Crossing the Rubicon: Next Generation EU

Crossing the Rubicon: Next Generation EU

Last week we highlighted the European Union (EU) members were set to gather in their first face-to-face meeting since the outbreak of Covid-19 in Europe. On the agenda, thrashing out the finer points of a recovery fund designed to help fight the economic crisis wrought by the pandemic.

We found the agenda interesting because of the requirement for unity at a time when relations looked challenged. As a Union, there is no common treasury to offer support for such events. Therefore, the progression of discussions and the outcome were captivating, but one thing we knew for sure, these discussions would be fraught.

The pejoratively termed ‘Frugal Four’ being Austria, Denmark, Sweden and the Netherlands had signalled well in advance their preference for loans over grants. In essence, they are very against ‘handouts’.

By kicking back against the construct of the proposal outlined in May (€750 billion package built up of low-cost loans and grants), a measure of success was achieved by the four countries. For example, the latest agreement now includes much greater oversight from the EU on how each member state will use the relief packages. It also contains a reduction in the value of grants; from €500 billion to €390 billion. As an additional sweetener, the frugal four will receive higher rebates on their budget contributions at the expense of the other members.

Notwithstanding the compromise, the agreed package will provide more meaningful support to those countries least financially able to implement stimulus packages on their own. Countries in the North of Europe relative to the South are generally better positioned financially, and we can see this from the map below: The darker shading representing higher levels of existing debt to GDP. By agreeing to grants as part of the overall package the Southern countries such as Italy and Greece are to be given a financial boost.

Chart: European Debt to GDP Levels

Source: European Commission & Bloomberg, July 2020

To give some sense of the divergence of ‘rich vs poor’, in the early days of the European outbreak Germany, as a prosperous nation, was able to swiftly present a domestic fiscal stimulus package of €450 billion to support business, equivalent to 13.3% of German GDP. Conversely, Italy and Spain were unable to match the pledges made by their neighbours. Now, however, Italy is expected to receive €82 billion in grants and access to €127 billion in low-cost loans, equivalent to 5% of GDP to support development in the coming years.

We can see in the chart below, how the holders of Italian government debt greeted this news. Spread compression between Italian and the often-perceived safer haven German government debt was already narrowing in anticipation of a deal, reflecting a lower perception of risk. After the announcement spreads narrowed even more.

Chart: Italian 10 Year Government Bond Spreads

  

 Source: Bloomberg, July 2020

So, what was the package agreed?

The conclusion of these negotiations is the Multiannual Financial Framework. The Framework sets out the Union’s budget for 2021-2028; €1,074 billion has been earmarked for the budget, covering areas such as digital innovation, migration, border management, security and defence. One-third of the packages presented here will have a focus on the infrastructure spending to support the European Green deal and progression towards the Paris Agreements goals on greenhouse gas emissions.

In addition, the most significant recovery package ever presented by the bloc titled ‘Next Generation EU’ (NGEU). This will provide support up to €750 billion broken down as follows:

  • €360 billion in low-cost loans to support business, and
  • €390 billion in grants

In total, the EU budget and stimulus spending programmes combined amount to almost 2 trillion Euros, or €1,824 billion to be exact.

Where we go from here will be interesting. The EU, rather than the independent member countries, becoming one of the largest issuers of European bonds has several interesting possibilities which we will continue to explore.

Conclusions:

  • Covid-19 has placed significant pressure on politicians to deliver stimulus packages to help sustain economies.
  • Despite facing threats of disunity, EU politicians have united in carving out a path for economic recovery.
  • However, compromises reached may produce headaches later as debts fall due and budget rebates get paid out to more affluent countries.

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