Euro assets (FX, periphery Government bond spreads, bank equity prices) found support in the past week from the European Commission’s “Next Generation EU” proposal
The EU brought forward the emergency European Recovery Instrument (ERI), an important tool for supporting economic growth, on top of: i) fiscal measures taken individually by countries; ii) EU initiatives already in place (SURE, ESM Pandemic Crisis Support, EIB Guarantee Fund for Workers and Businesses); and iii) the Multiannual Financial Framework (the EU Budget) for 2021-2027.
The EC presented its proposal, on May 27th, for a €750 billion scheme (5.25% of EU GDP), the so-called “Next Generation EU”. Funds will be raised from the EC in the financial markets. To facilitate access to financing, the EC will create headroom (which will act like a guarantee) by raising the difference between the maximum amount of funds it can request from member States to finance its expenditure and the actual spending. Funds will afterwards be channeled to member States as grants for the most part (close to €500 billion) and €250 billion as loans, with priority for countries that have suffered the biggest shock from the pandemic and have the least capacity to respond to it. According to the proposal, the funds raised will be repaid after 2027 and by 2058. Looking forward, the ambition is for political agreement by July, at the European Council, for the disbursement of funds to start in January 2021, although negotiations could take longer, with the risk of a final agreement being less far-reaching than the aforementioned proposal.
Recall that the speed and the breadth of the post-pandemic economic recovery is important also for the long-term stability of the euro area financial system, which -- having weathered the initial shock stemming from the pandemic on the back of massive fiscal, monetary, micro & macro-prudential supportive policies -- faces increased challenges in the medium term. According to the ECB (Financial Stability Review May 2020), these challenges include, inter alia, vulnerabilities in the corporate sector, especially in view of highly leveraged firms and elevated indebtedness for many sovereigns. Indeed, regarding non-financial corporates (NFC), debt entered the Covid-19 era from a high 108% of euro area GDP at the end of 2019. Alternative leverage indicators were also elevated at the beginning of 2020, with the ratio of Net Debt to Earnings Before Interest, Taxes, Dividends and Amortizations (EBITDA) at 2.4x as of Q1:20 from 1.9x in Q1:18.
Many firms may face rating downgrades in the current juncture (see graph), which could lead to higher funding costs and challenges for debt rollover, especially for speculative grade issuers. Note that €500 billion of corporate bonds, leveraged and syndicated loans, as well as short-term commercial paper, matures at end-2021. That risk is substantially amplified by the fact that issuers with a BBB rating, the lowest in the Investment Grade (IG) spectrum, represent a large (and rising) portion of the overall IG segment (53% of outstanding debt). Recall that downgrades of BBB-rated issuers to the High Yield (HY) universe could have non-linear adverse effects on bond prices, as markets for HY and (lower) IG bonds are highly segregated.
Many High indebtedness, particularly for certain sovereigns, poses another challenge to financial stability according to the ECB. Recall that the discretionary fiscal measures to support the economy against the negative repercussions from the pandemic amount to 4% of euro area GDP. Moreover, close to 20% of euro area GDP has been committed to loan guarantee schemes. Combined with an anticipated contraction in GDP in 2020 (circa -8% yoy), general government debt for the euro area is expected to reach 102.7% of GDP in 2020 versus 86.0% in 2019. A more severe and prolonged economic contraction than envisaged, if coupled with higher sovereign funding costs for some countries and the materialization of contingent liabilities (mostly related to the aforementioned loan guarantees), could risk setting the ratio of public debt-to-GDP on an unsustainable path in already highly indebted countries.