1. Research
  2. Products & Topics
  3. Periodicals
  4. Focus Europe
July 3, 2017
European defence and security spending is a thread that connects several disparate themes: the refugee crisis and the need to better secure EU borders; US criticism of Europe’s NATO spending; and the move towards closer European integration. [more]
30 June 2017 Focus Europe Defence spending, fiscal stimulus and European integration Mark Wall Chief Economist (+44) 20 754-52087 mark.wall@db.com Barbara Boettcher Senior Economist (+49) 69 910-31787 barbara.boettcher@db.com Kevin Koerner Senior Economist (+49) 69 910-31718 kevin.koerner@db.com ■ European defence and security spending is a thread that connects several disparate themes: the refugee crisis and the need to better secure EU borders; US criticism of Europe’s NATO spending; and the move towards closer European integration. ■ A Macron-Merkel alliance promises to push European integration. Strengthening the single currency area will take time. Progress towards a common treasury, stabilization funds and safe bonds is unlikely before 2020 – after the next European Parliamentary elections. These ideas are controversial, complex and not guaranteed to materialize. ■ Defence and security issues, on the other hand, are more immediate and are starting to be addressed by policy with the recent European Defence Action Plan (EDAP). How far Europe is willing to go in this area could signal the appetite for progress in other areas too. ■ In this report we do two things. First, we review the EDAP from a fiscal perspective. Our conclusion is the EDAP is too small to be considered an economic stimulus. If the project bond (leverage) element is fully exploited, the scale could be a little more relevant. A more meaningful economic impact would need either convergence to the NATO 2% of GDP defence spending target before the 2024 deadline or a higher target. However, merely meeting the existing target will be challenging enough in countries like Germany. ■ Second, we present a framework to help markets judge integration initiatives in general. The key dimensions of integration initiatives are: the political objective, source of funds, fiscal sustainability, sovereignty and mutualisation. We identify more positive and less positive characteristics based on existing European institutions. ■ Using this framework we judge the EDAP to be a very modest integration step at best. The political objective – closer Europe integration via defence policy – is a very significant political signal. The corollary is it is controversial. This limits the policy’s scope and minimizes the fiscal sustainability ramifications. In terms of sovereignty and mutualisation the EDAP does not break new ground. ■ Merkel and Macron have a unique opportunity to improve European institutions. The signaling benefits of integration should not be underestimated and may help restrain yields as the ECB gradually exits QE. However, achieving the headline objectives requires detailed mechanisms. We urge some caution. First, Merkel’s support for Macron should not be misinterpreted as Germany saying the price for greater European solidarity has declined. Second, mutualisation will remain politically very difficult. Page 2 Deutsche Bank AG/London 30 June 2017 Focus Europe Figure 1: US defence spending equates to more than 70% of the NATO total 65 67 69 71 73 75 0 5 10 15 20 25 2009 2010 2011 2012 2013 2014 2015 2016e EU NATO ex UK Non-EU NATO plus UK United States (rhs) Source: Deutsche Bank, NATO Defence spending trends Recent defence spending trends . The economic crisis and attending pressures on public finances added to the trends in place since the collapse of the Soviet Union in early 1990s and pushed European defence spending lower. Spending by EU NATO members fell by 12% in real terms over the last decade. Spending is now 1.5% of GDP despite an agreement in 2006, and reconfirmed in 2014, to raise defence spending to 2% of GDP. 1 European defence spending is at least bottoming out and beginning to rise – defence spending increased in 2016, led by Eastern European member states. However, at 1.5% of GDP in aggregate it significantly lags others, for example, 3.6% of GDP in the US and 4.2% of GDP in Russia. For comparison, Germany, France and Italy currently spend 1.2%, 1.8% and 1.1% of GDP on defence. NATO spending target . The NATO defence spending target is 2% of GDP. The recent confirmation of the target by 2024, which is just a voluntary objective, is currently met by only 4 of the 22 EU NATO countries (Greece, UK, Estonia and Poland). For those furthest away, closing the gap implies a significant commitment of resources, e.g., Spain would have to increase spending 15% per annum. Limited fiscal stimulus . From a level of 1.5% of GDP on average today, a linear convergence to the 2% 2024 target implies less than 0.1pp of GDP additional spending on defence per year for the EU. Since “stimulus” is calculated on a change basis, this implies no more than 0.1% of GDP stimulus for the economy per annum through the period of adjustment. This is not large enough to be considered equivalent to a fiscal stimulus programme. Put differently, for defence spending to be a meaningful source of economic stimulus either the convergence to the 2% of GDP spending target will need to be more rapid or the 2% target will need to be raised. Given the strategic environment, there is likely to be pressure for the former if not also the latter. The question is, will European politics support it? 122 of the current 28 EU members are also members of NATO. The EU member states not part of NATO are Austria, Cyprus, Finland, Ireland, Malta and Sweden. Deutsche Bank AG/London Page 3 30 June 2017 Focus Europe Figure 2: NATO Europe vs US spending – % of GDP 0.0 1.0 2.0 3.0 4.0 5.0 6.0 2009 2010 2011 2012 2013 2014 2015 2016e NATO Europe United States NATO total Defense spending, % of GDP Source: Deutsche Bank, NATO Figure 3: EMU Big 4 defence spending – % of GDP 0.80 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2009 2010 2011 2012 2013 2014 2015 2016e Germany France Italy Spain NATO target Defense spending, % of GDP Source: Deutsche Bank, NATO The politics of European defence spending Deeper defence integration foreseen in European treaties . The rapid agreement on plans for enhanced EU defence cooperation at the June European Council meeting has been a display of unity and preparedness for new areas of cooperation amongst EU countries as the Union faces the unprecedented separation from one of its largest members. Deeper European defence integration is by no means a new idea. In fact, it is explicitly foreseen in the EU treaty. But the topic remained dormant over the years, not least due to concerns in the UK that this would overlap with existing NATO capacities. No 'EU army’ . Following the UK's decision to leave the Union, France and Germany pushed to reinvigorate the plan and received support at a September 2016 meeting of EU defence ministers (excluding UK) in Bratislava. Current initiatives that foresee a “European Defence Fund” (more below), cost sharing for European battle groups and EU military missions of willing countries remain far behind the creation of an 'EU army' feared by critics. It would also not affect the neutrality of non-NATO EU members (any further defence integration is voluntary) nor interfere with the treaty commitments of NATO countries. 2 European preference to spend 'better' rather than 'more'. Responding to repeated US calls for increased European defence spending, EU heads of state, including French President Emmanuel Macron and German Chancellor Angela Merkel, confirmed their commitment to the NATO objectives. However, feasibility will depend on several factors, including EU members' fiscal latitude, European and national policy preferences as well public opinion. Emphasizing national budget constraints, European initiatives for deeper defence integration focus primarily on more efficient use of resources, interoperability and reduction of duplicity in military (R&D/procurement) expenditures. The aim is to "spend better and improve value for money" rather than a substantial increase in overall spending. 3 This goes in hand with the understanding that an increased military budget not necessarily translates into more effective and operational armed forces. 2See European Parliament (2016): “Implementation of the Lisbon Treaty provisions on the Common Security and Defence Policy (CSDP)” on Article 42(7) TEU. 3See European Commission (2017): “Reflection Paper on the Future of European Defence” and European Commission (2015): “In Defence of Europe” . Page 4 Deutsche Bank AG/London 30 June 2017 Focus Europe NATO commitment bound by EU Fiscal Compact. Current European defence integration plans do not include a European equivalent to the 2% NATO spending objective. Rather, NATO members that members of the euro area have to comply with the 3% of GDP fiscal deficit limit in the Stability and Growth Pact/ Fiscal Compact. Accordingly, leeway for spending increases varies substantially between members. The situation is different when it comes to the European Defence Fund (EDF). The EDF will be partly financed through the EU budget, with additional financing coming from national contributions. These will be treated as "one-offs" under the Stability and Growth Pact and therefore exempted from the Maastricht rule (more below). 4 Figure 4: Euro area NATO member state fiscal balances (2016) -5 -4 -3 -2 -1 0 1 2 Spain France Belgium Italy Portugal Slovenia Slovakia Latvia Estonia Lithuania Netherlands Greece Germany Luxembourg General Government Balance, % of GDP Maastricht deficit limit Source: Deutsche Bank, Eurostat Defence spending politicized ahead of German elections . The question of defence spending is becoming more politicized ahead of German September parliamentary elections. SPD candidate Martin Schulz said that his party would not accept the US "defence spending logic" (Bloomberg, 25.06.2017). Schulz emphasized that the 2% of GDP NATO target is non-binding (Politico, 12.04.2017) and called the implied increase in defence spending from currently 1.2% of GDP unrealistic (Bloomberg, 17.05.2017). Chancellor Merkel responded to US criticism by stretching the equal importance of German development aid (0.7% of GDP in 2016, meeting the UN target) but emphasized that Germany would do everything it can “in order to fulfil this commitment", with reference to NATO's spending targets (Politico, 18.02.2017). There are also voices in Germany that call for an international security engagement that goes beyond the 2% of GDP NATO target. Wolfgang lschinger, chair of the Munich Security Conference (MSC) and former German ambassador to the US, recommends a 3% of GDP target for international security spending, foreign defence, foreign policy and foreign aid (MSC, 18.02.2017). His proposal has the support of the German liberal party (FDP). The public discussion about Germany's military role and strength within Europe has always been rather ambivalent, not least due to historical considerations that also find expression in the country's preference for ‘soft power’ and diplomacy. On the one hand, opinion polls show strong public support for a common EU defence and security policy in Germany (85% of respondents, according to 4See European Commission (2017): “The European Defence Fund: Questions and Answers” . Deutsche Bank AG/London Page 5 30 June 2017 Focus Europe Eurobarometer), one of the highest results in Europe (see chart). On the other hand, 55% of the German population oppose an increase of military expenditure towards 2% of GDP target, according to a recent Forsa poll (stern, 15.02.2017). Also looking at the finance ministry’s current medium-term budget planning (that foresees an average annual (nominal) rise in the defence budget of around 3.5% until 2021) 5 suggests that German military expenditures relative to GDP over the next years might rather remain close to the current levels than move more rapidly to the 2% target or beyond. However, adjustments of the medium-term budget are common under a new government. Figure 5: Percent support for a common defence and security policy among EU member states (2016 Eurobarometer) 0 10 20 30 40 50 60 70 80 90 100 LT LU LV DE EE NL SI ES PL FR BE SK CY HR UE28 MT CZ EL BG HU DK RO PT IE FI IT SE UK AT Source: Deutsche Bank, Eurobarometer European Defence Action Plan (EDAP) Quality vs quantity . To avoid a situation where the additional defence spending is sunk into personnel costs and wages and to start making up for the fact that the post-crisis spending crunch hit defence capital spending and equipment, the NATO commitment has a secondary target of spending 20% of defence resources on equipment procurement and R&D by 2024. Only 5 of the EU NATO members satisfied this requirement in 2015. Collaboration. The economic crisis hit defence spending without any centralized coordination of where Europe could best afford to pull back on defence capital spending. One trend this may have provoked – strengthened by new external threats – is the increasing incidence of defence collaboration across countries, from joint training and exercises to equipment sharing and mixed brigades. Germany is at the leading edge of this trend with more bilateral and mini-lateral arrangements than any other European country. European Defence Action Plan (EDAP). In November 2016 the European Commission unveiled the European Defence Action Plan (EDAP), the main element of which is a European Defence Fund (EDF). This fund has two parts: a “research window” to inject more public funds into defence R&D and a “capability window” to help member states reduce the cost of defence procurement.  6 5See Federal Ministry of Finance (2017): "Regierungsentwurf des Bundeshaushalts 2018 und des Finanzplans bis 2021" . 6In addition to the European Defence Fund, the EDAP also includes policies to help foster defence industry SMEs and strengthen the single market for defence. Page 6 Deutsche Bank AG/London 30 June 2017 Focus Europe Figure 6: Europe lags the US in terms of defence equipment per soldier 0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 EU US Investment in defense equipment per soldier, 2016, USD Source: Deutsche Bank, European Political Strategy Centre/World Economic Forum Research window . The commitment of financial resources is starting very small – EUR25m from the 2017 EU Budget and up to EUR90m in total by 2020. The Commission intends to propose annual spending of EUR500m in the next multi- annual Budget from 2021. This is still a tiny sum from an aggregate EU GDP perspective. It also compares to total EU R&D funding in the 2014-2020 Budget of EUR77bn. Figure 7: 2016 defence spending per capita — NATO member states 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 Albania Belgium Bulgaria * Croatia Czech … Denmark Estonia France Germany Greece Hungary Italy Latvia Lithuania Luxembo … Netherlan … Norway Poland Portugal Romania Slovak … Slovenia Spain Turkey UK North … Canada United … NATO Total 2016 defense spending per capita (2010 US dollars) Source: Deutsche Bank, NATO Capability window. The intention is to support and incentivize joint procurement programmes, thus working with the need to raise defence equipment spending while also piggybacking on the European trend towards defence collaboration across countries. 80% of procurement takes place at a national level and the EU estimates that annual duplication costs in the range of EUR25-100bn. The Commission lists three advantages from the capability window. First, the pooling and synchronizing of national contributions, allowing more efficient defence spending. Second, the “possibility” of a contribution from the EU budget (not fully defined). Third, facilitating access to flexibilities in the Stability and Growth Pact to allow offsets against deficit calculations. The details are either less impressive or still absent. First, the pooling of national contributions refers to the pool of contributions from those countries involved in specific procurement projects for those projects alone. It is not a reference of a general pool whereby those with deeper pockets are willing to finance those with less financial resources. Second, the allocation from the EU Budget amounts to Deutsche Bank AG/London Page 7 30 June 2017 Focus Europe EUR500m until 2020 and EUR1bn annually thereafter. Since the guidance is that the overall spending associated with the capability window – whether national contributions or EU funding – is about EUR5bn per year, the volumes are very small (0.05% of GDP). Project bonds. The Commission documents say the capability window can be used to issue project-specific debt instruments. These instruments could be backed by (a) flows of funds from member states on specific projects, (b) guarantees/paid-in capital for specific projects or (c) guarantees/paid-in capital at an aggregate “umbrella structure” level within the capability window (details yet to be defined). It implies the EUR5bn could be levered up, making the volumes of spending proportionately larger. We can take the ESM as an example of what could be achieved. In the ESM the ratio of lending to paid in capital is x6.25 (EUR500bn/EUR80bn). Using the same ratio, EDAP procurement spending could be as much as EUR31.25bn (0.3% of GDP per year). Since fiscal stimulus is based on the change in spending, there would be a larger – but still not very large – stimulus in the year of implementation only. SGP incentives. There is an incentive for member states to make the most of the capability window and the leverage via project bonds. Any guarantees or paid-in capital from a member state into a project-related debt financing structure can be treated as a one-off within the Stability and Growth Pact and therefore excluded from the structural budget balance calculation when compliance with fiscal goals is being assessed. Section 4: How to judge integration initiatives A Macron-Merkel alliance is an opportunity to push European integration further, at least as far as the single currency area is concerned. Macron mentions common funds for investment spending, unemployment benefits and banking. Merkel has signaled her conditional support for a permanent euro area finance minister with a euro area budget. 7 Outright fiscal integration (i.e., fiscal transfers) will be politically difficult, even in the longer term. We expect smaller steps towards a more integrated Europe. Merely attempting these integration steps will entail political costs and benefits. Their materialization, success and sustainability requires a careful balance between competing forces. The value the market ascribes to an integration initiative is a function of the political objective of the integration initiative and the economic means by which that objective is achieved. Below we present the key criteria by which (spending- based) 8  integration initiatives will be judged. We then judge the EDAP against these criteria. 7 Merkel: “Of course, one can think about a joint finance minister if the framework conditions are right“. She was also open to the idea of a euro area budget “as long as it’s clear that this will truly strengthen structures and do meaningful things“ (Conference of the Federation of German Industries, Politico 20.6.2017). 8 Spending-based integration is different from integration via harmonization of rules, e.g., the Capital Markets Union Page 8 Deutsche Bank AG/London 30 June 2017 Focus Europe Political objective Endorsing integration objectives can be important signals in and of themselves, especially when they are totemic like banking union, defence policy, stabilization mechanisms, etc. The details are often left to follow, but merely achieving the consensus to formalize an integration objective can signal Europe’s progress. The EU has already gone into some detail in terms of identifying what it believes is required to create a stronger currency union with several “Presidents’” reports 9   and more recently a “reflection paper”. 10 The latter mentions the possibility of an EU Treasury, stabilisation mechanisms and safe bonds. It is not just the currency union that Europe is thinking about either. There are also time being invested in thinking about the road forward for the EU in general.  11   We have commented on these reports.   12 Source of funding The resources have to come from somewhere – and it is not going to come from the ECB given the prohibition on monetary financing. Beware old money dressed up as new and overly ambitious leverage ratios. New funds or old funds. One of the key questions is whether or not the funds being committed to a new initiative are new funds or not. For example, EUR8bn of the EUR20bn capital of the European Fund for Strategic Investments (EFSI) came from the EIB, thereby cannibalising another vehicle financing the European economy. It is not obvious, for instance, that the EUR5bn annual “capability window” in the EDAP is a commitment to spending additional resources or is merely the redirecting of resources to new uses (notwithstanding potential efficiency gains from reallocating existing spending). On- or off-balance sheet. The Greek Loan Facility and the EFSF were created in a hurry in 2010. As bilateral loan facilities, both are accounted for “on-balance sheet”. The ESM, on the other hand, is a superior structure. It is a standalone, separately capitalized facility and is “off-balance sheet”. The paid-in capital was a one-off payment and therefore shielded in the calculation of fiscal deficits. Private leverage. The EU often tries to take advantage of leverage. For example, the EUR80bn of paid in capital in the ESM backs total loans of EUR500bn. The EDAP mentions leverage, but does not detail yet what scale may be envisaged. Sometimes the EU stretches credibility of the scale of what can be achieved. For example, the EFSI can scale up its EUR20bn of capital and guarantees to EUR60bn of financial commitments. With private sector commitments, the EU believes the EFSI will drive EUR315bn of aggregate investment spending. This has yet to be proven. Note, because of the prohibition on monetary financing, the ECB will not provide the leverage. 9 http://europa.eu/rapid/press-release_IP-15-5240_en.htm 10 https://ec.europa.eu/commission/publications/reflection-paper-deepening-economic-and-monetary- union_en 11 http://europa.eu/rapid/press-release_IP-17-385_en.htm 12“EMU reflection paper – mere “wish list” or a plausible way forward”, DB Focus Europe, 9 June 2017 and “The future of the EU: Which road to take?”, DB Focus Europe, 24 March 2017. Deutsche Bank AG/London Page 9 30 June 2017 Focus Europe Fiscal sustainability More spending is not costless – someone has to pay and the larger liability needs to make sense from a fiscal sustainability point of view. Where possible, incentives should be created for structural reforms. Volume of net spending. The EUR500bn firepower available to the ESM is impressive. The EUR5bn per annum associated with the EDAP is not. However, size does not equate to net spending. The ESM is a backstop – designed to replace financing that would ordinarily be supplied by the market – whereas the EDAP is not. Fiscal rules. Considering that most member states are already in breach of the European public deficit and debt fiscal rules to greater or lesser degrees, to be effective an integration initiative that involves member states spending their own resources needs to be consistent with the Stability and Growth Pact rules. With the euro area public debt to GDP ratio around 90%, there is a trade-off between more flexible rules and debt sustainability. It would be different if common funds were being spent and no liability to a central facility was being incurred. This is politically controversial and someone still has to pay, either in terms of paid-in capital or guarantees (contingent liabilities). Multipliers, pro-cyclicality and incentives for structural reform. Public investment spending tends to have higher multipliers, as does defence spending (the Commission says defence spending has a multiplier of 1.6). The multiplier is not just a function of the particular tax or spend policy. It is also a function of the circumstances. For example, multipliers tend to be higher when output gaps are more negative. According to the ECB, the output gap should be closed by 2019. There are a few ways to interpret this. First, the effectiveness of fiscal stimulus will decline going forward. Second, the objective should increasingly move to encouraging structural reforms rather than simply boosting spending.  13 Sovereignty Solidarity (the availability of resources) must be balanced by sovereignty (the cost of access). The smaller the cost, the tighter may be the cap on the volume of solidarity. Otherwise, the solidarity may not be politically sustainable. Ex ante costs. Sometimes Europe looks for up-front policy implementation from all member states. One example was the Fiscal Compact – which strengthened the Stability and Growth Pact in various ways including the setting of the objective of balanced or surplus budgets and the introduction of a “debt brake” – as a precondition for the creation of and access to the ESM. Ex post costs. Access to common funds, flexibilities within fiscal rules, etc comes with a price. For example, member states cannot access the ESM loans for bank recapitalization without at least financial sector policies having to be agreed or loans for sovereign financing without more broad-based fiscal and 13In last week’s Focus Europe we looked at why Spain’s structural unemployment rate remains so high. The answer does not lie with construction jobs or youth unemployment per se. The issues are limited worker mobility between regions, wages not adapting to local conditions and the prevalence of temporary employment. Internal adjustment between regions reinforces the need for structural reforms - exiting the euro would not solve this problem. Spain demonstrates the need for carefully designed, locally specific reforms. That implies a highly integrated policy approach by the EU. http://pull.db-gmresearch.com/p/10332-B9A4/284444394/ DB_FocusEurope_2017-06-23_fcf9e57b-8ffe-4c10-9505-2b449d5cf5f4_604.pdf Page 10 Deutsche Bank AG/London 30 June 2017 Focus Europe structural policies being agreed. The more onerous the cost, the more the lending facilities play an ultimate backstop role only – a safety net used only in extreme circumstances. These facilities do not rule out uncertainty and volatility. Mutualisation This is the ultimate objective for integrationists and the red line for those who favour the original monetary union-only model. Mutualisation remains extremely contentious. We do not see genuine mutualisation of any significant volume without a significant crisis, and even then it is not guaranteed to be agreed. Limited liability. The EU has no open-ended common spending facilities and follows different models for making common resources available to member states. With the ESM, all member state had access to the common poll of resources from the start. With the Single Resolution Fund (SRF), national resolution funds gradually co-mingles into a common pool over an eight year phasing in period up to the maximum EUR55bn. Fiscal backstops. Sometimes facilities are not fully funded. To address the risk that the SRF might not have sufficient funds there are calls for it to have a borrowing capacity. One option is for it to have the authority to borrow resources on its own account. This would need to be underwritten by the member states and capped. An alternative is to give the ESM the power to lend to the SRF. However, this would reduce the resources available to the ESM and would contradict one of the lessons from the crisis, that is, the correlation between sovereign and banking stress. Indemnity. In general, European facilities grant loans that need to be repaid. Sometimes the instrument that Europe invests in is not a loan, for example, the ESM direct recapitalization mechanism would take an equity position in a financial institution. A loan or bond is a known stream of cash flows. An equity is a different level of risk being taken with European “taxpayer” resources. To protect the value of the investment and ensure the right incentives, if a member states cannot afford to co-invest alongside the ESM any loss incurred by the ESM will be converted into a long-term loan, limiting mutualisation risk. Figure 8: How to think about integration initiatives 1. Political objective 2. Economic means (structure and detail) 2.(a) Sources of funds 2.(b) Sustainability Positive: Off-balance sheet structure Positive: Satisfies fiscal rules or cofinanced Negative: Old money repurposed Negative: Deterioration in fiscal sustainability 2.(c) Sovereignty 2.(d) Mutualisation Positive: Balance between access and cost Positive: Co-financing (transfers unlikely) Negative: If does not incentivise reform Negative: Indemnification Source: Deutsche Bank Co-financing. One means of delivering financial resources to member states is the European Structural and Investment Funds. These funds are not loans and do not require indemnification. However, they do require the recipient country to have sufficient financial capacity to provide about 25-50% of a project’s financial requirements. Since the crisis the EU has begun to reduce the co-financing rates to improve the capacity of weak countries to absorb the structural funds Deutsche Bank AG/London Page 11 30 June 2017 Focus Europe committed to them. A similar approach could be used with future integration initiatives, notwithstanding the issues regarding the source of the funds (new, old, leveraged) and the impact on net funding from the EU. Expect a high degree of central European control over the use of such funds. EDAP as an integration initiative: politically significant, but very modest overall Higher defence and security spending potentially connects several separate themes, from the refugee crisis and securing Europe’s borders on the one hand to defending Europe against US criticism on the other. A common defence policy is also a route to a more integrated Europe. However, relative to the above integration criteria, the EDAP is a very modest policy at best. In terms of political objective – closer Europe integration via defence policy – the EDAP crosses a significant historical rubicon as the EU has seen itself more as a “soft power“ than as a military one (in fact, the EU’s engagement in the UN peace mission is larger than the US, for example). The symbolism of a European defence policy is high. The corollary is it is controversial and this probably limits the scope of the policy, for example, the EU denies it is trying to create an “EU army”. Figure 9: EDAP as an integration initiative: politically significant, otherwise very modest at best 1. Political objective – significant positive : closer union via defense policy 2. Economic means (structure and detail) – neutral to very modest positive 2.(a) Sources of funds 2.(b) Sustainability Not clear if old money or new; Not large enough to be a threat to sustainability. scope for leveraging private money Private leverage incentivised by fiscal rules 2.(c) Sovereignty 2.(d) Mutualisation Assets procured must be consistent with EU Very small provision of funds from EU Budget; objectives, but assets not owned or directed most risk is on the member state(s) procuring by EU the asset(s) Source: Deutsche Bank In terms of source of funds and financial sustainability, it is not clear the EDAP is “new money”; we suspect not. The EDAP wants to utilize leverage and member states that do use project bond financing can avail of the Stability and Growth Pact shield on the paid-in capital or guarantees. But the size of the facility is very small so far. There would need to be an agreement to either hit the NATO defence spending target more rapidly than 2024 or raise the target to believe the EDAP has an economic stimulus element. We think Germany would do well to reach the original target, so expectations should be limited. From the perspective of sovereignty and mutualisation there is little to suggest the EDAP is breaking any new ground in terms of (economic) integration. Other than the military assets being procured having to comply with centrally agreed requirements and procurement being opened up to other member states, there is neither common ownership of the assets nor a mutualisation of financial risk beyond the natural diversification of the two (or more) member states procuring the asset. Page 12 Deutsche Bank AG/London 30 June 2017 Focus Europe Appendix 1 Important Disclosures *Other information available upon request *Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg, and other vendors. Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr . Aside from within this report, important conflict disclosures can also be found at https://gm/db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Mark Wall, Barbara Boettcher, Kevin Koerner Deutsche Bank AG/London Page 13 30 June 2017 Focus Europe Additional Information The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). Though the information herein is believed to be reliable and has been obtained from public sources believed to be reliable, Deutsche Bank makes no representation as to its accuracy or completeness. Hyperlinks to third- party websites in this report are provided for reader convenience only. Deutsche Bank neither endorses the content nor is responsible for the accuracy or security controls of these websites. If you use the services of Deutsche Bank in connection with a purchase or sale of a security that is discussed in this report, or is included or discussed in another communication (oral or written) from a Deutsche Bank analyst, Deutsche Bank may act as principal for its own account or as agent for another person. Deutsche Bank may consider this report in deciding to trade as principal. It may also engage in transactions, for its own account or with customers, in a manner inconsistent with the views taken in this research report. Others within Deutsche Bank, including strategists, sales staff and other analysts, may take views that are inconsistent with those taken in this research report. Deutsche Bank issues a variety of research products, including fundamental analysis, equity-linked analysis, quantitative analysis and trade ideas. Recommendations contained in one type of communication may differ from recommendations contained in others, whether as a result of differing time horizons, methodologies or otherwise. Deutsche Bank and/or its affiliates may also be holding debt or equity securities of the issuers it writes on. Analysts are paid in part based on the profitability of Deutsche Bank AG and its affiliates, which includes investment banking, trading and principal trading revenues. Opinions, estimates and projections constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank provides liquidity for buyers and sellers of securities issued by the companies it covers. Deutsche Bank research analysts sometimes have shorter-term trade ideas that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. Trade ideas for equities can be found at the SOLAR link at http://gm.db.com . A SOLAR idea represents a high conviction belief by an analyst that a stock will outperform or underperform the market and/or sector delineated over a time frame of no less than two weeks. In addition to SOLAR ideas, the analysts named in this report may from time to time discuss with our clients, Deutsche Bank salespersons and Deutsche Bank traders, trading strategies or ideas that reference catalysts or events that may have a near-term or medium-term impact on the market price of the securities discussed in this report, which impact may be directionally counter to the analysts' current 12-month view of total return or investment return as described herein. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof if any opinion, forecast or estimate contained herein changes or subsequently becomes inaccurate. Coverage and the frequency of changes in market conditions and in both general and company specific economic prospects make it difficult to update research at defined intervals. Updates are at the sole discretion of the coverage analyst concerned or of the Research Department Management and as such the majority of reports are published at irregular intervals. This report is provided for informational purposes only and does not take into account the particular investment objectives, financial situations, or needs of individual clients. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst’s judgment. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Prices and availability of financial instruments are subject to change without notice and investment transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Unless otherwise indicated, prices are current as of the end of the previous trading session, and are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank, subject companies, and in some cases, other parties. The Deutsche Bank Research Department is independent of other business areas divisions of the Bank. Details regarding our organizational arrangements and information barriers we have to prevent and avoid conflicts of interest with respect to our research is available on our website under Disclaimer found on the Legal tab. ? ? Page 14 Deutsche Bank AG/London 30 June 2017 Focus Europe Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor who is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which coupons are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements. ? ? Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities, and as such, investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. The risk of loss in futures trading and options, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures and options trading, losses may be incurred that are greater than the amount of funds initially deposited. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the "Characteristics and Risks of Standardized Options”, at http:// www.optionsclearing.com/about/publications/character-risks.jsp . If you are unable to access the website please contact your Deutsche Bank representative for a copy of this important document. ? Participants in foreign exchange transactions may incur risks arising from several factors, including the following: ( i) exchange rates can be volatile and are subject to large fluctuations; ( ii) the value of currencies may be affected by numerous market factors, including world and national economic, political and regulatory events, events in equity and debt markets and changes in interest rates; and (iii) currencies may be subject to devaluation or government imposed exchange controls which could affect the value of the currency. Investors in securities such as ADRs, whose values are affected by the currency of an underlying security, effectively assume currency risk. ? Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. Aside from within this report, important conflict disclosures can also be found at https:// gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. Deutsche Bank (which includes Deutsche Bank AG, its branches and all affiliated companies) is not acting as a financial adviser, consultant or fiduciary to you, any of your agents (collectively, "You" or "Your") with respect to any information provided in the materials attached hereto. Deutsche Bank does not provide investment, legal, tax or accounting advice, Deutsche Bank is not acting as Your impartial adviser, and does not express any opinion or recommendation whatsoever as to any strategies, products or any other information presented in the materials. Information contained herein is being provided solely on the basis that the recipient will make an independent assessment of the merits of any investment decision, and it does not constitute a recommendation of, or express an opinion on, any product or service or any trading strategy. The information presented is general in nature and is not directed to retirement accounts or any specific person or account type, and is therefore provided to You on the express basis that it is not advice, and You may not rely upon it in making Your decision. The information we provide is being directed only to persons we believe to be financially sophisticated, who are capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies, and who understand that Deutsche Bank has financial interests in the offering of its products Deutsche Bank AG/London Page 15 30 June 2017 Focus Europe and services. If this is not the case, or if You are an IRA or other retail investor receiving this directly from us, we ask that you inform us immediately. ? ? United States : Approved and/or distributed by Deutsche Bank Securities Incorporated, a member of FINRA, NFA and SIPC. Analysts located outside of the United States are employed by non-US affiliates that are not subject to FINRA regulations. Germany : Approved and/or distributed by Deutsche Bank AG, a joint stock corporation with limited liability incorporated in the Federal Republic of Germany with its principal office in Frankfurt am Main. Deutsche Bank AG is authorized under German Banking Law and is subject to supervision by the European Central Bank and by BaFin, Germany’s Federal Financial Supervisory Authority. United Kingdom : Approved and/or distributed by Deutsche Bank AG acting through its London Branch at Winchester House, 1 Great Winchester Street, London EC2N 2DB. Deutsche Bank AG in the United Kingdom is authorised by the Prudential Regulation Authority and is subject to limited regulation by the Prudential Regulation Authority and Financial Conduct Authority. Details about the extent of our authorisation and regulation are available on request. ? ? Hong Kong : Distributed by Deutsche Bank AG, Hong Kong Branch or Deutsche Securities Asia Limited. ? ? India : Prepared by Deutsche Equities India Pvt Ltd, which is registered by the Securities and Exchange Board of India (SEBI) as a stock broker. Research Analyst SEBI Registration Number is INH000001741. DEIPL may have received administrative warnings from the SEBI for breaches of Indian regulations. Japan : Approved and/or distributed by Deutsche Securities Inc.(DSI). Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association and The Financial Futures Association of Japan. Commissions and risks involved in stock transactions - for stock transactions, we charge stock commissions and consumption tax by multiplying the transaction amount by the commission rate agreed with each customer. Stock transactions can lead to losses as a result of share price fluctuations and other factors. Transactions in foreign stocks can lead to additional losses stemming from foreign exchange fluctuations. We may also charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless Japan or "Nippon" is specifically designated in the name of the entity. Reports on Japanese listed companies not written by analysts of DSI are written by Deutsche Bank Group's analysts with the coverage companies specified by DSI. Some of the foreign securities stated on this report are not disclosed according to the Financial Instruments and Exchange Law of Japan. Target prices set by Deutsche Bank's equity analysts are based on a 12-month forecast period. Korea : Distributed by Deutsche Securities Korea Co. South Africa : Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). ? ? Singapore : by Deutsche Bank AG, Singapore Branch or Deutsche Securities Asia Limited, Singapore Branch (One Raffles Quay #18-00 South Tower Singapore 048583, +65 6423 8001), which may be contacted in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), they accept legal responsibility to such person for its contents. Taiwan : Information on securities/investments that trade in Taiwan is for your reference only. Readers should independently evaluate investment risks and are solely responsible for their investment decisions. Deutsche Bank research may not be distributed to the Taiwan public media or quoted or used by the Taiwan public media without written consent. Information on securities/instruments that do not trade in Taiwan is for informational purposes only and is not to be Page 16 Deutsche Bank AG/London 30 June 2017 Focus Europe construed as a recommendation to trade in such securities/instruments. Deutsche Securities Asia Limited, Taipei Branch may not execute transactions for clients in these securities/instruments. ? ? Qatar : Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial Centre Regulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall within the scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower, West Bay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Business Customers, as defined by the Qatar Financial Centre Regulatory Authority. Russia : This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation. ? Kingdom of Saudi Arabia : Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated by the Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities that fall within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al Olaya District, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia. ? ? United Arab Emirates : Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulated by the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial services activities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by the Dubai Financial Services Authority. Australia : Retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Please refer to Australian specific research disclosures and related information at https://australia.db.com/australia/content/ research-information.html ? ? Australia and New Zealand : This research is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. ? Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published without Deutsche Bank's prior written consent. Copyright © 2017 Deutsche Bank AG Deutsche Bank AG/London Page 17 David Folkerts-Landau Group Chief Economist and Global Head of Research Raj Hindocha Global Chief Operating Officer Research Michael Spencer Head of APAC Research Global Head of Economics Steve Pollard Head of Americas Research Global Head of Equity Research Anthony Klarman Global Head of Debt Research Paul Reynolds Head of EMEA Equity Research Dave Clark Head of APAC Equity Research Pam Finelli Global Head of Equity Derivatives Research Andreas Neubauer Head of Research - Germany Stuart Kirk Head of Thematic Research International locations Deutsche Bank AG Deutsche Bank Place Level 16 Corner of Hunter & Phillip Streets Sydney, NSW 2000 Australia Tel: (61) 2 8258 1234 Deutsche Bank AG Große Gallusstraße 10-14 60272 Frankfurt am Main Germany Tel: (49) 69 910 00 Deutsche Bank AG Filiale Hongkong International Commerce Centre, 1 Austin Road West,Kowloon, Hong Kong Tel: (852) 2203 8888 Deutsche Securities Inc. 2-11-1 Nagatacho Sanno Park Tower Chiyoda-ku, Tokyo 100-6171 Japan Tel: (81) 3 5156 6770 Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ United Kingdom Tel: (44) 20 7545 8000 Deutsche Bank Securities Inc. 60 Wall Street New York, NY 10005 United States of America Tel: (1) 212 250 2500