The European sovereign debt crisis that reached its zenith over the period 2010-12 exposed a key structural weakness in the construct of the Eurozone common currency – the lack of a cohesive region-wide fiscal strategy. The Eurozone muddled through, though not without some tense moments, but fiscally-speaking ended up wasting the ‘best’ crisis since the Euro was launched.
Since then various populist governments across the region have provided further tests to stability as they have sought to break the fiscal rules and the patience of Brussels.
At these times we have consistently argued that it was inevitable that Europe would have to bite the bullet, sort out its differences and get its fiscal act together. That was especially necessary if the next economic/financial crisis materialised before Eurozone monetary policy had normalised to a significant extent. It has also seemed to us that part of the solution would require some degree of region-wide risk sharing that comes with debt mutualisation.
Little did we know this would all be tested less than a decade later. The COVID-19 recession is the deepest in living memory, and without making any meaningful progress towards normalisation, the European Central Bank is pushing on a string.
That, as in most parts of the world, is leaving fiscal policy to do the stimulatory heavy-lifting. The recent joint German-Franco proposal for a €500 billion Recovery Fund, financed through the European Union (EU) budget by the issuance of common bonds, is therefore both welcome and timely.
The bare bones of the proposal has the European Commission (EC) issuing bonds supported by the national guarantees of member countries. The EC will then allocate grants to sectors and countries in most need following the COVID-19 outbreak. The biggest winners in such a proposal are likely to the largest countries such as Italy and Spain. The EC is expected to issue its more detailed proposal shortly.
The overall size of the proposal might seem small in the scale of the European economy, but right now it’s the principle that matters first. The proposal will face fierce resistance from member states that have long been against greater fiscal integration; the Netherlands and Austria come immediately to mind.
As is often the case in Europe, the devil will be in the details, and while the need for deeper fiscal integration is more widely acknowledged, there is still a strong lobby within national central banks that remains sceptical. The German Constitutional Court has repeatedly been a venue for challenges to the ‘euro-bond’ concept, and opponents of the idea will not give up the fight easily – because those same sceptics see themselves as acting in the interests of their own domestic voters and taxpayers. European institutions are wary of assuming the passive compliance of member-state voters on issues of EU solidarity, mainly because of the shock of Brexit which is still resounding through the continent’s forward planning.
But assuming the Recovery Fund is established in time, it sends an important signal about the political commitment to a more integrated Europe and will lead to further fiscal integration ahead. The proposal may well succeed because it is linked specifically to the shocking toll of the pandemic in Europe, rather than a general appeal to help the southern states out of (yet) another budget crisis.
Most importantly, greater fiscal integration helps close a gaping hole in the original construct of the Euro. Thus, positive news could well support the Euro, which is close to a three-year low versus the US dollar at a time when the US economy seems more likely to need a weaker currency to aid its own COVID-19 recovery path.
European shares might potentially also find some small positive impact, despite the fact that European banks and financials are more influential in the Eurozone equity index than in many regions. Eurozone stocks have underperformed the Global index by around 8% in 2020-to-date, as lockdowns have been especially stringent and activity almost at a standstill. However, one caveat is that France and Germany together account for 62% of the MSCI Eurozone equity index, while the countries that could most benefit from the plan, Spain and Italy, together make up less than 15% of the market index. This makes the joint weighting of Spain and Italy only a little larger than the Netherlands (13.8%), so even a rapid and comprehensive bond deal wouldn’t be an unequivocal positive for equity investors.
Thanks to Greg Fleming, Head of Investment Strategy, for additional comments.
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