EU recovery fund: What will be the impact?

On Wednesday 27 May, the European Commission was the third to present a plan for the EU recovery fund in less than a week. In April, European leaders already agreed such a fund is necessary to fuel the economic recovery after the major dip this year caused by the corona crisis. Yet, it will be very difficult to agree on the size of the fund and how the money should be distributed among member states: via grants or loans, the duration and via which distribution key.

In short, the European Commission proposes to raise EUR 750 billion in the market over 4 years, backed by the EU budget. Between more or less 2021 and 2024, EUR 500bn would be transferred to EU member states in the form of grants and EUR 250bn as cheap loans. In total the fund amounts to 5.4% of EU-27 GDP and 7% of EU-27 debt in 2019. The distribution key has not been officially proposed yet, but the distribution of the money should be mostly based on how hard economies have been hit by the pandemic. In addition, a small share of the grants would benefit those countries facing large challenges with the green transition. The fund would not require an ex-ante increase in national contributions to the EU budget, but ‘only’ national governments’ guarantee to pay interest and principal if there would be insufficient money in future EU budgets to cover these expenses. According to the proposal, bonds would mature between 2028 and 2058 – although in practice bonds could be rolled-over and refinanced. In order to limit the need for higher national contributions in the next multiannual budget running from 2028, the European Commission has proposed to introduce new revenue streams or so-called own resources. In fact it had already done so last year for other reasons and is now reframing that unresolved debate. More specifically, it has now proposed to introduce a carbon border adjustment tax, a digital tax on large tech giants, and own resources based on the enlargement of the emissions trading system (ETS) to the maritime and aviation sector and the operation of large companies.

The Franco-German plan

Earlier, on 18 May, Germany and France (through its respective leadership) presented a joint recovery plan for Europe. A 500bn recovery fund – 3.6% of GDP - that should solely be based on grants. It would be financed through joint long-term debt issued by the EC on behalf of the EU and repaid from the EU’s future budgets. The EC would need a yearly approval of each member state to raise funds. Details on how to distribute the grants and interest and principal payments were lacking. Although, the Commission was charged in April to come up with a proposal that would form the basis for negotiations, the Franco-German agreement, and specifically chancellor Merkel agreeing with increasing fiscal transfers, unleashed euphoria to hard-hit southern member states, the markets and among analysts.

This initial euphoria proved short-lived. On Saturday 23 May, leaders of the ‘frugal four’ (Austria, the Netherlands, Denmark and Sweden) presented a two-pager including a statement that money from the recovery fund should come in the form of cheap loans rather than grants and that it would require strong reform commitments from receiver nations. Additionally, it was stipulated that the increase in national contributions to the EU budget should last for at maximum two years.

Despite this opposition, the Merkel-Macron plan was an opening bid of great significance, representing a potential break with the past, especially for Germany who has a reputation of being against unconditional transfers to less well-off regions. Surely, Chancellor Merkel is taking another leap of faith, possibly spurred by the recent Karlsruhe court ruling on ECB QE, but her CDU party is going strong in the polls and the party didn’t lose any support after the French-German proposal. In contrast, the more Eurosceptic FDP and populist AfD have even slipped whilst the Greens and the Left actually seem to have gained somewhat (figure 1).

With regard to the public opinion, chancellor Merkel seems to be in a comfortable spot to support such a plan. Her approval ratings have surged since the start of the pandemic (the so called ‘flock to the leader’-effect). And the electoral group most likely to disapprove of the plan, the voters of the AfD, are already unhappy about the current direction of the government. So chancellor Merkel will unlikely lose support there. According to a recent Civey Institute poll for Der Spiegel, 51% of the Germans support the plan whilst 34% of the people oppose it, which doesn’t seem to be a bad starting point.

And the fact that several prominent German politicians including Armin Laschet and even former German finance minister and current Bundestag President, Wolfgang Schäuble – who made his reputation for being frugal and taking a very strict stance during the sovereign debt crisis – has thrown his weight behind Merkel’s call is probably even more significant.

Although net-transfers are already the case in the EU, the recovery fund could lead to a substantial one-time increase of (additional) net financial transfers between member states under the flag of solidarity. Yet even more so, the recovery fund would be a game changerif it were to lead to liability pooling. But there is a long way to go before an agreement on the details is reached.

Crucially, the Commission’s proposal will require the unanimous support of all 27 member states before it can become operational[1]. Whereas hard-hit countries are opposed to loans and conditionality, the frugal four[2] are opposed to grants and demand conditionality[3]. Meanwhile, Eastern member states will likely focus on the distribution key since they will receive less if this key is mainly based on the economic outlook for 2020 (and hence the size of the Covid-19 shock) instead of the level of per-capita-GDP, which is one of the main determinants of the current budget distribution key. As figure 2 shows, countries under the 45-degree line would ‘gain’ the most as compared to the EU’s regular way of distributing funds[4].

[1] Technically, all member states that are on board could decide to move ahead together, separate from the opposing ones. But for now such a ‘break-out’ scenario seems unlikely.

[2] And, reportedly, Estonia has also opposed the EC-plans.

[3] We also discussed the arguments of the proponents and opponents of Coronabonds in a piece published in April.

[4] We have calculated the amount of grants to GDP each country would get when using the current EU budget distribution key, which is based on GDP per capita amongst other things. We also calculated that amount if the distribution key would solely be based on the economic projection in 2020, using the European Commission’s forecast. Hungary and Bulgaria would ‘lose’ the most and Italy and the Netherlands would gain the most when the GDP growth outlook would become the main determinant. This graph is solely exemplary, the ultimate distribution key used will likely be incorporating multiple variables.

Room for a compromise

Still, we believe some form of compromise can be found. For starters, all member states agree that the current crisis justifies extra-ordinary measures to combat the economic fallout. Furthermore, if designed properly, the recovery fund could benefit all member states. All member states should receive additional money in the coming years to support the economy, while repayment costs would only come in the long term. But what is perhaps more important is the realisation that the potential costs of not moving forward with this fund could be far larger for all member states (the thinking here being that failure to resolve this crisis would ultimately lead to the demise of the Eurozone/EU altogether). This thinking, arguably, is what has swayed the Germans. And given the creditworthiness of debt backed by the EU budget, and hence all of its member states, and the expected large demand for a (non-dollar) safe asset, the interest rate on such loans is likely to be very low. Some indication for that can be gauged from long-term bonds issued by the ESM. For example, the 0.75% 5-Sep-2028 bond is currently trading at a yield of around -0.21% and a 0.77% 4-Dec 2028 EU bond is trading at around -0.14%. (Much) longer maturities are likely to require positive yields, however.

In addition, part of the plan is that new own resources for the EC could generate sufficient income to pay for interest costs – if there are any – and part of principal repayments in the future – again, if there are any. Clearly, this is a controversial topic and there has been quite some debate about such new own resources for years. Especially a common EU tax on corporate income has met with resistance by several member states. But other options, such as a digital tax, would appear less controversial. Indeed, the EC proposal leaves a lot of room for making compromises on this front.

Finally, even if this recovery fund will be designed as being ‘temporary’, implying principal repayments, it could still be decided at a later stage to extend the repayment by rolling over debt in to maturities that exceed the current repayment period. Indeed, highlighting such a possibility would be another sign of ‘Rubicon Crossing’ significance.

Step into line or step out of it?

Furthermore, we need to bear in mind that the opposing ‘frugal four’ lack firepower in terms of their combined weight in EU27 GDP. They represent only about 10% of EU GDP. To the extent that such a share is also an indication of their political weight, it seems unlikely they will be able to continue to block a policy which has the backing of all the rest. If not with the sole intention to improve the EC plan, it would severely damage goodwill towards and negotiating power of the frugal four in future negotiations within the EU. Especially for the Netherlands, which is already being seen as the villain by many given its tax-haven-like practices, it would further strain their relationship with other Eurozone member states, hurting their influence in the monetary union. Moreover, while in several comments Dutch PM Rutte has insisted nothing comes for free, Austria’s prime minister Kurz was quoted saying they were not aiming for a hard confrontation but rather a good discussion on the ratio of grants to loans. This could leave the Dutch the only Eurozone member state - one of its cofounders – persistently derailing progress. Which in turn underscores our line of thought it is unlikely they will persist.

The frugal four may – in their opinion - have valid concerns regarding the disbursement of funds to other member states and the extent of liability sharing, but it remains to be seen whether they really can afford to distance themselves from the bloc in these (geopolitically) testing times.

Crucially, not supporting southern member states could endanger the future of the Eurozone – as will be explained below - which would significantly harm the prospects of the open Dutch economy. That said, most of these implications are not visible right away. An agreement to support southern member states, on the other hand, will, and they fear a domestic political backlash. From a political angle, and in view of the populist trend, this is obviously a valid argument. But also in the Netherlands the Eurosceptic opposition has been losing ground – whilst the VVD of PM Rutte is – like Merkel’s CDU – riding high. Moreover, the risks and extent of such a backlash, can be contained by governments through:

Ultimately, indeed, it comes down to whether there is a political will to support the European project and to work towards greater integration, for the alternative increasingly is disintegration rather than muddling through. The only point we would like to make here is: are the ‘frugal four’ the ones who can/will make that choice? We doubt it.

But one step usually leads to more

Even if the Commission’s proposal were to be considerably watered down - or the fund would end up only concerning the Eurozone to circumvent Swedish and Danish opposition - and be temporary and limited in size, countenancing liability sharing would imply a Crossing of the Rubicon. It would markedly increase the probability of some form of joint debt issuance for longer in the future once the initial political - and legal - hurdles will have been taken. From a stability point of view, this would be a good thing, as we will explain below.

In the Eurozone’s short history we have seen plenty examples of similar situations: from an one-time Greek support package to ESM credit lines with no conditionality and from the ECB’s “temporary” public sector purchase programme and conditional OMT to unconditional QE and the pandemic emergency purchase programme.

In short, there are many hurdles to be taken and the jury is still out. The question is how far proponents and opponents are willing to go. But a compromise does not seem to be out of reach. The coming weeks could prove crucial in that respect and as such for the future of the Eurozone.

The required size of support is up for debate, but it is clear already that southern Eurozone member states are likely to require financial help. Their economies have been disproportionally hard-hit by the Covid-19 shock, largely because of a more severe domestic virus outbreak, stricter lockdown measures, and a more vulnerable sectoral composition: a larger share of hospitality and tourism in GDP. This is also reflected in our recently updated economic projections for 2020 and 2021 (see figure 3).

On top of that, their public finances are much less equipped to counter the economic fallout and to support the recovery later on. Or worse, given the further substantial rise in public debt ratios we expect (figure 4), countries will likely have to pursue contractionary fiscal policy in the aftermath of the crisis to keep public finances on a sustainable path.

One can argue that, pre-corona crisis, several countries had done too little to prepare their public finances for a next downturn. This is also highlighted by the deterioration in cyclically-adjusted government balances since 2014. But obviously, we aren’t dealing with a regular downturn this time around, and hard-hit countries cannot be held responsible for suffering the worst health- and subsequent economic crisis in modern history. Moreover, the austerity drive that followed on the heels of the sovereign debt crisis in 2010-2012 likely delayed the post-crisis economic recovery. In the absence of that austerity, a much less forceful monetary support programme, such as launched by the ECB in 2015, perhaps would have sufficed.

Given the already high debt levels, support in the form of loans is likely to be insufficient to help the South. It would save them money on interest costs, but it would still imply substantial austerity going forward to service the high debt in an ageing and low-growth environment. This, in turn, risks further undermining longer-term growth. Whilst this is arguably a political decision, this line of reasoning supports the case for grants rather than loans.

Furthermore, from the Northern countries’ perspective, more money to be spent in the South would not only be a token of solidarity, but is also important for their own economic perspective.

This has proved – and is likely to prove – hard to explain to voters. And it is a key reason why conditionality has often played a role in the design of support measures – to make sure there will be ‘something in return’.

Without support there will be ever more divergence in economic growth and wellbeing between the weaker positioned and at the same time hardest-hit countries and the stronger positioned less-hit countries. Current national support and state-aid options are much larger for stronger member states, which will benefit their recovery over that of weaker member states and distort the internal market by creating an uneven level playing field. Apart from a weaker resulting export market in the south, increasing economic divergence and political frictions will complicate future policymaking at EU level.

Moreover, weak finances and diverging prospects could also push weaker member states (when under duress) closer into China’s sphere of influence which could have long-term implications for the EU’s foreign policy. Over the past years, China’s influence seems to have already grown in Eastern EU member states, on the back of financial support via the One-Belt-One-Road initiative, for example. But also strategic assets, such as harbours, in southern member states have (partially) ended up in Chinese hands, following Eurozone induced disposal of state-owned assets to reduce public debt during and in the aftermath of the Eurozone debt crisis. Economic divergence may also further complicate future ECB policy-making, especially in light of the recent Karlsruhe ruling. Even more than now, monetary policy may be unable to suit all.

At EUR750bn the fund would equal 5.4% of EU27 annual GDP (i.e. excluding the UK). If all spending under this program were to fall under ‘investment’, this is 24% of total annual investment spending in the bloc (private and public). This is not an insignificant amount, although it is likely to be spread out over a number of years. According to the Commission the bulk of its borrowings would take place in the period 2020-2024, but given the decision process and implementation lag it’s probably fair to assume that most of the funds would be disbursed in 2021-2024, which would represent a 1-1.5% annual average demand boost.

Qualitatively, the direct economic impact of this impulse is clear. After all, investment means spending in physical and human capital, which itself immediately feeds into aggregate demand (as these goods and services need to be produced) and - assuming there is spare capacity – will also spur a further rise in aggregate demand through the multiplier effect. From this perspective, it can be argued that the demand boost makes more sense for those economies where the negative demand shock – which follows the lockdown period – is the biggest; in other words where the shortfall in demand is the widest in 2021-2024. At first sight, the southern and some eastern member states would appear the most logical candidates for being identified as ‘net receivers’.

But perhaps one of the most important aspects of this program is the signal it gives about the EU and the Eurozone. By issuing a sizeable amount of joint debt, the EU is sending out a strong signal to the world and financial markets that they are ‘here to stay’. This could lead to a more positive stance of external investors vis-à-vis the EU (for example through lower sovereign spreads and overall GDP-weighted bond yields), although such benefits obviously will need to be ‘earned’. The difference between how much each member state contributes and how much it receives in grants will likely be seen as an indicator of the EU’s solidarity.

So, for example, in the Commission’s impact analysis, in which it uses illustrative distribution keys (table 1) and assumes contribution keys based on country’s share in EU-27 GDP, Italy would receive EUR102bn of grants and be required to repay EUR64bn. So in net-terms, the transfer would be EUR38bn. Clearly the benefit would be received over the years 2021-2024, generating additional income, while additional payments to the budget would only start in 2028 and run until 2058.

Meanwhile, Bloomberg has presented different grant allocations, based on ‘sources with inside knowledge of the discussion’. According to these sources, for example, Italy would receive EUR82bn of grants. When taking Italy’s contribution share in the EU budget of 2018 (11.2%), it would be required to repay EUR56bn. So in net-terms, the transfer would be EUR26bn.

This example illustrates that it could matter a great deal what distribution and repayment key will be decided upon. Furthermore, it could even be decided later to extend the debt, when time comes, which would imply that no principal repayments would need to be made at all.

Loans versus grants, conditionality and crowding out?

Provided project selection is done in a diligent way, the investments should give a boost to growth. However, potential crowding-out effects and the way the funds are disbursed to member states (grants or loans and under what conditions) may also influence the plan’s economic effectiveness. For if recovery-fund financed investment simply replaces other (planned) investment (crowding out), its impact is likely to be diluted. The emphasis on ‘green’, ‘digital’, ‘strategic’ and ‘inclusion’ would suggest that such crowding-out effects can be avoided. If recent experience with the Juncker-plan (which has morphed into the InvestEU programme and will also play a part in the new investment strategy) is of any guidance, we may cautiously conclude that these initiatives did have a positive impact on overall investment in the EU and economic growth. By mid-2018 the plan had mobilised EUR335bn of additional investment raising GDP by 0.6% and by 2019 it had reached its EUR500bn target, raising GDP by over 0.9%-points, according to the Commission. Since its advent (regulation on the European Fund for Strategic Investments came into being in mid-2015), we have also witnessed a clear turn-around in the investment-GDP ratio (figure 5), although it probably wouldn’t be fair to ascribe all of that improvement to the Juncker plan since 2015 was also the first year of ECB-QE and an upward trend was already visible from 2013. If we were to translate the Juncker-plan experience one-for-one on the EUR500bn grant part of the fund, GDP could be raised by a little less than 1%-point by 2024. Obviously this is a rather simple illustration and the ultimate outcome will very much depend upon how and for what kind of investments the funds will be distributed.

The EC itself are forecasting a 1.5-2.25% higher EA27 GDP level by 2024, depending on assumptions made on the take-up rate for the loans.

Another issue with the plan is how it will be financed. If financed by higher taxes in future, its impact is likely to be diluted. This is where the discussion of loans versus grants comes in. If most of the funding comes in the form of grants financed by joint bond issuance and there is no requirement of future austerity to pay for it, effectiveness is likely to be higher than if most of the funding would come in the form of loans. In case of the latter, the main benefit for some member states would be the possibility to obtain cheap funding but at the risk of seeing higher rates on their remaining bond issuance. Moreover, only without (over very limited) conditionality would some member states likely make use of such funds.

And what about the long-term?

Besides acting as a (temporary) demand boost, the investment plan could also raise future economic growth, or at least prevent long-term growth rates from falling even further! After all, the resulting increase in productive capacity through investment in new technologies and human capital could also spur economic growth in a more durable fashion.

Does additional investment lead to higher growth in future? A quick answer to that question is a “yes”. One way of approaching this question is to look at the (long-term) return to capital. In other words, how much additional GDP does an additional unit of capital generate? There are various metrics. The European Commission publishes an estimate of the marginal efficiency of capital, which is defined as the “change in GDP at constant market prices of year T per unit of gross fixed capital formation at constant prices of year T”. This measure can be quite volatile from year-to year and very sensitive to macroeconomic fluctuations. Another method comes from Caselli and Feyrer (C-F), who show that the return on capital can be approximated by multiplying the capital share (1- adjusted wage share) by the ratio of GDP to the capital stock. The European Commission also publishes the net return on the capital stock but only as an index (2010=100). However, if we multiply that base-year with the C-F method, the results are not very different. Comparisons of these measures are shown in figure 6 as well as in table 2 below, zooming in on several member states.

The upshot of this is that despite low or negative rates in financial markets, the macroeconomic return on capital (i.e. investment) is overwhelmingly positive – especially when viewed on a trend-basis. In fact, the C-F method shows that returns are not materially different for member states, although the marginal efficiency method clearly shows the dismal performance of the Italian economy post-2009. Still, returns are very decent, even for the other southern member states. Taking into account that such investments can be financed through low-yielding very-long maturity bonds, it would almost seem like a no-brainer.

For the southern member states, the EU investment fund initiative would thus work in the same direction from various angles:

To be fair, the current EC plans would only be a modest economic injection and member states themselves will still have a crucial role to play. But if this recovery plan (cum joint debt issuance) is sufficient to restore confidence in the EU and stabilize markets it could turn out to be a good investment.

As mentioned, not only would the recovery fund as designed by the Commission’s proposal help the recovery, it would also mean ex-ante liability pooling for the very first time in Eurozone history (in size at least). It would be the first step towards common debt issuance needed to prevent frictions due to speculation on countries leaving the Eurozone, to complete the capital market and make the euro a reserve currency.

Intra-Eurozone frictions

Issuance of a common safe asset is crucial for the viability of the Eurozone. This is not a new point of view. The absence of a common safe asset has been very expensive for all countries, as we have explained in a recent publicaton and in an older publication. The important point here is that, in the absence of a common safe asset, every flight to safety in uncertain times, by definition results in increasing tensions between member states as money flows from south to north. The fragmentation of public debt markets along national lines is the Achilles heel of the Eurozone. The result is that without the introduction of a common safe asset, the next eurocrisis will be a copy of the previous one. It’s illustrative that the eurocrisis in 2010-2012 could only be overcome by a massive purchasing programme by the ECB. This resulted in de facto (ex post) mutualisation of public debt of the Eurozone countries. It illustrates that without debt mutualisation the euro ultimately is not viable.

The higher national debt levels, the more work is in store for the ECB to keep interest rates under control, limiting debt sustainability risks. Needless to say that at this point, public debt in several member states would likely no longer be sustainable without the ECB’s help. ECBs policy in this regard also causes frictions in certain member states, arguing that the ECB is overarching its mandate. With a sufficiently large and well-designed common safe asset that discussion would become one of the past.

The euro as a reserve currency

Another implication of the current absence of a common safe asset is that it frustrates the development of the euro into a full-fledged international currency. Although the euro is the second largest currency in the world after the US dollar, its development into a currency that in the long run could compete with the US dollar has more or less come to a standstill. An important factor is that Europe lacks a well-developed capital market. Efforts to develop a so-called capital market union (CMU) are handicapped by the absence of a common safe asset as well. Even the ECB rather explicitly pleads for the introduction of a common safe asset to underpin the development of the CMU and the international position of the euro.

This also has geopolitical consequences. Today, Europe plays second fiddle to the US, which to a large extend has to do with the strong international position of the dollar and the subordinate role of the euro. The commonly guaranteed debt issuance as proposed by the European Commission, or France and Germany for that matter, could be a modest first step in the right direction, strengthening the CMU-project and underpinning the international position of the euro.

The current proposal for the recovery fund will of course not be enough. To compete with the US dollar, the market in common safe assets should be comparable in size with the market in US Treasuries and, very important, include maturities over the full length of the yield curve. But, you have to start from somewhere and the current proposals are just that start. If the experience with a common safe asset is as good as we expect, it may help to improve the quality of the discussion.

The 750bn EC-plan for the post-Covid-19 recovery in the EU should provide a welcome, albeit modest, boost to the economy. However, its signal – with limited joint debt issuance – is powerful. To be clear, this decision is ultimately a political decision, because it can well be seen as a true ‘make or break’ moment for Europe. After all, muddling through is becoming less and less of an option in the post-Covid-19 world.