First published on

Published on 8 February 2022

In recent times, the EU authority has been challenged by Romania and Poland, both of whom have asserted the primacy of their domestic laws over EU treaty law in certain areas.   Hungary is also a well-known thorn in its side.  Given these threats, and the reputational sleight of the departure of the UK, we anticipate that the EU will refocus on its main perceived power base: control via the euro of access of member states to refinancing.  We believe the EU is looking to strengthen its authority by attracting new members to the EU and existing ones to the Eurozone. It is also probable that the EU will snuff out any potential threats to its credibility by smoothing over post-Brexit relations with the UK on financial services.

Renewed Focus on Enlargement of a) Eurozone and b) the EU

a) Eurozone

Croatia and Bulgaria have for about two years been plodding slowly through the Eurozone-joining process. Each is in the “waiting room” stage of the process known as ERM2[1]. They are required to semi-peg their currencies to the euro, and to ensure conformity of their banks’ IT systems with the standards and connectivity required by the ECB and related banking authorities.  Recently, however, Bulgaria riled EU authorities by interfering in plans to allow North Macedonia to join the EU itself.   Since gaining full “Candidate Status” in 2012, North Macedonia’s EU accession plans were until 2019 blocked by Greece who objected to its former name. The EU is now privately trying to accelerate North Macedonia’s joining, but for deep-seated historical reasons Bulgaria refuses, pending resolution of long-standing disputes between the two Balkan states.  Our sources indicate that Bulgaria is being offered a simple trade off: lift your objection or you will be stuck in the ERM2 waiting room for ever. Such a response sheds an interesting light on EU enlargement.

b) Further EU Enlargement

Since Croatia’s 2013 EU accession, the subject of enlargement has kept a low profile. Given that the EU faced arguably its most serious existential challenges at around this time, with a banking collapse in Cyprus (2013), the third sovereign debt failure of Greece (2015), the migrant crisis and defiance of Hungary (2015) and of course Brexit (2016 – 2020), many observers considered the topic of enlargement to be on the back burner. Surely the addition of small and economically weak countries was undesirable; this would only add to the list of countries seeking future EU bailouts? But the EU and ECB’s thinking now appears to have changed.

Having abandoned technical, financial engineering strategies such as sovereign bond-backed securities, the ECB’s strategy since the pandemic has been to create new euros by issuing supranational bonds, then offer the new liquidity to compliant member states. This seems to be working so well that perhaps the ECB is less worried about the financial weakness of any of the countries applying to join its family. This would be consistent with subtle recent changes in its policy stance; no longer does the ECB urge member states to undertake structural reforms with the aim of balancing budgets.   In effect the fiscal rules have been quietly suspended.  But President Macron of France is determined to broadcast this point loudly and go further, calling for formal relaxations of the rules as he extols the virtues of spending irrespective of member state debt levels.

Let us list the contenders for EU membership.  In addition to North Macedonia, three other countries are in the relative final stages of joining the EU. Serbia, Albania and Montenegro were all awarded full “Candidate Status” over ten years ago.  The first two are expected to complete the joining process in the next three or four years.  Montenegro is officially on track but moving more slowly.

Until recently Turkey would have been added to this list, since its assistance in handling the 2016 migrant crisis won favour with the EU. But since then, Turkey’s domestic human rights policies and changes to the functioning of its democracy have been declared incompatible with the lofty Copenhagen criteria which frame “EU values”.

Post Brexit Relations on Financial Services

Moving from the EU’s eastern to western borders, let us consider the outlook for financial services relations with the UK.  The end 2020 Brexit deal excluded financial services. Acting in reliance on a mutually agreed but non-binding statement issued in June 2020, during the next six months the UK unilaterally issued multiple “equivalences”, i.e. it considered some of the 41 areas of financial services operating within the European Economic Area as within the scope of the UK’s onshore regulations. But in doing so the UK badly misread the changing geopolitics and seemed blind to the new reality. In January 2021 the relevant minister, John Glen, naively announced his hopes of agreeing an equivalence deal by the end of March, but by June the talks had broken down irretrievably. This snub by the EU was partly an irate response to the UK’s raising (so soon after the agreement) the issue of the renegotiation of the Northern Ireland protocol. But it also reflected the EU’s stated desire to build its own financial infrastructure and move businesses such as euro clearing to the continent.

Now a further seven months have elapsed. Nothing in the form of EU infrastructure planning has happened. We suspect the simple reason is that the supervisory and regulatory arms have realised that they lack the competence to build such infrastructure or even understand how to start to plan.

Consequently, the bulk of the multi-trillion euro foreign exchange business continues to be cleared through the London Clearing House. The EU continues to permit pre-Brexit arrangements under a series of temporary extensions of time. For example, the European Markets Infrastructure Regulation (EMIR) covering all trading of derivatives expires in June 2022. So far so good; disruption has been avoided as London branches of EU firms have been permitted to continue to trade derivatives. This temporary equivalence has been extended for a further three years just this week, although the UK authorities have disbarred four firms for exploiting the regime, as a bit of sabre-rattling. Neither has the EU recognised UK trading venues as ‘equivalent’ for derivatives trading.     Should relations with the UK deteriorate further, no doubt these two points will be raised as leverage.

Conclusion – Likely Future ECB and Monetary Policy

Whilst there seems to be little prospect of member states like Germany, the Netherlands and Austria acceding to President Macron’s demands to formally roll back the fiscal rules, there is little doubt that the ECB is satisfied with appealing to present and new member states through its supranational bond liquidity mechanism. This arrangement has preserved the most important power which the EU/ ECB exert over member states: access to euro refinancing. Nothing will change, we predict, whilst financial markets and stronger states such as Germany put up with this largesse. Everything therefore appears calm and the ECB firmly in control, but as set out above, riddled with risks to stability.

[1] European Exchange Rate Mechanism2