European parliamentary elections increasingly important

Published: Apr 2014

Since Russia sent armed forces into the Crimean peninsula, one thing has become clear, the West is weaker than it was. In itself, this is understandable. After the Cold War ended, defence spending in the West – especially in Europe – has decreased steadily. Furthermore there was no obvious enemy. The Soviet Union had disintegrated, many eastern European countries came under the umbrella of NATO and China was not expected to show aggression to the outside world.

As globalisation took off, the focus shifted from military to economic power. On top of this, the US was getting fed up with having to act as the world’s policeman, not least because the wars in Iraq and Afghanistan turned out to be far too expensive, even for the wealthy Americans.

Obviously, Moscow and Beijing saw things differently. The collapse of the Soviet Union made Russia much weaker – and poorer – but it still had a trump card. Namely, oil and gas exports. This ramped up earnings to such an extent that the country had plenty of money to rebuild its army. The expectation is that a few years from now the Russian army will (hypothetically) be a formidable adversary. The Chinese are also very active. Like the Russian defence forces, the Chinese People’s Liberation Army is building up its strength.

Chart 1: In recent years military expenditures have increased much faster for Russia and China than for western countries
Chart 1: In recent years military expenditures have increased much faster for Russia and China than for western countries

Source: Thomson Reuters Datastream/ECR

Any kind of armed conflict would have grave implications for the globalisation process and thereby for the financial markets. Earlier on both the US and Europe assumed that, as an inevitable result of globalisation, many states would introduce a capitalist system in order to become more prosperous, which would benefit Western economies. Naturally, overt aggressive action by any side would be a game changer.

Moscow’s priorities

For geographic reasons, commodity-rich Russia is vulnerable to foreign invasions. The former Soviet Union surrounded itself with satellite states, which acted as a buffer. Then the Berlin Wall fell and the Soviet Union collapsed. Russia’s protection mechanism crumbled.

At the same time, it has nuclear weapons to deter would-be belligerents. However, the country has another weak spot. Mass migration in the early years of the Soviet Union meant that populations with different religions, ethnic backgrounds, and historic affiliations were thrown together. The mix of different people did not gel; often they were sworn enemies to start with. In other words, Russia and the former Soviet states are very exposed to external infiltration. Moscow therefore wants a strong conventional army in order to keep various ethnic minorities under control.

Another advantage of having an army is that it could – if the opportunity presents itself – regain lost ground in countries that used to be part of the Soviet Union but have become autonomous. Ukraine is a prime example. Sections of its population would prefer to link up with the West rather than be dependent on Russia. Should these citizens get their way, suddenly there will no longer be a buffer zone between Russia and the West.

China faces a different situation as it needs to import many commodities. As the country develops economically, it is increasingly vulnerable to blackmail by commodity-exporting countries and/or by countries threatening to stem the flow of commodities into China. For this reason, China is looking suspiciously at Japan, which is also a commodity importer. In that sense, Japan and China are rivals. Based on these considerations, it is no surprise that China has made use of its growing prosperity to build a large army; an important aim is to safeguard the inflow of commodities.

European strength increasingly necessary

Currently, the Americans are shifting their attention eastward. They, too, have plenty of commodities at home, unlike the European countries that have to import numerous raw materials. Inevitably, this pitches them against the awakening giants, China and Russia. The only solution is a closer collaboration within Europe, in military and economic areas. Individually, each European country is too weak to rival China or Russia. In recent decades, Europe’s global standing has declined. Undoubtedly, this process will accelerate in the context of the ‘new world order’ that is shaping up, unless the European countries manage to join forces.

An ever larger portion of the European population does not want this to happen. They blame Brussels and the euro for the fact that their household finances have deteriorated, particularly in comparison with the promises that many politicians have made in the past. In our view, this blame game is unjustified. The aforementioned decline has everything to do with poor or unsuitable education/training and inflexible job and product markets.

In this respect, the European parliamentary elections in May will be crucial. From our perspective, the current developments in Ukraine should alert voters to the fact that the European countries will become insignificant in the not too distant future – unless they work together. Failing to do so would gravely undermine the European project. One can only hope that this ‘wake-up call’ will translate into electoral losses for the anti-Europe parties.

However, for the time being the opinion polls point in the opposite direction. The election outcome could be a very important signal for the longer-term investors in Europe and determine the fate of the euro.

Chart 2: Lower yield spreads vs Germany reduce pressure on weak EMU governments to implement structural reforms
Chart 2: Lower yield spreads vs Germany reduce pressure on weak EMU governments to implement structural reforms

Source: Thomson Reuters Datastream/ECR

Experts agree that if the EMU and the euro are to survive, a banking and fiscal union is necessary. The latter would imply that if one of the member states goes under, the other states will have to foot the bills. In practice, Germany will carry the heaviest burden. Therefore the richer Eurozone states – led by Germany – will only be prepared to move in this direction if the chance of a sovereign default is minimal in real terms. To achieve this, two developments are essential.

Countries such as Italy and France need to do more to restructure on a large scale in order to boost potential growth to a similar level as in Germany. Reforms are the only way to overcome the current economic misery, prevent public finances spiraling out of control and to free up money to increase defence spending.

Money illusion

In that sense, we are not impressed that bond yields in the distressed Eurozone member states – for example, Italy and Spain – have dropped sharply. As far as ECR Research is concerned, this should be filed under money illusion. Because of the massive money creation around the world, investors are hunting for higher returns. When the ECB promised to buy unlimited quantities of short-term government debt, everyone chased after the high yielding bonds issued by the weak Eurozone countries. As bond yields dropped, in a cyclical sense these member states were better off. Therefore they attracted more capital, and so on. The downside is that all of this eases the pressure on politicians to push through structural reforms. Especially in the longer term, the outlook is getting worse, not better.

In addition, Eurozone countries will need to work closely together or they will be steamrollered by superpowers like China, the US and India as their economies lag behind. Under such conditions, it would be very risky for the European countries to guarantee each others’ finances.

If the opinion polls are correct, the anti-Europe parties will gain a lot of seats. In all likelihood, this will make it very hard for Europe to achieve the degree of integration and collaboration that is needed to offer the member states a healthy financial future. In the longer term, this will certainly affect the euro and the performance of the European stock markets.

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