EU leaders reach a historic recovery plan agreement, signaling a significant step towards social cohesion
Euro area markets (Equities, periphery Government bonds, FX) remained in a “wait-and-see” mode ahead of the EU Council meeting, which lasted four days, before an agreement was reached on Tuesday on the Next Generation EU mechanism (NGEU).
Note that the euro has appreciated by 3% in NEER terms and by 7% against the USD to $1.145 following its March lows on the back of: i) the strong commitment by the French and German leaders to support the European economy through the recovery fund; ii) the aggressive monetary easing by the ECB through emergency asset purchases, with a total of €1,470bn, relaxed collateral requirements and targeted long-term refinancing operations, which boosted confidence in the EUR; and iii) the improvement in global risk appetite that caused safe-haven currencies to decline (JPY, USD). In a similar vein, euro area periphery Government bond spreads have narrowed significantly, remaining slightly above pre-coronavirus levels (see graph page 3).
The agreement is a key ingredient for the European response to the pandemic shock.
On the one hand, relative to the original proposition, the European Commission (EC) has made additional concessions to the “frugal 4+1” member states (The Netherlands, Austria, Sweden, Denmark and Finland with a total EU GDP of circa 15%) including: i) a “super emergency brake” where countries would have the right to escalate an objection to an EC proposal to approve a plan to the Council; and ii) lump sum rebates on the annual gross national income-based contribution will be maintained for the Frugal 4 and Germany.
More importantly, there will be a higher-than-originally-envisaged percentage of loans and a smaller share of grants in the €750bn package following the resistance of the “frugal 4+1” member states. Indeed, the grants component in the NGEU proposal has been cut from €440bn to €390bn and the loan component has been increased from €250bn to €360bn (loan-guarantees under the original proposal were circa €60bn). Despite the fact that the pricing of Recovery Fund loans will be attractive relative to individual funding costs for some member states, especially those with sovereign ratings in the BBB or lower, it is doubtful that these highly indebted countries will choose to add additional liabilities to their balance sheet. Thus, the “effective” size of the mechanism could be significantly lower than the headline figure suggests.
On the other hand, the overall size remains impressive at EUR750bn (higher than 5% of EU GDP), suggesting a swift policy response in the Covid-19 crisis and long-lasting positive developments regarding the social cohesion of the European Union. Under the agreement, the Commission will be able to borrow up to €750bn on the financial markets with the Recovery Fund. The borrowed funds may be used for back-to-back loans towards member states and for expenditure channeled through the MFF programmes (grants). Together with the ESM Pandemic Crisis Support and other initiatives for workers and businesses, the total nominal amount of Covid-19 related EU fiscal support has a firepower of up to €1,200bn.
Overall, the agreement is a strong political signal for the cohesion of the EU. Investor attention will now turn to incoming economic data for Q3 in order to evaluate (cont’d on page 2) the improvement of the economy following its Covid-19 related slump (euro area Q2 GDP data are expected at 31/7 with consensus forecasts of -12.4% qoq).