Perspective

EU takes giant leap and edges towards fiscal union


One of the longest ever EU leaders’ summits ended after four days of intensive talks with an unprecedented agreement. The club of 27 member states agreed to create a €750 billion EU recovery fund (also known as Next Generation EU), which will be made up of €390 billion of grants and €360 billion of loans to be distributed amongst member states to aid in the recovery from the coronavirus pandemic.

The “frugal five” get their way

Negotiations were held up by the frugal five member states (Netherlands, Austria, Denmark, Sweden and occasionally Finland) who managed to reduce the grant component from the originally proposed €500 billion to €390 billion, though the overall size of the fund was unchanged and the gap filled by increased loans.

It’s worth noting that the first proposal of such a fund was at least twice as large. Still, the agreement means that funds will be distributed from the second half of 2021 until 2026, with most of the disbursement completed by 2023. Ideally, funds would be distributed sooner, but if good value projects are found and backed, the additional fiscal stimulus will boost GDP growth over those years while the reform effort could also lift productivity growth over the medium to long term. This should help boost demand for European equities and credit.  

The loans distributed by the fund will be repaid with very low interest rates over a 30-year period from 2027. Meanwhile, the cost of the grants will be picked up through the annual subscription charges for EU membership.

The amounts member states receive and repay depends on past GDP growth, unemployment rates, and to a lesser extent the actual impact of the coronavirus pandemic on the economy (a point that frugal members were unhappy about).

Many of the smaller and poorer member states stand to be net beneficiaries, along with countries such as Greece, Portugal, Spain and Italy.

Germany, France and many of the northern member states would end up being net contributors to the fund over the long-term, hence the resistance from the frugal five. In the end, the deadlock was broken by the rest of the EU agreeing to increase the size of the annual rebates the frugal member states receive. For example, Austria’s rebate will be doubled to €565 million, while the Netherlands’ rebate will increase from €1.57 billion to €1.92 billion. This of course increases the burden on Germany and France, but technically keeps the whole union involved in the process.

Conditionality strengthened

Funds offered are not without conditions or oversight. Member states are expected to use funds to invest in reforming their economies, including digitalisation and a green investment agenda.

The Netherlands successfully pushed for the inclusion of emergency brakes, to allow member states to object to and halt the distribution of funds if another member state is not honouring promises to reform its economy. However, as a compromise, the dispute must be resolved within three months and the outcome will be decided by the European Commission.

Another dispute arose due to the inclusion of a “rule of law” clause which sought to stop funding to countries that fell foul of EU rules. This was clearly targeted at Hungary and Poland, who have in the past weakened institutions including judicial independence.

With some of these countries threatening to block the whole deal, a compromise was reached where a weighted majority of member states would have to vote for the suspension of funds.

The negotiations also wrapped up the Multiannual Financial Framework (MFF) for 2021 to 2027 which will total €1.074 trillion. This will not only cover the cost of administrating the EU, but also six other major spending programmes. This includes: investing in modernised, sustainable agricultural, maritime and fisheries policy; advancing climate action and promoting biodiversity protection; investing migration and border management and investing in security and defence (see chart 1).

EU-recovery-chart1.jpg

Safeguarding the union

Combined with the European Central Bank’s (ECB) huge quantitative easing programme, the EU recovery fund should be sufficient to allay near-term fears over funding for member states. At the height of the coronavirus crisis in March, the cost of borrowing for many governments, including Italy and Spain rose sharply (see chart 2).

Compared to German bond yields, the spread of Italian bonds rose over 150 basis points, signalling market concerns that Italy may not be able to keep its public finances under control. Indeed, when considering Italy’s economy, required fiscal stimulus and its politics, even we questioned its survival in the monetary union (see: Are Italy’s days in the eurozone numbered?).

EU-recovery-chart2.jpg

Since the ECB upped its Pandemic Emergency Purchase Programme (PEPP) to €1.35 trillion and news first broke of the potential creation of the EU recovery fund, the premium that investors had demanded to lend to riskier member states started to fall. It was therefore imperative for the EU to deliver the agreement in good time.

Though EU politicians focus on the response to the coronavirus pandemic, most investors agree that the real motivation for setting up the EU recovery fund is to bail out overly indebted member states. This is why the criteria used to determine the distribution of funds is skewed to historic metrics rather than attempting to measure and respond to the cost of the crisis.

Large transfers to eastern Europe also have little to do with the pandemic. However, more forward-looking politicians are using the crisis as an opportunity to shape the future of the union. Greater investment in digitalisation, and green projects is important, but so is the requirement to protect the rule of law.   

Evolution of the Union

The European Union is used to re-distributing income (Structural and Cohesion funds) and the provision of aid, but what makes this an evolutionary step is that it will mandate the European Commission (its civil service) the ability to borrow €750 billion that would be jointly guaranteed by all member states.

Where the European Stability Mechanism (ESM) was set up in 2012 to help bailout countries, this will be the first time jointly issued debt will be used to finance regular fiscal policy.

This is not the EU’s “Hamiltonian” moment. Debt has not been mutualised, and the sum (around 5.4% of GDP) remains small in comparison to the aggregate size of the EU’s balance sheet.

Yet, with this crisis, the taboo of jointly-issued debt has finally been overcome, which potentially paves the way for additional future use of the mechanism. It may yet take a few decades and several crises, but the first steps towards a fiscal union have been taken.

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

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