European Developments Ahead of the Annual Review of EU Budget Rules

With real or anticipated developments in the US and Japan dominating the markets' focus, Europe has been pushed off the front pages. The EC meets tomorrow and may dominate the headlines. The competition is mild due to a light data schedule in the North American morning, outside the Bank of Canada meeting, which is not expect to produce a change in policy nor a substantial shift in its economic assessment at Carney's last meeting.

In its annual review of compliance with its budget rules, the EC is likely to do four things. First, it is likely to end the excessive deficit procedure against Italy.   This is not simply some bureaucratic move. It will free up 8 bln euros in EU structural funds already earmarked for Italy. This will help the Letta government provide some much needed economic stimulus.  Nevertheless, austerity is not over in Italy.   Economic Minister Saccomanni has suggested that the 1% increase in the VAT (to 22%) may still be implemented in H2.  

It will also embolden Letta to press his case for the EU to exclude investments from the deficit calculations. The EU will likely debate the issue in June, but not reach a final decision until the end of the year.

Second the EC will likely grant an extension to Spain, France and the Netherlands in reaching the deficit targets. This is already been hinted and now may be formally announced. Portugal has not requested more time, but may be granted it at a future date. 

Leaving aside Greece, Portugal bonds have been among the best performers this month, with the 10-year yield dropping 43 bp, while Spain and Italian yields are flat. Meanwhile, reports that the book "Why We Should Leave the Euro" written by Portugal's Joao Ferreira do Amaral is an overnight sensation in Lisbon, though opinion polls show the majority favor remaining in EMU.

Third, France, Spain and Belgium will likely be criticized and urged to taking stronger strides. France may be urged to reduce state spending and not rely as much on tax increases. The fall of the Berlin Wall did not provide France with the same incentives as Germany to restructure. The gap between the two pillars of Europe continues to grow. France was not subject to the same market and official pressures as others to reform. 

In this context, we note that following the agreement between IG Metall's 770k workers in Bavaria and the employers' union association for wage increases in excess of inflation, Volkswagen agreed to a similar package today for 162k employees at six plants and a financial services unit.  The VW employees will get a 5.7% pay increase over 20 months (Sept 1, 3.4% increase and July 1 '14 a 2.7% wage increase).  Rising wages in Germany, insofar as they translate into an increase in unit labor costs, may help narrow the competitiveness gap, with having to rely exclusive on layoff and wage cuts in the periphery. 

Previously, France was able to compete not with Germany but the periphery and now the periphery is becoming more competitive as reflected in unit labor costs and rising exports. Spain will be pressed for closer surveillance of its macro economic imbalances, but the EC will likely stop short of triggering formal procedures.  Spain's budget minister reported that the central government's deficit in the first four months of the year widened to 25.01 bln euros from 24.76 bln in the year ago period.  The significance lies with the direction of the movement not the magnitude of the deterioration.

Fourth, the EC will likely discuss the EU proposal to enhance corporate tax reporting to include a country-by-country breakdown of profits and taxes. This grows out of both the governments' desires to collect more taxes, but also the avoidance that came out of the recent US testimony by Apple executives that revealed (among other things) how an Irish subsidiary with no employees recorded $30 bln in profit and did not pay any government taxes or another Irish subsidiary paid 0.05% taxes on $22 bln profits. Other companies use subsidiaries in the Netherlands for similar purposes.  The new reporting rules may come into effect in a year's time.  

The EU's failure to extend its arms embargo against Syria cast a pall over month's EU Summit, not tomorrow's review.  The failure works in the interests of the UK and France, which wanted the sanctions lifted so the rebels could be armed.  Czech, Finland and Austria, among others wanted the sanctions to remain in place.  For the record, the Obama Administration remains opposed to arming the rebels. 

Lastly, though not on the agenda tomorrow, we note that the EU continues to press if case to increase the tariff on solar panel components from China even though many, if not most, members are opposed.  Germany and the UK appear to be leading the resistance.  The EU decision is due in early June, with the planned provisional duties to effect more than 100 Chinese companies responsible for some 21 bln euro of solar panel related materials.   

The "dumping" probe is to end in early December, when EU governments decide whether to impose the provisional duties for five years.   It is Europe's largest trade dispute with China.  There is a second investigation under way into the solar panels themselves and provisional anti-subsidy duties may be announced in early August.