The agreement on the EU budget, including the recovery fund of EUR 750bn, is an important political milestone with a potentially macro-economically relevant impact to facilitate Europe’s recovery from the crisis from 2021 on.
Scope Ratings’ Giacomo Barisone (GB) – Managing Director – and Alvise Lennkh (AL) – deputy head – of the sovereign and public sector ratings group take stock of the new EU budget deal.
What does the outcome of the EU budget deal mean for Europe?
GB: First, politically, it is a very important signal that leaders agreed – already in the first month of the German EU Presidency – on the budgetary resources and objectives to facilitate Europe’s recovery from 2021 on. Once again, European leaders have demonstrated that in times of distress, compromise and action are possible, not only to tackle an emergency, but also to support a more robust recovery. This decision sets a confidence-building precedent that extraordinary financial measures are available from the EU to cushion against future economic and social shocks.
Secondly, economically, the potential for a more durable recovery has been strengthened. The EU’s recovery fund is the first significant common European counter-cyclical fiscal response to an economic crisis, to be comprised of EUR 390bn in grants and EUR 360bn in loans, financed by bond issuance backed by the EU budget, which comes on top of EUR 1.1trn via the next seven-year budget, bringing a total budget size of EUR 1.8trn. However, the macro-economically relevant element for Europe’s recovery in terms of additional fiscal stimulus relates predominantly to the recovery fund. At EUR 750bn, the fund is slightly above 5% of EU-27 GDP, assuming that all grants and loans are disbursed.
The direct fiscal stimulus will mostly derive from the grants, which will be committed, on average, at around EUR 130bn a year between 2021-2023. The resulting additional stimulus amounts to near 1% of EU GDP per year – although the actual impact is likely to be somewhat lower as some commitments may only be disbursed after 2023. Still, a productive use of such grants, supported by careful project and investment selection as well as appropriate reforms in the context of the European Commission (EC)’s Country Specific Recommendations, could facilitate a faster and more even economic recovery.
Third, geopolitically, and longer term, the European Commission’s significant increase in capital market borrowing of up to EUR 750bn will increase the availability of safe assets denominated in euros, which could further support the safe-haven role of the euro in the global financial system.
How significant is the agreement on the EU budget in the context of Europe’s forceful and evolving policy response to the impact of Covid-19 on EU economies?
AL: The decision critically shifts the focus from emergency measures adopted over recent months to Europe’s recovery over coming years. While the first measures provided a safety net for sovereigns and corporates1, which avoided the near-term risk of any immediate liquidity crisis, the deal on the recovery fund and the EU budget provides important longer-term growth incentives.
In addition, the agreement underlines the important coordination of fiscal and monetary policies in Europe, setting a precedent for future crisis response at the EU level. Additional steps toward the completion of the banking and capital markets unions will also be key to facilitating an even and sustainable economic recovery in the EU, which will enhance the EU’s global economic and political objectives as well as the attractiveness of euro-denominated assets.
The deal for the Recovery Fund is the result of tough negotiations and includes a number of compromises. What are the key political implications?
AL: The hard-fought negotiations highlighted significant divisions within the EU between more “frugal” northern countries and the southern countries. As a result, the deal includes a number of important compromises such as an increase in budget rebates for some northern countries and the adoption of an ’emergency brake’ mechanism, which allows any individual member state to oppose disbursement of recovery monies, requiring then a decision by EU finance ministers and, in case of disagreement, by the EU Council. Such a governance structure may postpone payments in the case of non-productive usage of recovery fund resources, reinforcing the incentives to allocate the Recovery Fund’s resources for projects related, for example, to addressing climate change and the digital economy.
In addition, leaders have also agreed on the implementation of additional European-wide taxes, including on non-recycled plastic waste (effective January 2021), a carbon border adjustment mechanism and on a digital levy (both to be effective January 2023). As the proceeds will be used for early repayments of the forthcoming EUR 750bn in borrowings, these new instruments could, depending on final design and implementation, gain in importance over time, underpinning the joint nature of this fiscal effort.
Overall, we believe that the negotiations highlighted the willingness and ability among EU leaders to reach an agreement. We expect the parliamentary ratification process, including the European Parliament, to be completed by end-year with the Recovery Fund becoming operational in 2021.
What is the impact of the deal for Central and Eastern Europe (CEE) and Southern Europe?
GB: CEE economies, alongside economies in southern Europe, are key beneficiaries – economically and from the perspective of debt sustainability.
First, both regions have been the largest beneficiaries of EU funds relative to their economic size in the EU budget of 2014-20, with EU funds accounting for more than half of all public investment in many economies. The Next Generation EU fund and EU Budget for 2021-27 present an opportunity for such countries as budget allocations remain large – and in some cases have even increased – which can facilitate a recovery in the coming years. While the ‘regime of conditionality’ still needs to be introduced, going forward, in case of breaches of the rule of law, measures can be taken by the Council on the basis of a qualified majority as opposed to unanimity. This change in governance alone may incentivise all member states to avoid any such procedure related to the adherence of the rule of law.
However, the ability for such economies to deploy additional EU funding will be crucial. EU fund absorption rates vary markedly among CEE and southern European countries, reflecting variation in the co-financing capacity of governments as well as institutional factors such as governance quality and long-term planning capacity, the control of corruption and the extent of decentralisation. For example, the cumulative absorption rate of 2014-20 EU funds is currently well above 50% in the Baltic countries and Poland, but only around 40% on average in Italy, Spain, Romania, Croatia and Bulgaria.
Secondly, the EC loans are highly concessional with lower interest rates and longer maturities compared to what governments could in many cases issue on their own. This will positively impact government debt sustainability over the medium term. Under the Recovery Fund, EU members can borrow up to 6.8% of gross national income, or about EUR 120bn in the case of Italy and EUR 85bn for Spain.
What impact will this agreement have on European sovereign ratings?
AL: Sovereign credit rating outlooks depend on a complex interplay of monetary, fiscal and economic factors, including the social and political repercussions of this pandemic. We acknowledge that decisions on the EU budget and recovery fund are credit positive and form a good opportunity to facilitate and support Europe’s economic recovery and transformation in 2021 and beyond alongside continuing the enhancement of the overall EU economic architecture.
Still, we will assess individual sovereign credit profiles selectively to account for varying fiscal adjustment capacities and underlying degrees of economic resilience and abilities to absorb and reverse the significant economic and fiscal impact from this shock over the medium term.
*As the first responders to the crisis, both the EC and the European Central Bank implemented measures to alleviate liquidity and funding pressures for governments, corporates and workers, including the EUR 1.35trn asset purchase envelope for private and public sector securities by the ECB, EUR 100bn for the unemployment insurance initiative SURE, EUR 240bn as a European Stability Mechanism backstop facility and a EUR 25bn guarantee fund from the European Investment Bank aimed at mobilising EUR 200bn.