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11 November 2022

Ukraine aid and EU holdouts

Will Europeans will step in if America were to reduces its financial and military support for Ukraine? We don't think so.

At the EU ambassadors' meeting, Hungary said it will block the €18bn the European Commission proposed loaning to Ukraine to keep its economy and public services afloat, and to restore critical infrastructure destroyed by Russian missile and drone strikes. The explanation the Hungarian government gave is that Hungary does not want the EU to take on new loans.

EU officials told Politico that they see this as a blackmailing tactic for Hungary to get the release of the €13bn in funds the EU is withholding over the rule of law dispute. Annalena Baerbock echoed this criticism, saying that humanitarian winter aid for Ukraine is not a matter to play poker over. But if poker is indeed the game they are playing, Hungary is unlikely to exit the game just now.

EU countries will have to decide next month whether to suspend about €7.5bn in EU funds for Hungary under a rule-of-law conditionality mechanism, or whether the anti-corruption reforms Budapest has promised can be considered sufficient to drop the sanctions. Similarly, the EU has been holding back Hungary’s access to €5.8bn in Covid recovery funds, and is requesting further judicial reforms before releasing that money.

Germany’s position is crucial. The vote on suspending payments next month will be by qualified majority decision. A number of countries, including Netherlands, Belgium and Ireland, are already critical and likely to vote against the release. If Germany were to cast a negative vote, this would be enough to block it.

The coalition parties in the Bundestag put forward a motion urging the government to thoroughly scrutinise Hungary’s reform proposals and whether they will have a sustainable impact in practice. If this is not the case, Germany should get ready to vote against the release, they argue. Since the motion comes from the coalition parties, the government cannot just simply ignore it. Baerbock’s comments signal that they won’t, and that the German government is ready to get tough on Hungary over law and order. This is the opposite of what Angela Merkel had promised Viktor Orbán. But this also means that Hungary will use its vetoes in other policy areas, especially on Ukraine and Russia. The EU looks a lot more united from the outside than it is from the inside.

10 November 2022

French military focus turns east

Emmanuel Macron is preparing the French military to enter into a major conflict. Presenting the national strategic review on how France’s defence will look in 2030, Macron outlined a shift in priorities for the military from anti-terrorism to preparing the army to participate in a major conflict. Forget operations in Africa: France will turn to the east. The war in Ukraine is likely to trigger major geopolitical rivalries in the future, France thus has to prepare for a world with more geopolitical conflicts, according to Macron. The world of yesterday where nations were seeking interdependencies to prevent conflicts is turning into a world where independence is the way to prevent the outbreak of a war.

France’s role as balancing actor inside Europe and Nato continues to rely on intelligence and nuclear deterrence, the backbone of French territorial security. But Macron also called for a new inclusive approach to European air defence systems, and not just promoting a national industry. A thinly veiled message to the German government that it must take a European strategic dimension into account for its anti-aircraft shield project. France is also putting efforts into mobilisation, including talks with the defence industry about the changeover to a war economy, preparing for mobilising reservists to double their numbers, and extending the age for national service.

As for Africa, France wants to change the model to act only at the request of the African authorities and only in support of their armies. While some 3,000 French soldiers are still deployed in Niger, Chad and Burkina Faso, this number should decrease to focus on cooperation and support in terms of equipment, training or intelligence with partner countries. A new organisation of the French presence in West Africa will be defined within six months, announced the president. Similarly, Operation Sentinel will be scaled down. France will switch its forces to the east, with the aim of becoming a leading partner of Nato and Europe, writes Les Echos.

9 November 2022

Is a deal on NI protocol near?

Could there be a breakthrough over the Northern Ireland Protocol by the end of this year? The EU has begun testing the UK’s live database for tracking goods moving from Britain to Northern Ireland. It will take them a couple of weeks to go through it. If the EU is satisfied with this database, it could pave the way for an agreement on customs checks, one of the biggest disputes over the protocol. At the core of the dispute is the fact that Brexit deal moved the land border into the Irish Sea, meaning that Northern Ireland is still part of the single market for goods. When border checks started to be implemented, it ignited tensions in Northern Ireland, an echo of past traumas from the Troubles. For unionists, those border checks symbolically re-enacted the dividing lines of what it means to choose between being part of the UK or uniting with Ireland. How can everyone move forward from there? To avoid those broad based intrusive checks, the EU has long said it needs access to real-time, detailed data to protect its single market border.

Live data will not solve every aspect of the dispute, as the Irish Times pointed out. There is still contention over the jurisdiction of the European Court of Justice to settle disputes in Northern Ireland, something non-negotiable for the EU and unacceptable to London. But there is positive resolve on both sides to end the stalemate. Simon Coveney, Ireland’s foreign minister, said that a negotiated settlement is doable by the end of the year. Rishi Sunak’s government hopes a deal will in turn defuse tensions in the region and help to restore a working government in Northern Ireland.

Timing matters. The deadline for forming an executive in Stormont passed, as the DUP continued refusing to participate in the executive as long as its demands to rewrite or withdraw from the protocol are not taken forward by the UK. Under current legal provisions, new elections are to be called for January at the latest. But those could prove to exacerbate tensions between unionists and republicans. Chris Heaton-Harris, the Northern Ireland Secretary, is looking into whether to delay the January deadline further. An announcement is expected today. They cannot push the deadline forward indefinitely.

8 November 2022

Cheap advice

Is it not funny that financial market economists frame the debate on monetary policy entirely in terms of the economic cycle? They don't even talk about inflation. They did not predict it would rise when it was low. They predicted it would fall when it was high. And now they are ignoring it altogether.

There are quite a few economists out there who advise central banks to stop raising rates, or else risk a severe recession. This type of advice is cheap and dangerous. It does not reflect the debates that are going on inside the central banks. So we are wondering whether these economists believe in the perfect Phillips curve, that states the inverse relationship between unemployment and inflation. Or maybe they think that central banks are bluffing.

The latter is the view of Robin Brooks at the Institute of International Finance, a lobby group for banks. He tweeted this week that the big story of 2022 is that markets are finally looking through the rhetoric of the ECB. By rhetoric he means the ECB's repeated referral to the inflation target. This is not an atypical comment these days. Judging by the comments from the central bank-watching fraternity in general, we see this inflation target denial as endemic. 

So why do they frame the debate purely in terms of economic growth? Is the economic cycle a perfect substitute for the inflation cycle? Central banks and grown-up economists know, of course, that the Phillips curve is not a perfect description of our world. Stagflation exists. A steep economic downturn will weigh inflation down, but we agree with Christine Lagarde that it won't take care of the problem on its own. The task for central banks is therefore more difficult than trying to figure out the nature of the cycle. Central banks are right to see through the headline inflation numbers and recognise their volatility. But they can't ignore that the various measures of core inflation range between 4 and 6% across Europe and the US. It is far from clear that present interest rates, which are below those inflation rates, can get the job done.

If the central banks follow the doveish central bank watchers' advice, they take a big risk if they get it wrong. They will have ended up killing inflation targeting, and all the foundations on which central bank independence rests. 

We have made the observation that the majority of public discussions on monetary policy are not motivated by a desire to hit the inflation target, but by other motives that are usually not explicitly stated. Remember the German economists a decade ago who objected to QE with the argument that the inflation target only constituted an upper bound? Everybody bends these targets to their prejudices. Some ignore them completely.

Not every member of every central bank policy committee believes in the target either. Some central bankers, too, have private agendas. But what they all have in common is that their credibility as policymakers is tied to their success in meeting the target. If a central bank moves too early and ends up with a persistent inflation overshoot, or if the central bank moves the goalposts and raises the targets, we would interpret this as an acknowledgement that inflation targeting as a whole is finished. 

Most central bankers know this, of course. Many financial economists do not. We think that central banks would take a large - in Europe's case existential - risk if they dropped the ball and allowed the cheerleaders to call the shots.

7 November 2022

Immature, confused - a bad combination

The reason German foreign policy is so difficult to understand from the outside is the combination of immaturity and confusion. There has been no mature discussion in any political party about the role of defence and security at a time when the US can no longer guarantee European security. There has been no public discussion about a separate European defence capability except in some general, aspirational sense. The debate is also confused about the interests of the country, which are usually mixed up with the interests of industry. To make matters worse, German journalism shares those two confusions. The way the German media write about defence has a certain pre-school quality to it.  

We are therefore not surprised to read in FAZ this morning that the Social Democrats have taken a vote during their party convention to claim a German global leadership role, as though this was some competition you enter into for a trophy. True leadership starts not by making demands, but by making sacrifices. It is not of act of leadership by Olaf Scholz to override the security agencies and allow a Chinese company to buy a semiconductor firm, or to allow another Chinese company to buy its way into critical port infrastructure. When he goes to China with a plane-load full of businessmen in tow, he is clearly not showing leadership either, except of the narrow Mercantilist kind. 

The unilateralism that Scholz represents is not one that leads anybody, except his party. Germany is clearly not a leader in Nato, having skimped on defence spending for decades, and continuing to do so despite Scholz's dishonest claim to the contrary. Germany could be a leader in Europe, together with France. But since Scholz became chancellor, he managed to alienate both the eastern Europeans and France simultaneously. Where Scholz is leading is in the fight to sustain Germany's unsustainable industrial model. There is a certain logic to this. Industrial workers and pensioners are the SPD's core voter base. The intellectuals and students have long gone. We can say, maybe, that the SPD is acting rationally. But leadership, this is not.

4 November 2022

Olaf alone in Beijing

Spot the logical flaw in this statement that made the rounds on the German twittersphere yesterday:

  1. We have lost Russia as a partner. 
  2. We can no longer free-ride with low defence spending. 
  3. You can't expect us to drop our special relationship with China as well.

The sheer number of category errors in that statement is astonishing, given its brevity. But let us point out just one: we, the rest of the world, are not expecting you to do anything. The problem is that when you can no longer get cheap Russian gas, and when the Americans, your new best friends, won't let you export sensitive technologies to China, your special relationship with China will come to a premature end. The problem is you have not thought this through.

As Olaf Scholz set off for his day trip to China, we noted one huge difference to previous meetings. German business community as a whole does not like it. Nor does the German public. In a poll from ARD-DeutschlandTrend 49% want Germany to reduce their trade relationship with China. Only 10% want to deepen it. But perhaps the biggest surprise for Germany's corporatist chancellor is the growing scepticism of businesses themselves. Germany ia not just BASF, the company with the biggest influence on Scholz. Germany has many companies who are well-placed to benefit from the economic model shift that is now taking place. They are just not the analogue-age DAX30 behemoths.

German business as a whole does not support Scholz. This is very different from the mostly uncritical attitude towards previous relations with Russia. The president of the Hessian business association, whose own companies also have China operations, is quoted by Tagesschau as saying: 

"Dependencies on single countries make us subject to being blackmailed. The world does not only consist of Russia, China and the US. Being pro-globalisation means becoming more creative."

This is language we have not heard before from the business community. What is also noted is that, unlike on previous occasions, some of Germany's high-tech companies did not accept Scholz's invitation, including the chiefs of Mercedes-Benz, Bosch, Continental, Infineon, SAP, and Thyssen Krupp. 

What is happening in China today is pretty much a blast from the past. This trip is best seen as an addiction relapse.


3 November 2022

Turkey, guarantor of the grain deal

Russia is back as partner in the grain deal, at least for now. Turkey mediated their return by providing assurances for its operation, more priority for cargo to go to poorer countries, and a written letter from Kiev to refrain from pursuing military goals in the Black Sea grain corridor or its ports. How to allow equal treatment of Russian grain exports, the second part of the deal, was also part of their negotiations, we understand.

The engagement with Russia over the deal is a diplomatic success for Recep Tayyip Erdogan. Russia had pulled out last weekend after a drone attack in the Crimean port of Sevastopol. Cargo ships that had already been cleared were tacitly allowed to leave Ukraine’s ports on Monday and Tuesday. But shipments were bound to come to a halt sooner or later, as without a safety guarantee from both belligerants, ship owners would have find it difficult to send their ships through the Black Sea or find insurance for their cargo.

The grain export operation is resuming the way it worked before: ingoing and outgoing ships will be approved by the UN, and inspected in Turkey by delegations from the UN, Turkey, Ukraine and Russia. Ukraine’s tugboats accompany the cargo ships through the corridor to stay clear of mines. The deal is set to expire on 18 November, though the UN hopes that it can be continued and that none of the parties object to it. But the deal may even continue if Russia is not actively part of its operation.

Vladimir Putin gave verbal assurances that, should Russia decide to leave again if it considers assurances to be violated, grain exports from Ukraine could still continue, citing Turkey’s neutrality and mediation efforts as a reason. This is a message for Nato states: do not pressure Turkey to take your side against us, let them be the go-between, otherwise all bets are off.

2 November 2022

Push-back against EVs

We recall a conversation a few years ago with a group of investors and a company that specialised in technologies to reduce emissions of fuel-driven cars. It was a great technology, but the trend towards electric vehicles was already unstoppable at the time. We thought then that the game was up for the fuel-driven car. We are now surprised to see that, in 2022, the debate is back, in France at least. We have some sympathies with François-Xavier Pietri, a French economic journalist, who is making waves with a campaign for the EU to drop the 2035 deadline to end the production of fuel-driven cars.

We think his argument is ultimately wrong, but he points to issues that need to be addressed. Perhaps the most important one is the net environmental impact of one technology versus the other. After the diesel scandals, the European car industry dropped all research into making diesel and petrol cars more fuel-efficient. They redirected their research and developments towards EVs. The 2-litre car (per 100km driven) was a realistic development proposition, but this is now not going to happen. EVs will lead to massive increases in the price of cobalt, lithium and other rare earths needed for the production of batteries. There are a series of environmental issues related to the mining of some of those metals. And issue of supply-chain security. The electricity to power EVs is also, partially, derived from fossil fuels. So this is not a case of clean versus dirty.

Another consideration is equality. Poorer people cannot afford the financial outlay of an EV, and may find their mobility reduced as a result of diesel bans. EVs are more expensive, but they also last longer. We think that the initial cost problem is solvable through financial contracts that spread the usage costs over the vehicle's lifetime. But there will be at least a transitional period of friction. 

Where Pietri goes wrong in our view, is what we might call the snapshot fallacy, or the tomorrow-I-am-sober fallacy. We recall a discussion in Germany a few years ago where it was widely argued that EVs had a higher life-span carbon footprint than diesel cars. That calculation depended crucially on the then still prevailing low production volumes. Once production volumes and the share of renewable energy in electricity generation increases, the carbon footprint calculation is a different one. Pietri's criticism of the short-range of EVs relative to fuel-driven cars falls into the same category. Tomorrow they will drive longer distances than today.  

In every transition we should consider friction, and the impact on the poorest. If you are poor you might still have €1000 for a secondhand diesel car. But you don't have access to car finance, even when it makes economic sense to take a loan to benefit from a lower annual total cost of transport. Suffice it to say this is a solvable problem, but it may not be solved. 


1 November 2022

Fighting dirty

Here is a statement of propositional logic: If the probability of a Russian nuclear attack is falling, and if the probability of such an attack is inversely proportional to Russia's military success, then it must be that Russia is doing relatively better. That observation does not appear to square with what is happening on the ground. Ukraine's pushback has been extraordinarily successful.  

But the statement is true in one sense. Vladimir Putin is not using nukes because he thinks he has got something better: a strategy to put Ukraine, and the rest of Europe into a deep freeze over the winter. 

That strategy, too, may fail. But it started well, from Putin's perspective. The Economist quotes the director of Ukraine's largest power company as saying that Russia has superb energy sector intelligence which it uses for targeted attacks, as he put it, in a very methodological way. When we read those words we were reminded of what happened to the German rail network a few weeks ago. Communication lines were cut in two critical places. Whoever did this had deep inside knowledge. We have witnessed other seemingly random infrastructure attacks of late, against an oil pipeline in Poland, cut internet cables in the Shetland island and the south of France, or before that the explosion of the Nord Stream 1 pipeline. We know that Putin has invested in subversive networks abroad. The dismissal of Germany's cybersecurity chief over Russia connections should serve as a warning sign.

Western and northern European infrastructure is one of the weakest links in the western alliance. Norway has quite a few oil and gas pipelines running through the North Sea, plus Baltic Pipe, which goes to Poland. We are also critically reliant on unprotected underwater internet cables. If Russia continues its attacks on Ukrainian utilities with the same success rate, and if Russia succeeds in destroying some of those pipelines, the probability of a nuclear attack is indeed reduced. Be careful what you wish for. 

The reason we keep a more open mind about the outcome of this war is the knowledge that Putin fights dirty, that Europe has massively underinvested in infrastructure security, and that we are about to hit a recession of yet unknown length and depth. 

31 October 2022

Grain exports to continue - for now

Russia pulled out of the grain deal that the UN and Turkey brokered with Moscow and Kiev in July to allow ships exporting grains safe passage through the Black Sea corridor. Moscow justified its move by saying they can no longer guarantee safe passage of the ships after Ukraine’s drone attack on the Russian fleet in the port of Sevastopol last Saturday. The US and the EU immediately condemned the move. It is, without a doubt, a serious blow for mediation efforts between Russia and Ukraine and it plays into each of their war narratives. What will it mean for grain exports? The UN intends to continue with them. Today, 12 ships are to leave their ports towards Istanbul, with four going in the opposite direction. Will Russia use it for political leverage or even militarily? Will Moscow block or threaten those transports? Will they pressure Turkey if they continue with the inspections? We shall see.

Back in July, both Ukraine and Russia signed a deal to ensure safe passage through a corridor from Odessa and two neighbouring ports to Istanbul. It was heralded as the first step towards a peace deal. It helped to lower grain prices and secure supply to poorer countries, particularly in Africa where nations depend on Ukraine for their grains. Since the first ships left their ports on 1 August, Ukraine has exported 9.3m tonnes of grains and other foods, according to UN figures. Compared with the previous year, when grain exports reached 47m tonnes, this seems to be close if we assume that exports are equally distributed over four quarters, which they are usually not.

It is also worth recalling how the deal is enforced. Ukrainian vessels guide grain ships in and out of port through mines that Ukrainian forces laid. Turkey inspects the ships for weapons, at the request of the Russians, while the incoming and outgoing ships are coordinated by a newly installed unit in Turkey. The agreement was due to expire after 120 days, so in mid-November. Russia had previously signalled that it may not prolong the deal.

If Russia no longer supports the deal, this does not necessarily mean that the operations could not go ahead. But it adds an extra layer of uncertainty and risk that ship owners may not want to take. So the effects may not be seen for the 200 ships that are already on their course either in or out of Ukraine, but they could impact the ones that intended to sign up for a shipment but would hesitate without a Russian guarantee. This will be the other crucial moment to watch out for.