EU Recovery Fund agreement: potential long-term game changer

History making

What had been planned as a two-day summit has become one of the longest in EU history, confounding many EU observers who thought there was little chance of any agreement in such a short time. But a pact has been reached on a €750bn package aimed at funding post-pandemic relief efforts across the EU, as well as sign-off on the region’s next seven-year budget, the Multiannual Financial Framework (MFF), which will be worth over €1trn.

The key agreement was on the total size of the recovery effort which has been held at €750bn with a mix of €312.5bn in grants and €360bn in loans, corresponding to €672.5bn through the Recovery and Resilience Facility. Although less than the original €500bn Franco-German proposal of grants, the ‘frugal countries’ finally accepted the real game changer, namely that the EU will borrow in the market for grants to individual member states. The payment of these will be conditional on progress made on recovery plans, focusing on the Commission’s country specific recommendations for reform. The balance of the agreement, made up in other programmes under next generation EU including spending on innovation and green projects, have all seen cuts compared to the initial proposal.

Compromise on both sides

As always, the tough negotiations have yielded rewards for both sides, those being the (mostly) southern states most affected by the pandemic and in need of funds quickly, and the northern ‘frugal’ countries who were opposed to the idea of allowing the EU to borrow money and hand it out as budgetary expenditure for member states. The price for a final deal has been a boost to the budget rebates that those ‘frugal’ countries receive going forward, for example Austria’s annual reduction will be doubled compared with prior years. The northerners have also secured an emergency brake that allows any country to raise concerns that another may not be honouring promises to reforms, although this is time limited and the final decision will be in the hands of the Commission.

A major sticking point along this road concerned the allocation criteria and timeframe for the funds. Agreement has not changed from the Council’s proposal which means 70% of the grants get given out in the first two years (2021-2022) with the balance in 2023 depending on the depth of the downturn this year. Economists calculate that the most affected countries like Italy and Spain will receive grants of roughly 2.5% and 3% of GDP, whereas Germany, France and the Netherlands have maximum allotments of less than 1% over the two years.

Some questions remain…

As has been known for some time, the fund will only become effective on January 1, 2021 with the real economy not benefitting before the middle of next year. The fact that the plan now faces a potentially difficult passage through the European Parliament and must be ratified by all member states may also mean a delay in getting the funds to economies that need the help now. Additionally, the cuts in top-up funding in areas like development, green and health issues is a concern to many who had hoped these negotiations would kick start investments in these areas. Many observers have spoken of the enduring acrimony from these historic talks which may not result in similar responses in the future, as ultimately this is still a one-off fund built for the pandemic and lasting grievances have a habit of returning.

…but history will look back favourably

Even if there is a greater weight towards loans than grants and that conditions relating to the rule of law have been avoided, the landmark agreement reached today is a step towards fiscal coherence. Germany and France have acted together in the way that reassures markets, and in some senses, the pressure is now off the ECB which has been the only game in town for too long.

Market impact

In the near-term, the spreads of Italian over German bond yields are tightening to levels not seen since before the Covid outbreak, while further out, we may see a transformation of the investment landscape as European bonds especially benefit from fiscal co-ordination at the heart of this plan. The dwindling risk of the break-up of the bloc has already seen the euro bid up over the last few weeks, but it is the increased economic stability that may enhance the single currency’s appeal among long-term international investors. For now, the March high at 1.1495 is the major resistance level for EUR/USD and profit-taking may develop around this level, but technical signals remain strongly aligned for more upside, with the January 2019 peak of 1.1570 above.