April 24, 2020
Thinking through the details of a recovery fund
In our assessment of the economic impact of the agreed way forward, we know most of what we need to know right now. The European Council has agreed on Angela Merkel’s version, not the coronabond or the Spanish proposal. As FAZ reports this morning, the plan is for the EU to increase its budget capacity from the current 1.2% to 2%, for a period of two to three years. This increase will not come in the form of direct contributions from the member states, but of guarantees. The paper puts the annual volume at €100bn per year, which would be be approximately 0.6% of EU-27 GDP on our calculations. The total borrowed could be in the order of €250-300bn over the period.
This extra borrowing is not the fund itself, which the Commission hopes to lever to a larger size. A portion of the funds will be made available directly in the form of grants, another portion will generate investment through loans and will need to be levered for the overall package to achieve the target size. This is the big political decision that still needs to be made. The Dutch and the Germans differ in their diplomacy and language, but we urge readers not to fall for the solidarity rhetoric. Both countries want most of the disbursements to be in the form of loans. This is also what we think will happen.
The part that will come in the form of grants will include a certain redistributive element, with an emphasis on member states that are harder-hit by the crisis. But we would be surprised if the EU were able to agree a radical re-allocation of resources even within that category, simply because of the way allocation decisions are made. The Germans talk about solidarity, but they also have poor regions that want to benefit from the fund. If we assume total borrowing of €300bn, half of it in the form of grants, the average macroeconomic impact would be 0.4% of GDP for three years running. This would be eurozone-wide, a bit more in the south-west, a bit less in the north-east. Given the scale of the downturn this is next to nothing, no matter how strong the redistribute element will be.
As ever, beware of headline totals. Ursula von der Leyen said last night that the size would be measured in the trillions, not billions. As we scour this morning's headlines, we find plenty of gullible journalists impressed by that number. We think it is an illusion. So was the eurogroup’s €500bn package, because it conflated into a single round number the ESM’s outstanding capacity plus the estimated lending capacity of two levered funds.
It is best to think of the various categories separately. Most of the new money would come in the form of loans to the private sector. The European Commission will thus try to lever the portion of the €200-300bn that is not earmarked for grants to blow up the fund to the desired headline size. The method for that will be the infamous Juncker investment plan. Readers may recall that we have been among the loudest sceptics of this method. We are in good company. The European Court of Auditors also found in its assessment of the Juncker plan that, while it did fund investment, it is questionable whether these investments would not have been funded elsewhere.
We are also not sure that this mechanism is suited to address the solvency issues of the private sector. We recently noted an interesting proposal by a group of economists who suggested that the EU take equity stakes in companies. A final version of their report has now been published that goes into the funding details. We agree that this would constitute a superior way for the EU to disburse the fund than through credits. It would be neither a loan nor a grant. But it would raise the question of who would cover the losses if the route chosen were through a fund that this is financed with the help of member state guarantees, and we presume the EIB.
Ansa reports that the Commission will make a proposal in the second or third week of May. Investments won’t start until 2021 at the earliest.
The advocates of coronabonds have lost this battle, in part because they had no strategic plan. They got outfoxed by Angela Merkel and her allies, who have a much deeper understanding of what the EU can do in a situation like this. The EU can raise debt, for sure, but it cannot act as a fiscal stabiliser under current treaties. If Giuseppe Conte had really wanted a coronabond, he would have needed to team up with Emmanuel Macron and Pedro Sánchez. But that didn’t happen.
Benoît Coeuré made a series of wise comments yesterday in front of the French Senate, where he highlighted the useful but limited role the ECB can play in the forthcoming triage of public and private sector debt. He said debt sustainability is a political concept. The ECB will play a limited role to support the process, but it will not be the principal actor in this game. The impact of the crisis on public sector debt would depend largely to which companies will default on loans backed by government guarantees. He calls debt restructuring a fiscal act, with the load transferred from one actor in the economy to another. We pose the question whether this transfer can be accomplished at the level of each member state.
This begs the question whether the recovery fund can be turned into a debt transfer mechanism, freeing the countries most affected by the coronavirus from having to take on the debt of their defaulting private sectors. This would be the biggest difference from the Juncker plan, which had a very different purpose. The ECB cannot monetise EU debt any more than it can monetise national debt. So, this means that the debt would end up back with member states. The only redistributive element would occur to the extent that the grants and the loans are not proportional to the guarantees.
So, no matter how you twist and turn this, this is not a fiscal stimulus. At best it may turn into a vehicle of debt transformation. That would be the biggest upside we can identify.