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Is the European Recovery Fund a game changer for the region?

19 May 2020
News that Germany and France have joined forces to propose a half-trillion euro recovery package has seen the single currency rally sharply over the past few sessions. While clearly positive after failed rounds of negotiations previously, there are still a number of questions that linger. As always in the eurozone, the detail may matter more than the headlines further down the line.

Just over a month ago, we wrote about European coronabonds and how the battle between north and south was developing. We suggested there were long-term questions over burden sharing with a possible solution being to use the bloc’s joint budget to pay for a recovery fund. In a nutshell, southern countries including France wanted some concrete form of fiscal integration and debt mutualisation, while northern countries opposed any idea of joint debt issuance and were unwilling to back the debt of those countries.

Berlin and Paris proposal

French President Macron and German Chancellor Merkel have agreed in principle to set up an extraordinary package of €500bn using the EU budget to deal with the Covid-19 crisis. This will be funded by borrowing on the markets according to normal ‘capital key principles’ and be part of the next EU multiannual budget with binding repayments over multiple budgets. The areas most affected by the crisis – southern Europe – should benefit the most as the fund will provide direct fiscal stimulus in the form of grants, primarily to those industries and regions.

The key area of contention, whether the fund is a scheme of repayable loans or grants has therefore come down in favour of countries like Italy and Spain. Was there any other alternative? For countries like Italy, creating loans and adding to its ballooning debt pile (200% of GDP in 2021 according to some forecasts) would simply be pushing the country down an extremely painful road and in all likelihood, another EU debt crisis.

‘Landing zone’ sparks northern backlash

As expected, the proposal has already triggered scepticism among the ‘frugal’ northern member states who want most of the money to be repaid by the member recipients. Any type of common debt issuance has always been frowned upon and there is also concern about a precedent being set, even though the fund is temporary in nature. Even supporters of the recovery package agreed have questioned the total size of the fund which amounts to under 4% of EU GDP spread over several years. They also worry about the timing of release with the multiannual budget only due to commence in 2021.

Of course, the Franco-German proposal, a tie-up between the two largest EU contributors is grounds for optimism. The next stage will be the task of getting all 27 EU member states to agree, including countries like Austria, the Netherlands and Sweden, which will be more uncertain and complex. We note that negotiations on the EU’s regular seven-year budget, through which the recovery funding will be funnelled, have been stuck for more than two years. The task of brokering all sides to an agreement will fall to European Council President Michel at a summit which is yet to be scheduled.

Positive market reaction, so far

Spreads between Italian and German yields have come down significantly since the announcement, with the potential risk premium in the euro reduced. Progress is being made, in stark contrast to GBP where that premium is rising with the stuttering Brexit talks.

After going nowhere for two weeks, EUR/USD surged higher past several strong resistance levels to its biggest 1-day advance in six weeks. Upward momentum has now improved but overcoming the early May high at 1.1017 will be key, which is also near the 200d MA. On the downside, 1.0825 is acting as strong support.

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