The Financial Express

EU economic rescue plan: An attempt at debt mutualisation

| Updated: August 09, 2020 21:34:10

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EU economic rescue plan: An attempt at debt mutualisation

In the very early hours of Tuesday, July 21, 27 member countries of the European Union after four days of  very acrimonious negotiations agreed to  an economic rescue plan to help member countries to manage the Great Depression-scale (1929-33) economic shock from the Covid-19 pandemic.  The European Commission (EC)  predicted last month that the European Union (EU) economy would contract by 8.3 per cent in 2020. European Central Bank (ECB) President Christine Legarde said that the Eurozone economy could contract by as much as 12 per cent this year and the shape of the recovery was very uncertain.

Now according to Eurostat, the Eurozone economy contracted by 12.1 per cent during the second quarter of this year and the same figure for the EU economy stands at 11.9 per cent. It further stated that seasonally adjusted GDP decreased by 15 per cent in the Eurozone area and 14.4 per cent in the EU in the second quarter of 2020. These were by far the sharpest declines since time series started in 1995. Countries that recorded the highest decline during the second quarter are Spain (-22.1 per cent), France (-19 per cent), Italy (-17.3 per cent) and Portugal (-16.5 per cent) but the remaining 23 EU member countries also recoded negative growth rates but lower than these figures but mostly in the double digits.

However, chain linked volumes annualised change on the previous period,  the EU recorded -39.8 per cent and the Eurozone by -40.3 per cent. More precisely, the EU economy shrank at a 39.8 per cent and Eurozone by 40.3 per cent annual rate between April and June, 2020. The rapidly deepening economic crisis has been just accelerated by the pandemic but not caused by it. The underlying tendencies have been already well advanced for quite sometime even before the pandemic struck.

The economic rescue plan was  built upon a Franco-German proposal, calling on the EC for a €750 billion  to respond to the economic downturn caused  by the pandemic. The EC also agreed on the EU's next seven year budget, the  Multiannual Financial Framework (MFF) worth €1,074 billion from 2021 to 2027. The total package is €1.8 trillion equivalent to 4 percent of EU GDP. To give further boost to the EU economy, the ECB left its interest rate unchanged at minus 1 per cent which effectively means it is paying borrowers to borrow money. Yet the borrowing costs of Italy and Spain now exceeds 6 per cent in view their dismal growth prospects. The ECB further injected €1 trillion buying government bonds and private corporate bonds.

Although Eurozone member countries (19 out of 27 EU member countries) use the same currency, Euro, but do not have a single treasury to coordinate the economic recovery policy to deal with the pandemic. The attempts to run a common monetary policy without a common treasury has failed. This has laid bare the institutional weakness of the Eurozone.

The agreed recovery fund is a recovery tool to deal with the specific downturn caused by the pandemic but such a policy initiative  lacks a proper built in cyclical stabilisation mechanism for the Eurozone as a whole, which is left to individual national governments to deal with their own resources. In fact, the Eurozone has a poor record of enforcing fiscal rules.

Furthermore, when an individual member country, say Italy or Spain issues bonds, investors are not sure whether such bonds have the backing of Germany, the largest and strongest economy in the EU accounting for 28 per cent of Eurozone GDP and 24.7 per cent of EU GDP. In the absence of such a guarantee there will be bear runs derailing the recovery process as have happened to Greece, Ireland and Portugal in the past and likely now to happen to Italy and Spain.

The solution lies in the issuance of bonds  that would come with a "joint and several guarantee", that is jointly guaranteed by all member countries, more precisely debt mutualisation. But the "frugal four" (Austria, Denmark, the Netherlands and Sweden) are against any grants because that could lead to big spending and could also lead to a mutualisation of member states' debt which they oppose.

Also, there is the problem of moral hazard associated with such a joint guarantee where fiscally irresponsible countries would like to freeride on fiscally responsible countries. This fear mostly prevented the fiscally responsible countries in the Eurozone like the "frugal four" and Germany to shy away from debt mutualisation. This is very symptomatic of a two  speed Eurozone with a North and a South.

The issue of debt mutualisation has had a long history of divergent views between the South and the North in addressing Eurozone's economic and financial crises since its inception. The South views that the principal threat to Eurozone comes from panic or fear caused by an  economic or a  financial  crisis that can suddenly increase the costs of borrowing causing insolvency. The North views that  removing the market discipline will dampen the need for reform. The EU  Brussels summit has now also opened up East-West divide with Hungary and Poland leading the charge going against the widely accepted liberal political and legal norms in the EU.

There has been increasing concerns about the use of both "fiscal dominance" and "financial repression" by countries facing acute economic crisis in the EU. Furthermore, policy interactions are increasingly blurring the boundary between monetary policy and public debt management.  Such policy interaction creates uncertainty about the impact of increased public debt levels on inflation, interest rates and future growth further adding to the concerns of the "frugal four".

However, many observers already warned that debt mutualisation would lead to another market distortion and the creation of another layer of inefficiency. The borrowing costs of individual member countries  would no longer  reflect  the real cost of borrowing based on their economic performance and the sustainability of their public finances. As such other member countries would have to bear the cost of overborrowing.

During the acrimonious four day negotiations in Brussels last month, the distrust between the "frugal four" of the North and fiscally lax Southern counties like Italy, Spain and Greece came  to the open and still remains very deep making any long term solution very difficult. This is the reason that the "frugal four" proposed preferential loans financed through the EU's budget rather than directly funded financial rescue plan as proposed by France and Germany. But Germany also joined the "frugal four" to  reject the idea  of common debt instrument called "Coronabonds" in late March this year; now it seems have changed its position on mutualised debt.

The currently agreed economic recovery fund is composed of €390 billion in grants, scaled down from €500 billion initially proposed by the EC and €360 billion in loans. The total amount of the fund is €750 billion. Italy and Spain are the two principal beneficiaries of the fund. Italy is set to receive €82 billion in grants and €127 billion in in loans, total amounting to €209 billion. Spain is the second biggest recipient with a total amount of €140 billion of which €72.7 billion in grants and the rest is as loans. These two countries together will receive 47 per cent,  close to half of the total rescue fund. The rescue fund will create €3,201 per capita debt liability for EU citizens. These two biggest beneficiaries of the rescue fund Italy and Spain contribute 11.7 per cent and 8.2 per cent respectively to the EU budget, Just about 20 per cent together.

Furthermore, internal dissensions led to watering down of the most strict conditionalities originally proposed  such as linking budget spending and  the rule of law and others, particularly targeted at countries like Hungary and Poland. Also, other conditionalities like a right to veto a stop to the supply of fund if recipient countries do not implement reforms were avoided. This has further widened the distrust between the frugal North and the profligate South as well as the West and the East. Overall, nothing much has changed, Eastern Europe remains increasingly authoritarian, and the South remains heavily in debt at a time when the UK, one of the net contributors to the EU budget bailed.

The price tag for the compromise reached was an extended rebate amounting to €27 billion over the seven year period for the  five net contributors, Germany, the Netherlands, Sweden, Austria and Denmark with the Netherlands being the largest beneficiary. These countries are also at the same time the principal beneficiaries of the internal market.

The recovery fund is the first and foremost part of the wider efforts to bring the  Eurozone and the EU through the current economic crisis caused by the pandemic. For the first time in the EU's history, it will take on debt to finance an economic stimulus  package and the EU will tap financial markets on a significant scale to secure the fund. The issuance of this EU debt is also eligible for the ECB purchase programme. The borrowed fund will be repaid through the EU budget between 2028 and 2058.

The fund will not be available until the beginning of 2021 at the earliest. That may make it too late for hard hit countries like Greece, Italy and Spain. Also many observers believe  given the size of the recovery fund relative to the need remains insufficient. So the fund is unlikely to change the situation in the short run.

For the first time, the EU will be able to run budget deficits to respond to exogenous economic shocks using an EU instrument for sharing debt and transfer the funds to countries that need it. This particular EU debt will be mutualised, but not the already existing eurozone debt. Even then, this attempt at the mutualisation of debt has a catch because  bond issuance would not come with a declaration of "joint and several guarantee", thus making it less than full debt mutualisation. As such the EU's attempt at debt mutualisation remains away from the type of debt mutualisation originally envisaged.

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