The European Union (EU) seems to have finally come together to deliver a comprehensive fiscal rescue package to help member states battle the devasting economic impacts of COVID-19. In her speech to the European Parliament (27 May) announcing the €750 billion package, European Commission (EC) President Ursula von der Leyen said it was “Europe’s moment”.
While the 27 EU member states still need to approve the deal, it appears to have garnered support from Germany and France, which should help cement it. In my view, the package, dubbed “Next Generation EU”, represents a significant step to bolster Europe’s economy and show unity.
It’s clear the coronavirus has devasted Europe’s economy. Estimates suggest EU gross domestic product (GDP) declined significantly in the second quarter of 2020 versus 2019. Overall, the EU economy is expected to shrink by high single digits this year, but a second wave of infections and further lockdown measures could see GDP drop in the double digits this year.
The EC stated that Next Generation EU will boost the EU budget with new financing raised on the financial markets for 2021-2024, would be rolled out across three pillars:
- Supporting member states to recover
- Kickstarting the economy and helping private investment
- Learning lessons from the crisis, which includes a new health programme (EU4Health), strengthening a key support programme to cope with future crises (rescEU), and spurring research and innovation
Historically, the EU budget was not allowed to go above 1% of EU GDP, but this plan temporarily lifts the ceiling to 2%, which is a big step. The Commission will use its strong credit rating to borrow €750 billion on the financial markets, to be repaid through future EU budgets over a 30-year span starting in 2028 and ending in 2058. It is quite a lot of money, with a long horizon to pay the bonds back.
Significantly, the fund would be comprised of €500 billion in grants and €250 billion in loans. Italy and Spain, the two countries most impacted by the coronavirus, will receive €81.8 billion and €77.3 billion in grants, respectively. Italy has a particularly high debt burden, so the grants are important.
A Groundbreaking Moment
The plan still needs EU member approval, so negotiations could result in a few givebacks as several member states have objected to taking on more debt. However, the two largest economies, Germany and France, have given their support to the issuing of EU debt, something we think is groundbreaking. It involves all 27 EU members—not just the eurozone—so it shows Europe is willing to work together at a pivotal time in terms of leveraging the combined taxing power of its members. It took an existential shock—COVID-19—to galvanise the EU. While Next Generation EU is designed for a limited time, it could be a mechanism to use for future crisis events.
The money will have to be repaid out of the EU budget through some additional taxes that push along its agenda. The interest costs should be very low, with rates well below 1%.
Within its Next Generation EU plan, the EC references the European Green Deal, the EU’s growth strategy. All public investments should fall to the green oath, “do no harm”. In other words, countries receiving money from the EU budget or this plan should continue to invest in transitioning their economies to more renewable energy, with the goal of reducing carbon emissions. For investors, this should be positive for the green bond or carbon-reduction space. The coronavirus crisis and climate change are two problems to be addressed at the same time.
In our view, the issuance of new EU debt should reduce the risk premium in European credit, and in peripheral government bonds. Germany up until now has not favoured EU debt, so its acceptance now means we crossed the rubicon so to speak. Fiscal transfer hasn’t been done before, so it is a huge step and we think now’s the time to do it.
At an individual country level, Italy and Spain will likely be better off as they are getting a transfer, while German and France will pay more. As such, the peripheral bonds in Europe should be well supported: Spain, Italy, Portugal, Greece and Cyprus.
German bonds had been the bedrock of the EU; when there have been rough patches and talk of a break up, many investors wanted to own German bonds as sort of a safe haven. But now, we think the chances of a eurozone breakup are reduced, and investors could view the new EU bonds as a safe haven. So, German bond yields could go slightly higher, but more likely, peripheral spreads will come in. This also marks the beginnings of a large, liquid bond market of global importance. The euro should likely be a more robust currency longer term, and credit risk premium should be reduced.
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