Nicola Mai (PIMCO) | With euro area output expected to drop by almost 10% this year, and unemployment and fiscal deficits to rise, an ample, blunt and well-coordinated response from European ministers was warranted. However, the new measures announced by finance ministers last week disappointed – again.
At face value, the €540 billion (bn) package announced by euro area finance ministers last week sounds impressive. But details suggest it is insufficient and leaves the burden of crisis management in the hands of national governments and the European Central Bank (ECB). While the ECB has the firepower to stabilise the region for some time, the continued lack of political coordination means the region will remain fragile.
Our projections for the euro area foresee a nearly 10% fall in gross domestic product (GDP) in 2020, a nearly 4% rise in unemployment, and a steep rise in fiscal deficits to above 10% of GDP across most countries. Although we expect a short recession, lasting perhaps until the middle of the year, the damage will be deep: Output may not return to pre-crisis levels until sometime in 2022. The crisis will leave sovereign balance sheets in a vulnerable state, underscoring the importance of a coordinated crisis response.
The euro area finance ministers’ package includes:
- €240bn in European Stability Mechanism (ESM) loans to sovereigns for healthcare expenditures, offered with light conditions
- A €100bn European Commission low-cost lending facility for sovereigns to help finance unemployment schemes
- A €25bn increase in European Investment Bank (EIB) funds that, when leveraged, could provide €200 billion in financing for companies
This package looks unconvincing in the following respects:
- Insufficient scale: The measures look small relative to the scale of the crisis. In the ESM facility, sovereigns can borrow up to 2% of their respective GDP, not a particularly high amount. The €25bn of guarantees that could be leveraged to provide €200bn of loans pales in front of the almost €2 trillion commitment already implemented by national governments. And the €100 billion (less than 1% of euro area GDP) committed to help with unemployment is tiny compared to what will actually be spent for that purpose.
- More debt: The use of loans will not relieve national fiscal deficits. Both the ESM’s and the European Commission’s facilities are funding tools, not transfers, and will add to countries’ deficit and debt levels.
- Potential stigma: The use of ESM programmes, albeit with few conditions, raises a potential stigma for the countries that access them – unless all countries tap into the facility at once. Granted, asking for ESM support can lead to the activation of ECB purchases under the central bank’s Outright Monetary Transactions (OMT) programme. But the conditional nature of this type of support, coupled with its inherent lack of flexibility, suggests that the ECB is better off sticking with the programmes it set up more recently (more below).
- Lack of mutualisation: Ministers said that discussion continues regarding a common “Recovery Fund” for investments but conceded that how to fund it remains a clear sticking point. One option being considered is the issuance of the first-ever European-wide bonds, a complex move because the euro area has 19 different fiscal authorities. Opposition from Northern European countries remains strong, suggesting that common bonds are far from imminent.
De facto mutualisation works, but is imperfect
This unconvincing pan-European fiscal response leaves the ball in the court of national governments and the ECB for tackling the crisis. The recent launch of the ECB’s €750 billion Pandemic Emergency Purchase Programme (PEPP), on top of its earlier commitment of €120 billion of asset purchases, means that the central bank can continue to buy time for sovereigns: In practice, however, the ECB is providing a de facto, though not de jure (or officially sanctioned) mutualisation of sovereign risk. While the strategy may be effective for now, we see at least three problems with this setup:
- ECB’s conditional commitment: The macroeconomic deterioration we expect means the ECB will probably need to renew its commitment to stabilising the region at some point. In the absence of a more unconditional sovereign yield-control strategy (see In Europe the Crisis Policy Response Is Substantial, But More Is Likely Needed), markets will wonder about the central bank’s commitment to its “lender of last resort” role, and about what next steps could the ECB take.
- Incomplete government response: The lack of a truly unconditional commitment will leave governments in weaker peripheral countries in doubt about the duration and consistency of the support they receive. The result may be a suboptimal amount of support for fiscal easing, causing a macro deterioration that could be worse than it needs to be.
- More euroscepticism: The absence of a convincing federal fiscal response to what is a common and exogenous crisis could increasingly antagonise populations of weaker countries towards the European Union. The recent increase in eurosceptic sentiment in Italy and Spain is telling in this regard.
Outlook and investment implications
History suggests that crises foster creativity and innovation in European policymaking, and common bonds could be an example of this. But judging by the tone of discussions and the reported acrimony in recent meetings, we don’t see this as imminent. We believe the sense of division and fragility within the euro area will remain for some time.
Our conviction that the ECB will do what’s needed to stabilise the system for now means that we see some value in peripheral sovereign spreads at current levels. However, and in order to increase our conviction in this belief, we need to see more from euro area officials. We’re not there yet.