E.U. Bonded to Recovery

Authors: Sauradeep Bhattacharyya and Bryce Yeo Region Head: Harsh Didwania Editor: Harsh Didwania

Background

Covid-19 reigned havoc through the entirety of 2020 and rampaged economies across the globe. The EU after a historic deal struck between German Chancellor Angela Merkel and French President Emmanuel Macron, has set a commission to raise funds to mitigate consequent unemployment risks and to finance Covid stimulus packages for countries in the EU. Including Hungary, the Commission has till now proposed a total of €87.8 billion in financial support to 17 Member States. Financial support will be provided in the form of loans granted on favourable terms from the EU to Member States.

The EU still enjoys a strong triple A credit rating. These excellent credit ratings allow low yielding bonds like SURE social bonds to have high demand in the bond market which results in better efficacy in raising funds. Another factor that adds to low cost of issuing debt, is the current global situation where negative-yielding debt is close to an all-time high of $16.8 trillion largely driven by bonds from EU countries offering sub-zero returns (Ashworth, 2020). Even Italian debt, the highest yielding of the EU issuers offers less than zero returns to 4 year maturities. Hence in this market the cost to produce a comparative advantage to attract demand is very low.

The EU has now become part of a big five of issuers in Europe, alongside Italy, France, Germany and Spain. It could be the biggest European seller in 2021, with nearly 300 billion euros possible — a third of which will be designated green bonds. It will also become the largest social-linked bond issuer in the world. The SURE program will nearly double the $72 billions of total social-bond issuance this year so far (Ashworth, 2020).

Economic Impact

GDP and Unemployment:

According to Eurostat (2021), In December 2020, the euro area seasonally-adjusted unemployment rate was 8.3%, only 0.7 percentage points up from 7.4% in December 2019. This shows that these bonds along with mobilisation of other financial support schemes by member states of the EU had been able to mitigate the negative economic and political effects of the coronavirus outbreak on their territory.

Private Consumption accounted for 53.2 % of its Nominal Gross Domestic Product (GDP) in September 2020 (CEIC, 2020). Consumers form half of the E.U. Economy. This consumer spending is purely driven by salaries. It is expected that economic activity will shrink when people lose their jobs rather than get hired. Unemployed workers will then be forced to tighten their belts as they look for new jobs. Thus, an overall increase in unemployment depresses GDP growth.

To boost GDP growth, the E.U. provides financial assistance through SURE Bonds of up to €100 billion in the form of loans to affected Member States. This is twice the amount of private equity investment of the E.U. GDP. These loans are underpinned by a system of voluntary guarantees from Member States. The Council has already approved a total of €90.3 billion in financial support to 18 Member States. €53.5 billion has already been disbursed to 15 Member States. Currently, the top three countries for which financial support has been approved are Italy (€20.95 billion), Spain (€11.03 billion), and Poland (€5.28 billion) (European Commission, 2021).

Financial Support for social causes:

EU SURE social bonds provide investors with confidence that the funds mobilised will serve a truly social objective. The EU strives to use SURE Bonds as an ESG (Environment, Social, and Governance) debt instrument allowing the investor community to allocate their funds towards the social needs of EU Member States hit by the pandemic crisis. The SURE Regulation requires all Member States to be regularly reporting to the Commission on how the borrowed funds have been spent. This guarantees that SURE bonds are really social bonds.

Greater Stability in the Bond market:

Eurozone countries have no common treasury and issue debt separately. That means they have different ratings and consequently differing degrees of safety, with only Germany and the Netherlands having a triple A rating. This varies their ability to raise funds in the international bond market. SURE bonds allow for a larger euro-denominated bond market with a more holistic yield curve over different maturities, which can serve as a benchmark for other issuers. It would also increase the liquidity of the bond market by reducing spreads and issuance costs for smaller EU countries. Backed by a formidable financial powerhouse-the EU, SURE bonds would be more attractive to international investors, and would strengthen the euro as a global currency due to greater demand.

From a prudential perspective, an additional advantage of Eurobonds is that a larger European asset class emerges for financial institutions to invest in, not linked to any one country. This reduces the dependency of banks on the rating of their sovereign for their funding costs, which has been a divisive factor in European banking markets. It also eases tricky discussions about the limitations of large exposures to sovereigns and the introduction of a risk weighting for sovereign bonds. That is because financial institutions will automatically redistribute their assets over these new bonds, and thus have more balanced portfolios (Lannoo, 2020).

Political Impact

Fiscal Federation:

The new Franco-German proposal for a 500 billion euro European recovery fund could turn out to be the most important historic consequence of the coronavirus.

It is even conceivable that the deal struck between German Chancellor Angela Merkel and French President Emmanuel Macron might one day be remembered as the European Union's "Hamiltonian moment", comparable to the 1790 agreement between Alexander Hamilton and Thomas Jefferson on public borrowing, which helped to turn the United States, a confederation with little central government, into a genuine political federation (Kaletsky, 2020).

The key innovation of financing the recovery fund with bonds issued directly by the EU in its own name and guaranteed by its own revenues, instead of using funds raised by national governments, whether acting together or separately, will allow for greater pan European spending redistribution by allowing targeted distribution of funds to beleaguered nations by the EU. This has the potential to transform the Euro zone landscape into a fiscal federation.

Pan-European Taxes:

To guarantee and service billions of euros of new borrowing on its own account, the EU will require more tax revenue than it now receives. Dr Merkel and Mr Macron have therefore proposed to increase the European Commission's budget from 1.2 percent to 2 percent of EU gross national income, yielding about 180 billion euros per year in extra revenue (Kaletsky, 2020)..

To raise this amount, the EU will need to levy new taxes on its own account, although the exact nature of the EU's new taxes is not known it will presumably be the subject of fierce debate and lobbying.

There is broad consensus however, that this tax revenue will be in the form pan-European taxes based on economic activities that transcend national boundaries, such as carbon dioxide emissions, financial transactions and digital transactions (Kaletsky, 2020).

Some of this extra tax revenue will flow into recovery projects, but most will be needed for other EU spending, to subsidise the poorer eastern countries and also help to buy off governments that might otherwise block the recovery fund and other EU initiatives and reforms. This will also replace the United Kingdom's net contributions of roughly 10 billion euros per year (Kaletsky, 2020).

The triad of bonds being issued by the EU in its own name, pan-European taxes on cross-border activities along with leverage to benefit from low interest rates, if carried out to fruition will see transformation of the EU landscape into one of great political stability and fiscal coordination.

Backlash

Ms Merkel and Mr Macron’s announcement applies pressure on the so-called frugal states in the north to concede that at least part of the recovery fund should be distributed in the form of grants, rather than loans, to beleaguered countries. This might result in some unseemly late-night squabbles between the EU and the self-styled "Frugal Four" northern governments (the Netherlands, Austria, Finland, and Sweden), which have vehemently opposed funding for Mediterranean EU members which, according to Wopke Hoekstra, the Dutch Finance Minister, have mainly themselves to blame for "failing to reform" (Kaletsky, 2020).

There might also be backlash to increased European Commission's budget to be funded by increased pan-European taxes, as Dutch or Swedish taxes could potentially be used to pay for Spanish or Hungarian development.

Conclusion

The new SURE bonds scheme allows the EU to leverage its activities with borrowing, instead of just using the EU budget as a pass-through mechanism from pan-European taxes to current spending. Because of today's near-zero interest rates for triple-A sovereign borrowers, the leverage available to the EU, to raise a modest amount of extra revenue is enormous. This could pave the way for realising the objective of a next generation “greener” EU by allowing borrowing for a digital inclusion fund, vehicle electrification fund or for a comprehensive climate-change fund.

As to the current backlash, our opinion is that a compromise would not be difficult to forge. Even if one concedes to the Frugals’ insistence on offering 50 percent of the support through loans instead of grants, with near-zero interest rates and long maturities loans are economically almost equivalent to grants. And using loans instead of grants would make EU debt financially more sustainable, thereby maximising the scope for further borrowing without risking the bloc's triple-A rating. So overall, SURE bonds are a welcome move which will provide greater economic flexibility and political stability to the EU region as a whole and successfully see through a resilient European recovery from the pandemic.

References

1. Ashworth, M. (2020, October 21). Brussels blows the roof off the bond market. Retrieved February 22, 2021, from https://www.washingtonpost.com/business/brussels-blows-the-roof-off-the-bond-market/2020/10/20/37f3ea80-12c4-11eb-a258-614acf2b906d_story.html

2. CEIC DATA. (2018). European Union Private Consumption: % of GDP. Ceicdata.com. https://www.ceicdata.com/en/indicator/european-union/private-consumption--of-nominal-gdp#:~:text=European%20Union%20Private%20Consumption%20accounted,an%20average%20share%20of%2055.3%20%25.

3. CEIC. (2020). Retrieved from https://www.ceicdata.com/en/indicator/european-union/private-consumption--of-nominal-gdp

4. Eurostat. (2021). Euro area unemployment at 8.3% [Press release]. https://ec.europa.eu/eurostat/documents/portlet_file_entry/2995521/3-01022021-AP-EN.pdf/db860f10-65e3-a1a6-e526-9d4db80904b9

5. European Commission. (2020). EU SURE Social Bond Framework [PDF]. Retrieved from https://ec.europa.eu/info/sites/info/files/about_the_european_commission/eu_budget/eu_sure_social_bond_framework.pdf

6. European Commission. (2021). SURE - DISBURSEMENTS UNDER VARIOUS BOND MATURITIES [PDF]. Retrieved from https://ec.europa.eu/info/sites/info/files/about_the_european_commission/eu_budget/sure_disbursements_table_4th_issuance_02.02.2021.pdf

7. Kaletsky, A. (2020, May 26). Businesstimes.com.sg. Retrieved February 22, 2021, from https://www.businesstimes.com.sg/opinion/franco-german-proposal-can-be-europes-hamiltonian-moment

8. Lannoo, K. (2020, June 29). EU debt plan makes sense and is worth backing. Retrieved February 21, 2021, from https://www-ft-com.libproxy.smu.edu.sg/content/aafffb52-aab6-4db7-9e70-b1916a2c2024