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April 10, 2020

Italy has folded for the sake of a deal. Plus ca change.

We would not normally publish today, the Good Friday bank holiday. But we decided to produce a briefing after all to put some of yesterday’s important news into context. There will be no briefing next Tuesday. We will be back on Wednesday, April 15.

The big news yesterday is no doubt the eurogroup agreement. As we wrote yesterday morning, it would have been unwise to bet against a deal, which did not stop some people from doing so. We have been through this before with the eurozone crisis. Then, as now, the problem was never an inability to reach agreement but the nature of the agreement itself.

Wopke Hoekstra and Roberto Gualtieri, the two principal opponents at the eurogroup meetings on Tuesday and yesterday, came back with diametrically opposed interpretations of what was agreed. Gualtieri said that conditionality for an ESM programme was off the table. Hoekstra said it was still there. They are both right. It is the job of diplomacy to find the right words to make this possible. EU diplomats are exceedingly good at that. Only fools ever bet against an EU deal. In this specific case, the text says access to the ESM is unconditional, but also says the standardised terms will be set by the ESM governing board. It probably will never get to this point but, if it does, the dispute is only postponed.

What interests us is the overall economic effects of what has been agreed, as opposed to the headline numbers. The only tool with any chance of a macroeconomic impact would be the recovery fund. Ministers kicked this issue back to the European Council, which had previously kicked it back to them. The text mentions innovative financial instruments, but gave no details of what that might mean. The eurobond discussion is not over, but eurobond proponents certainly missed an important moment during the crisis as momentum had built up in the discussions. We think this momentum is now fading.

What was agreed yesterday is well below macroeconomic relevance. The text claims that the discretionary measures by member states so far account for 3% of GDP. We flatly dispute that number. We suspect that it throws together measures at various stages in the fiscal pipeline. But experience shows that only a fraction of what is earmarked will ultimately get through. The amount of discretionary fiscal spending unleashed in the eurozone so far is small compared to the US and the UK. The automatic stabilisers will be higher, so in the end we have to look at the total fiscal effect.

The measures agreed yesterday are the following.

  • A €2.7bn emergency support facility from EU budget resources, that is 0.03% (!) of GDP.
  • An EIB lending facility for €25bn. This is good news but we urge readers not to buy into the spin, especially the large multipliers. The ECB did the heavy lifting on credit support. The impact of the EIB programme will be to support credit flows, but the marginal effect will be much smaller than it would be in normal times.
  • An ESM enhanced-conditions credit line of up to 2% of member states' GDP as a benchmark. The 2% is not an accidental number. It reflects the size of the remaining funds in the ESM. The text refers to standardised terms, which implies conditionality in our view, and kicks the decision to the ESM governing bodies and EU institutions. Everybody who asks for one will get it, so long as they promise to spend the money on healthcare-related issues. We think this facility, and all the fuss made around it, is ultimately irrelevant. The ECB’s pandemic emergency purchasing programme makes a liquidity squeeze very unlikely this year. The PEPP supersedes OMT and, as we keep pointing out, the various limits, even the capital key, are irrelevant in an emergency. Furthermore, Italian politics precludes an ESM programme.
  • A temporary credit programme by the European Commission to support national employment systems, under the acronym of Sure. The maximum size is €100bn. Again, these are credits. 

This is it for what has been agreed. Mostly loans and lending support. We don’t want to be completely downbeat. The Sure facility will help especially those member states with weak unemployment insurance systems, like Italy, and those with insufficient provision to fund furloughed workers or short-time work schemes. The EU plugs important gaps in the system. But we should not fool ourselves that this any of this is macroeconomically relevant. 

So, this leaves the still-disputed recovery fund to do virtually all the heavy lifting, or not. We fear that Jacob Kierkegaard is correct in his expectation that this fund will ultimately be folded into the EU’s budget. Where we disagree with him is that this can be leveraged to reach a macroeconomic scale. We have been there. The EU’s budget is of the order of 1% of GDP, of which most is firmly earmarked for non-discretionary programmes. Let us remember the last time that EU thought it could leverage its resources: the infamous Juncker investment fund. This was a paper tiger that mainly reshuffled existing investments into different categories. There was no perceptible impact on aggregate investment at the level of the EU. We expect the recovery fund to be in the same category: an attempt by the EU to prove its relevance, but without having any concrete effect. 

So what’s the bottom line? We think the Italians have folded. The battle for the eurobond is lost. The re-nationalisation of policy is in full force. And we are set for another financial crisis soon, when the impact of Covid-19 on the debt sustainability of member states becomes only too clear.

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April 10, 2020

ECB governors agreed on size of bond purchases, less on composition

ECB minutes usually come four weeks after the respective meeting, but yesterday the central bank also released the minutes of its video conference three weeks ago that launched the €750bn pandemic emergency purchase programme. Most interesting to us in this double serving are: how the governing council's economic outlook evolved in the first week of European Covid-19 lockdowns, and any differences of opinion among governors on policy. 

Even recognising that its own staff forecast was already outdated and uncertainty on the downside was high, the March 12 meeting still considered rather benign scenarios. The baseline scenario foresaw a 0.3% drop in 2020 GDP, while a mild scenario put the drop at 0.6-0.9% and a severe scenario of 0.8-1.4%, all of them without fiscal or monetary response. This is extraordinarily optimistic. Data from China, and now from eurozone countries, suggest it is reasonable to expect a 30-35% drop in economic activity due to lockdowns. This means 0.6-0.7% GDP drop per week of lockdown, assuming the economy then bounces back to the previous level of activity. Still, even the milder assumptions warranted a strong policy response and governors agreed unanimously in both instances. Any disagreement was on the details.

At the March 18 meeting there was consensus that the economic situation, not to speak of markets, was already deteriorating rapidly and there was a significant risk of recession. The deflationary effect was being compounded by the drop in oil prices. Isabel Schnabel, in charge of markets, reported a generalised widening of spreads even as the benchmark German bond yield had risen. The intense flight to safety had widened spreads of even highly-rated eurozone governments. Corporate bond spreads had also widened. 

As to policy, even in the calmer environment of the first meeting, governors were clear they needed to ensure that a temporary disruption of cash flows didn't lead to balance sheet problems in the corporate and banking sectors, and therefore to a broader financial crisis. Everything possible must be done to prevent the lasting damage to the economy that this would cause. Points made about the policy package include that monetary stimulus would only be really effective once the spread of the coronavirus had been contained, and therefore in the short term the fiscal response was very important. It was even suggested that relaxing the conditions of the TLTRO III funding-for-lending programme, so that overall lending volumes didn't need to increase, might not be enough if banks were forced to actually reduce their credit exposure. We note that the supervisor relaxed banks' capital and liquidity constraints as much as possible to prevent this, but as governors noted there could still be intense market pressure on banks. 

Adding volume to asset purchases was preferred to lowering rates, given the cost of long-term refinancing operations had been lowered substantially. It was important that the expansions of asset purchases were on a yearly basis, not monthly. This would allow government bond purchases to be concentrated on the markets under more stress in the short term, with convergence to the capital key in the latter part of the year when hopefully the crisis would have abated. At the March 18 meeting there were reservations expressed on the need for a new asset purchase programme. While not questioning the proposed amount of new purchases, some felt they could equally have been carried out under the existing asset purchase programme, or even under the OMT. We would note that OMT cannot be launched at will, it is conditional on the target country being under an ESM programme, so that wouldn't have been an appropriate tool. These sceptical governors seem to have wanted to ensure adherence to the capital key, which in the end would be applied flexibly.

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April 10, 2020

France triples its fiscal stimulus

The French government is topping up its emergency measures to fight the economic fallout from Covid-19. In just four weeks the finance ministry has tripled its direct stimulus and revised downwards its growth forecast from -1% to -6% for this year. This is still at the optimistic end of expectations. Depending on the length of the lockdown, the pace of the exit strategy and the international network effects, the impact on growth could be worse. A 10% drop as some suggested may not be so far-fetched. 

Also, the recovery will be uneven in the economy and that might call the state in as an active corrective. Hairdressers might get back to business as usual quickly, but tourism will be down for longer and production chains might take a while to come together again. Bruno Le Maire told Les Échos that he identified twenty strategic enterprises that might need some form of government support, be it as a loan, capital injection or even nationalisation.

The fiscal figures in this second budget are already staggering. The deficit is to pass from 3.9% to 7.6% of GDP and the public debt ratio will grow to about 112%, a rise by 14 percentage points. Tax revenues are expected to fall by €37bn, as corporate tax, VAT and income tax will bring in less. On the expenditure side the economic support package is increased from €45bn to €100bn. Direct spending almost triples from €12bn to €35bn, most of it taken up by partial unemployment with €20bn. For small firms and the self-employed the budget also increases from €1.2bn to €6bn, while health care costs are exploding from €2bn to €7bn. Another €1bn will be available for small and medium-sized enterprises at the brink of bankruptcy.

This is unlikely to be the final version of the 2020 budget. More expenditures are to be expected the longer the lockdown lasts, and the economic impact is just at its beginning. 

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April 10, 2020

Direct lending to governments, big and small

Monetary financing of governments may be forbidden by Art. 123 of the treaty on the functioning of the EU, but it is already being deployed by the US Federal Reserve and the Bank of England. In the UK, the central bank and the treasury have agreed to use an existing overdraft to ease ministerial spending in the short term. In the US, the Fed will lend $500bn to states and local governments, with a $35bn credit guarantee from the treasury. Taboos are falling fast.

The UK news is a lot less dramatic than headlines suggest. Nevertheless, it comes as a surprise and a bit of a U-turn given remarks by Andrew Bailey just this week opposing monetary financing. The Bank of England will be allowing overdrafts on its so-called ways-and-means facility. This was in daily use before 2000, when treasury cash management was taken over by the debt management office. Debt issuance, however, is not instantaneous, and so in periods of stress overdrafts are preferable. The ways-and-means facility was briefly used in 2008 at the height of the global financial crisis and reached a high of £20bn. It is expected that volumes will be higher in the current crisis, but the treasury is committing to repaying the overdrafts quickly, and in any case within the year. Activating the facility just makes life easier for the debt management office. 

In the US, state and local governments don't have access to the Federal Reserve's balance sheet, unlike the treasury. This makes them quite like private-sector entities. Municipal debt, even more than state debt, is an important asset class in the US market, and the Fed was already supporting it through this crisis. But state and local governments are as exposed to cash-flow problems as the private sector. It is not inconceivable that liquidity problems might cause debt defaults. The US Congress' $2tn coronavirus stimulus does not support states and municipalities directly. Hence the need for a dedicated liquidity facility from the Fed. The Fed will buy short-term notes from US states, counties with a population of over 2m people, and cities of over 1m. The idea is that states, and maybe large counties, may use these funds to support smaller counties and cities. The Fed reiterates its support for municipal bonds in the primary and secondary markets.

Miguel Carrión writes: these developments illustrate a few principles that are contrary to the design philosophy of the eurozone. Government debt and cash flow management interact with monetary policy in ways that make it advisable to have overdraft facilities, which are not used in normal times anyway. Sub-federal debt is an important asset class susceptible of primary market support, and it is a proper role for the central bank to lend directly to sub-federal governments in times of stress, without conditionality. Fears that such facilities may lead to irresponsible fiscal actions by governments, or to runaway inflation, are overblown.

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April 10, 2020

Some bad Covid-19 news from Germany

We have been busy unfollowing economists and journalists who give out statistically-illiterate cross-country Covid-19 comparisons based on published data. So, we are delighted to report on the kind of data that gets us a little closer to understanding what is going on. A team from the university of Bonn, led by the virologist Hendrik Streeck, carried out an anti-body test in a hotspot area. The result was that only 14% of the population carried antibodies. A further 2% of the local population was infected by the virus currently. The data would be consistent with a mortality rate of 0.37% overall. 

While this mortality rate is lower than previous official estimates, the number of people with antibodies is also much lower than we thought, and hoped. As Technology Review writes, the test was carried out in the municipality of Gangelt in the Heinsberg district, near the Dutch border. This is Germany’s Covid-19 hotspot where the disease was spread during the carnival celebrations.

The researchers approached 1000 residents and obtained 500 blood samples. Nicholas Christakis from Yale University said that an infection rate of only 15% in a hotspot area would imply that only a small fraction of the overall population is infected at this point. This in turn would suggest that the virus has yet to spread to the majority of the population. This preliminary test result is therefore bad news. It would appear to falsify more hopeful assertions, such as the one from Oxford University, that a large percentage of the population is already infected. If we assume that the virus will ultimately spread to 60-80% of the population, then most of the pain is still ahead unless infections can be stretched out for long enough, until a vaccine is available.

There are caveats with the data. We don’t yet know the accuracy of those anti-body tests. And the sample may be too small to arrive at wider conclusions. Christakis wants the US to carry out a test with 200,000 people from New York and small towns in the Midwest. The German test is one of the first carried out globally but more are expected shortly, including one among healthcare workers in the US. 

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