Some may be underwhelmed by the details, but the fund represents a significant development for the longer term, with important implications for ‘peripheral’ risk.
Last week, following an initial proposal from French President Emmanuel Macron and German Chancellor Angela Merkel on 18 May, the European Commission shared its plans for a European recovery fund.
The €500 billion in grants represent an important symbolic step closer to debt mutualisation. First, leaders have recognised the need for fiscal transfers. Second, it would be done through joint issuance, albeit through the European Commission backed by the EU-27 budget, showing a greater understanding that a priority is to minimise the cost of debt issuance and avoid burdening national balance sheets (as the grants would not count towards debt/GDP ratios, neither would the contingent liabilities).
The additional €250 billion in loans proposed by the Commission may not be fiscal transfers, nor can they be excluded from a member state’s debt/GDP ratio, but they do offer further lower-cost support for peripheral countries without being subject to the same scrutiny over how the grants will be spent.
Through the disbursement of proceeds according to economic need rather than just impact from COVID-19, the plan takes account of the less favourable position of some southern states which are still suffering from the prior crisis. It thus seems that high-debt countries will be the primary beneficiaries.
The repayment terms, meanwhile, appear more favourable than had been expected. The Commission’s proposal spreads the cost over 30 years, beginning only in 2028, and there is also a plan to increase the ‘own resources’ ceiling and generate income through new emissions and digital taxes, which correspond with the push towards a greener European budget.
Agreement on additional taxation has historically been difficult, but the reduction in direct member-state contributions to the fund may well be incentive enough in this case and could lower the burden by as much as €25-35 billion per annum according to the proposal document.
Yet that is not to say that turning the proposal into reality will be easy, as all EU national governments will have to ratify it. Austria, the Netherlands, and a few other countries might resist, but the fact that the two European ‘superpowers’ seem to have granted their approval is an important positive.
Questions remain for investors too. Does the proposal go far enough? A slight disappointment may be the pace of implementation, with only €120-150 billion scheduled to be raised in 2021 and the remainder to take place in subsequent years out to 2024.
Moreover, at less than 6% of European GDP, the proposal is clearly not sufficient to absorb all of the virus-related costs – but that isn’t the only goal. As important as the fund itself is, we should also bear in mind the broader objective of signalling European solidarity and establishing a framework for risk-sharing that could be revisited in future crises.
In isolation, the plan is probably not enough to reassure markets about peripheral bonds and the funds would probably arrive too late. However, we think it needs to be viewed in context of other support from the European Central Bank, the Support to mitigate Unemployment Risks in an Emergency (SURE) programme, European Investment Bank, and European Stability Mechanism.
The proposal does not represent full debt mutualisation; nor is it a guarantee that risk-sharing will expand in the future. It is indeed being presented as a temporary, rather than permanent, solution. The political reality is that this is essential to sell the plan to the so-called ‘frugal four’ (Austria, Sweden, Denmark, and the Netherlands) as well as sceptical domestic electorates.
It has nevertheless indicated that the EU has moved closer towards debt mutualisation and risk-sharing. If the eventual agreement resembles the present proposal, then the belief it restores in the European project is likely to outweigh the economic benefits the fund produces in its own right. The coming negotiations will be very telling in that regard.
Taken together, there may be enough to allay market concerns in the near term. As highlighted by the recent moves in spreads, shorting ‘peripheral’ risk has become significantly less attractive.