A Game Changer For The Euro Awaits

Olivia Álvarez (Monex Europe) | The European Commission is expected to present a new proposal for the Eurozone recovery fund next Wednesday 27th May. EC President Ursula von der Leyen, has previously called for an “ambitious” plan to overcome the current unprecedented crisis, after several failed attempts to come up with a joint fiscal effort in the area. The latest proposal from France and Germany for a mutualised debt issuance may mark a turning point in the history of the European integration project.

The core of the €500 billion German-French proposal is the idea of raising mutual debt via the EU budget to be distributed among countries worst hit by the pandemic in the form of grants. The plan has strong economic and symbolic significance. On one hand, it could serve as an effective mechanism to channel funds to fiscally challenged countries like Italy and Spain, in order to ease the economic pain left by the pandemic. Crucially, it will also complement ECB´s efforts to stimulate the recovery via asset purchases, by narrowing peripheral bond yield spreads. On the other hand, a step towards the direction of a mutual debt mechanism in the Eurozone also removes the political risk of further fragmentation in the area. If the proposal becomes reality, a debt instrument backed-up by European institutions could share in the dominance of US and Japanese safe assets worldwide and provide the EU some extra political capital.

As the proposal currently stands, von der Leyen has reportedly found a “landing zone” for the size of the recovery fund, although the €1.5tn firepower demanded by Southern European governments has faced opposition from Northern states and some Eastern European countries. The ECB puts the fiscal cost of the pandemic at between 1 trillion and 1.5 trillion euros, while the worst-case scenario could rise as high as 2.5 trillion euros according to Bloomberg estimates. Beyond of the package size, however, the strategy faces additional challenges and questions:

  • Loans vs Grants: For the package to work most effectively, a large part of the stimulus must be given as grants to damaged economies, as opposed to loans on capital markets conditions. The advantage of grants over loans stems from the neutral effect on national risk premiums, and therefore their ability to promote a sustainable recovery. Germany and France are proposing that 500 billion euros are granted to countries in financial distress and this is the benchmark markets will likely be assessing the final plan against. If the grant portion was cut to, for example, €200bn, the measures may have a limited impact in boosting market confidence.
  • Distribution criteria: The economic impact of the bailout will depend on how the funding is distributed among member states. If it is spread evenly across the bloc, the significance will be diminished. The German-French proposal allows a disproportionate share of the funding according to idiosyncratic financing needs.
  • Duration and maturity: The temporary nature of the recovery fund may be a problem in creating enough confidence to raise low-cost funds in capital markets, therefore curtailing the instrument´s potential to overcome the dominance of the German bund as the safest government-backed asset in Europe. The duration of the debt may be constrained by the seven-year period in which the EU budget operates. This would prevent the bloc from building out a full yield curve, which is critical for this instrument to succeed as an alternative European safe asset.
  • Strings attached: Member states will also have to discuss how the debt will be repaid out of future EU budgets in a sustainable manner. The commission stands ready to ask member states to grant it fresh revenue streams or “own resources” in the form of already existing custom duties. Other likely ideas –aligned with EU policies- are plastics or digital taxes, which are, in turn, politically contentious among some state members.
  • Timing: Even if agreed, the recovery money would only arrive next year after a full round of negotiations in the European Council and Parliament.