On Tuesday, EU leaders reached agreement on a €750B COVID-19 recovery fund, composed of grants and loans, and settled on a €1.074T budget for the next seven-year period. While the total size of the recovery fund matched expectations, grants will make up a smaller portion (€390B) than initially proposed (€500B) in the Franco-German plan. This reduction came at the behest of the fiscally conservative ‘Frugal Four’ nations, which also insisted that dissemination of these funds be linked to the EU’s country-specific reform recommendations. Though welcome, at about 5.4% of EU GDP, the fund is relatively modest in size, particularly considering it will be dispersed over a multi-year period.
Nonetheless, the deal is significant from a political and symbolic point of view. The €750B price tag is to be met by the joint issuance of debt for the first time, at least in any material size. While this crisis has already seen the toppling of several sacred cows in European fiscal and monetary policy, the breaking of the debt-mutualisation taboo with this fund is the most notable. The presence of the traditionally hawkish Germans as the driving force behind this fund makes it all the more remarkable and speaks to the sense of urgency felt within the EU. With the funds raised from bond sales not due to be fully repaid until 2058, the agreement sends a strong message about the permanence of the Eurozone, with added significance in the year of Brexit.
In the short term, this agreement is likely to support the sovereign debt of peripheral European nations that stand to be the largest recipients of the available support. But the long-term financial ramifications for Europe may be more significant. While intended to be temporary, this initiative sets a precedent for a mutual fiscal capacity, which could be used to respond to future shocks, making the entire monetary union more stable. The lack of a common Eurozone safe asset has seen portfolio flows leave the periphery in droves during times of stress, bound primarily for the safe haven of Germany. A mutually issued bond should reduce such behaviour. The agreement accords with existing plans to deepen the capital markets union, and taken together, these efforts have the potential to transform the European financial markets landscape. It is too early to conclude that full fiscal federalisation is on the way, but the direction of travel implies that the tail risks surrounding the common currency have diminished. This should make the region more investable in the eyes of global pools of capital that have latterly eschewed it, with such flows aiding both the euro and European equities.
Thomas O’Mahony, Investment Director on Cambridge Associates’ Global Investment Research Team