pretty stable relative to the rest of the eurozone it seems an unlikely flashpoint, but the Austrian elections, to be held before September 2013, could prove noteworthy. Not only is there the anti-euro party Team Stronach, currently polling at around 10%, but also the far right FP, polling at around 20%. Both parties are hostile to bailouts and the FP is only 6% behind the most popular party.10 On top of that, the Austrian government might still collapse over another EU related issue, the threat of Christian Democrat Foreign Minister Michael Spindelegger to veto the long term EU Budget this further increases the chances of the EU and the eurozone becoming a key election issue. France: Hollandes twin challenges Will Frances decline continue? Fitch, the last remaining agency to have France at AAA, has warned that there is more than a 50% chance it will be downgraded in 2013.11 The numbers do not make pretty reading for France, with total funding needs reaching 243bn in 2013. Worse, economic growth is expected to be a meagre 0.4% in 2013, with the country still running a current account deficit of 2% of GDP and showing little sign of reversing either trend.12 The state accounts for 57% of GDP, while improvements in competitiveness, both in terms of unit labour costs and business climate, have been slow and painful. In fact, in many of these areas, if reforms continue apace in Italy, Ireland, Spain and Portugal, the competitiveness of these countries could look more favourable than France at some point in 2013. Will markets lose patience with France? Off the back of this, Frances borrowing costs could well increase in 2013, but markets will likely continue to give it the benefit of the doubt. Meanwhile, the political challenges are also mounting up. According to the French Institute of Public Opinion (IFOP), only 37% of French said they were satisfied with President Francois Hollande in December down from 61% in May, right after his election. This appears to be driven, at least in part, by Hollande having to continue with austerity, rather than pursuing the spending policies he advocated at the election. This is likely to continue in 2013, potentially decreasing his popularity further and begging the question whether he will be tempted to increase spending. Greece: another tough year Will Grexit return? Despite securing a bond buyback and the release of a large tranche of bailout funds, the Greek question is likely to return in 2013. The focus will be delaying any further decisions on Greece until after the German elections, so a Grexit looks unlikely in the first part of the year at least. However, with economic growth optimistically forecast to be -4% next year, it will be another painful one for the Greek people. Unemployment, which was targeted to be 22.4% at the end of the year had already reached 26% in September (with little signs of change since then) and only looks to be rising as the impact of poor growth and internal devaluation kick in.13 Another funding gap is likely to open in Greece at some point next year and, ultimately, the fundamental problem of whether the eurozone is willing to take losses on its loans to Greece remains unanswered.

Will the Greek government hold its ground? Though the Greek government has achieved a level of relative stability (compared to the past), Greek politics remain exceptionally fragile and divisive notably the far right Golden Dawn party has strengthened its grip on third place in the polls. Ireland: Bouncebackability? Back in the game? 2013 could prove to be a crucial transition year for Ireland as its bailout winds down in November although it is expected to return to the markets in early 2013. Recent indicators suggest this transition will happen fairly smoothly. How will the Irish deal with legacy debt? The issue of legacy debt and the Irish bank bailout will remain a key question for the Irish government. Some sort of easing of the bailout terms (interest rates, length of loans) rather than a deal on transferring the debt burden to the ESM or getting a deal on the promissory notes issue seems the most likely option. Portugal, Slovenia and Cyprus: Yet more bailouts? Portugal must return to the markets in September 2013 or ask for a second bailout. Despite meeting most targets, as in the other Mediterranean countries, austerity-fatigue is starting to take hold. The turnaround in exports - although positive - has not been enough to produce any serious hope of sustained economic growth. Portugal is likely to need some additional help, either more funding or eased bailout terms, in 2013. Slovenia has been on the cusp of a bailout for some time, with its troubled banks close to pushing it over the edge. The government is taking steps to recapitalise the banking sector but it looks unlikely to be enough with some assistance potentially coming in the middle of next year. Meanwhile, Cyprus has already requested a bailout with the details in the process of being finalised. With a huge amount going to its banking sector, expect a significant overhaul of the financial sector as well as structural reforms. The pain continues: Eurozone-wide recession almost guaranteed The ECB forecasts between -0.9% and 0.3% growth in the eurozone, with individual countries forecasts providing a similar picture.14 However, even these figures are seen as slightly optimistic, particularly with the knock-on impact of further cuts in many countries and the reduction in trade activity across the eurozone. Expect lots of missed growth and deficit targets once again next year. Section 2: Will a Banking union be completed in 2013? Disagreements over the resolution fund: This has already started, with Germany trying to kick any direct recapitalisation of banks by the ESM or another resolution fund well into 2014. The December EU summit conclusions called for progress on this area during 2013, with the focus on the Recovery and Resolution Directive, which harmonises resolution schemes across the EU rather than providing a joint backstop. However, with this directive already stalled due to existing disagreements and not scheduled to come into force until 2018, it is clear that Herman Van Rompuys timetable to have an agreement on the resolution fund in 2013 could prove incredibly optimistic. Approval by European Parliament (EP) and some national parliaments: The draft text changing the voting modalities at the European Banking Authority (EBA), approved at the December European Council, still needs to pass through the EP which has co-decision any changes will be done by Qualified Majority Voting (QMV) meaning everyone may not be happy.15

Section 3: Britain in the EU a mid-life crisis or full divorce? On 1 January, the UK will have been an EU member for 40 years, but the relationship is becoming increasingly complicated. With the 2014 European elections approaching and UKIP on the rise, Europe will continue to be a major issue for the UKs governing Coalition, the Conservative party and indeed the EU as a whole. However, David Cameron could potentially avoid any major flashpoints in the UK Parliament next year, with votes on the EU budget (the so-called own resources decision) and the 2014 crime and policing block optout possibly not due until 2014, although that remains uncertain. Instead, 2013 could prove the calm before the storm (the European Parliament elections in 2014 and General Election in 2015). Regardless, there are several developments to watch next year: Camerons big Europe speech: David Camerons long-awaited Europe speech now scheduled for mid-January is likely to make a firmer commitment to renegotiate the UKs EU membership terms, although there is an intense internal debate in the Conservative party as to whether to commit to a referendum and, if so, what kind of referendum. Several senior figures within the party including Cabinet members Owen Paterson and Michael Gove as well as Boris Johnson, Liam Fox and David Davis have said that leaving the EU would not be a disaster, and at the very least should be the alternative if renegotiation fails. Indeed, in a recent exchange in the Commons, David Cameron let slip for the first time that he considers a future for the UK outside the EU "imaginable". This has raised the stakes and means that David Cameron will be forced to frame the debate as a choice between renegotiation or Brixit, as opposed to renegotiation or the status quo, or a straight in/out vote. Can Cameron deliver on the EU budget? Cameron managed to muster an alliance crucially including Germany - to block an unsatisfactory deal in November. His negotiating mandate is exceptionally narrow following a Parliamentary vote backing a cut to the EU budget, rather than the freeze called for by the Government. However, the perceived difference between the Government and Parliament is more a matter of miscommunication.16 If the Government had used the same baseline as everyone else commitment appropriations over the full seven years its original position would have been a real terms cut. Following negotiations with EU leaders in November, the UK remains on course to achieve a freeze or a cut, when comparing 2014-2020 to the 2007-2013 budget period. As always, EU countries are divided between net contributors and net recipients, with France and Italy caught somewhere in the middle. European Council President Herman Van Rompuys most recent proposal if it leaves the UK rebate intact and adds some more cuts to payments appropriations- could well prove to be close to the final agreement (which would mean a cut, budget period to budget period). The European Parliament also has to give its assent. Still, the UKs baseline an extrapolation of the payments made in 2011 means that Cameron has to fight incredibly hard to live up to the high threshold he has set for himself for a freeze and convince his backbenchers and the Opposition that he managed to secure a good deal. However, the key domestic test will come in early 2014 when Parliament will vote on funding for the EU budget, effectively a sign-off on the budget itself. How many EU crime and police laws will the UK ditch? In October 2012, the Home Secretary, Theresa May, announced that the Government was minded to exercise its right to opt-out en bloc from 135 EU crime and policing laws, including the European Arrest Warrant (EAW) and organisations like Europol and Eurojust, in order to avoid them falling under the full jurisdiction of the ECJ for the first time.17 An evaluation of each of the 7

measures and fierce Coalition negotiations between Oliver Letwin for the Conservatives and Danny Alexander for the Lib Dems are now underway in order to decide which measures the UK might apply to opt back in to. EU Justice Commissioner Cecilia Malmstrm has warned that the UK will not be able to cherry pick and that on each of these opt-ins, there will have to be a negotiation, which could potentially lead to a stand-off. It is unclear how and when (the deadline for the decision is in June 2014) the Government plans to gain Parliamentary approval for its decisions, but it is likely to try to bundle the optout and individual opt-in decisions together as a package vote, to ensure that individual optin decisions are not held hostage to fortune and the backbenches. The EAW remains a make or break measure for both the Conservatives and Lib Dems, and a very difficult issue to solve. The Lib Dems will not support the opt-out unless the EAW is retained and many Conservatives would refuse to opt back in to the EAW unless it is reformed.18 Will the UK be able to manage the banking union? The UK Government managed to achieve a substantial victory by securing a double majority principle at the European Banking Authority (EBA) to counter the risk of eurozone caucusing which was its main objective. Absent a new treaty change proposal (unlikely), banking union discussion will focus primarily on the eurozone in 2013. However, there are still flashpoints. Under the current proposal, for example, the EBA voting rules need to be revised when the number of outs reaches four or fewer. The regulation establishing the EBA is subject to QMV, meaning the UK could lose gains it has made, though the UK has secured a commitment that the voting rules will be revised in the European Council, where unanimity applies.
Cited by the WSJ, ECBs Draghi to speak in Spanish Parliament early next year, 11 December 2012: http://online.wsj.com/article/BT-CO-20121211-706618.html 2 For a fuller discussion of this issue see, Open Europe blog, About that Spanish bad bank, 29 October 2012: http://openeuropeblog.blogspot.co.uk/2012/10/about-that-spanish-bad-bank.html 3 For a more detailed analysis of the problems in the Spanish banking sector and the real estate market, see Open Europe, Not so bullish now?, April 2012: http://www.openeurope.org.uk/Content/Documents/Pdfs/Spain2012.pdf 4 We lay out our full expectations of Spanish funding needs next year in Regional debt, national problem?, July 2012, see: http://www.openeurope.org.uk/Article/Page/en/LIVE?id=9142 5 We discussed these issues in more detail in our blog Silvio is back, Mario is out: what lies ahead for Italy, 10 December 2012: http://www.openeuropeblog.blogspot.co.uk/2012/12/silvio-is-back-mario-is-out-what-lies.html 6 See Open Europe blog, An update on Italy, 19 December 2012: http://openeuropeblog.blogspot.co.uk/2012/12/silvio-mentions-euro-exit-again-but.html 7 Italian funding needs are calculated by adding the amount of debt maturing (which needs to be rolled over) taken from the Italian Treasury and the level of the total budget deficit estimated by the IMF in its October 2012 WEO. 8 See Open Europe, What will the German Constitutional Court ruling mean for the eurozone?, 12 September 2012 for our full analysis of the decisions: http://www.openeurope.org.uk/Article?id=9284 9 A report by Goldman Sachs examining this issue was recently cited by Zerohedge, see: http://www.zerohedge.com/news/2012-12-19/who-will-keep-german-and-thus-europes-economy-running 10 For the latest poll results see: http://de.wikipedia.org/wiki/Nationalratswahl_in_%C3%96sterreich_2013 11 Cited by CityAM, Fitch affirms France AAA rating, 14 December 2012: http://www.cityam.com/latestnews/fitch-affirms-frances-aaa-rating 12 These estimates are taken from the IMF WEO October 2012 database. 13 Hellenic Statistical Authority, Labour Force Survey, September 2012: http://www.statistics.gr/portal/page/portal/ESYE/BUCKET/A0101/PressReleases/A0101_SJO02_DT_MM_09_20 12_01_F_EN.pdf 14 These are the ECBs latest estimates for economic growth and were cited by ECB President Mario Draghi in his last monthly press conference of 2012: http://www.ecb.int/press/pressconf/2012/html/is121206.en.html 15 For our full analysis of this issue see: http://www.openeurope.org.uk/Article?id=9697 16 We discussed this issue at length in our report, The rocky road to a new EU budget, 19 November 2012: http://www.openeurope.org.uk/Article/Page/en/LIVE?id=9581&page=PressReleases 17 For a fuller discussion of this issue, see, The first comprehensive cost-benefit analysis of EU crime and policy law, by Dominic Raab MP, published by Open Europe 29 October 2012: http://www.openeurope.org.uk/Article/Page/en/LIVE?id=9524&page=PressReleases 18 For Open Europes original proposal on this, see, How the coalition can repatriate 130 crime and policing laws overnight, 29 January 2012: http://www.openeurope.org.uk/Article/Page/en/LIVE?id=8409&page=PressReleases
1