Is the European Reconstruction Fund a “game changer” for the Eurozone?

The news that Germany and France have joined forces to launch a comprehensive stimulus package worth half a trillion Euros has boosted the common currency in recent trading sessions. However, as always in the Eurozone, as the deepening talks progress, it may be more about the details than the headlines. Just over a month ago, the topic of corona bonds as a possible European way out of the crisis came up. The key issue is the use of the common European budget to finance a reconstruction fund. The countries of the South, including France, wanted a concrete form of fiscal integration. Further equal distribution of debt, while the countries of the North rejected any idea of a joint debt issue and were not willing to pay the debts of other countries.

Proposal by Berlin and Paris

French President Macron and German Chancellor Merkel have agreed in principle to launch an extraordinary package of 500 billion Euros. It will come from the EU budget to deal with the Covid 19 crisis. This will be financed by borrowing on the markets according to the usual “capital key principles”. It will be part of the next EU multi-annual budget with binding repayments across several budgets. The areas most affected by the crisis – southern Europe – should benefit most. The fund will provide direct fiscal incentives in the form of grants, mainly to industries in the affected regions. The main issue of whether the fund is a system of repayable loans or grants has therefore fallen in favour of countries like Italy and Spain.

Were there alternatives?

For countries like Italy, creating loans and increasing its mountain of debt (200% of GDP in 2021 according to some forecasts) would simply put the country on an extremely painful path and in all probability trigger another EU debt crisis.

Reactions of the Northern European countries

As expected, the proposal has already aroused scepticism among the “thrifty” northern member states. They want to have most of the money reimbursed by the recipients of the members. Any form of joint issuance of debt instruments has always been frowned upon and there is also concern that a precedent will be set. Although the fund is of a temporary nature. Even the supporters of the agreed rescue package have questioned the overall size of the fund, which is less than 4% of EU GDP over several years. They are also concerned about the timing of the release, as the multiannual budget is not due to start until 2021.

Of course, the Franco-German proposal to create a link between the two largest EU contributors gives cause for optimism. The next stage will be to get all 27 EU member states to agree. This includes countries like Austria, the Netherlands and Sweden. It is important to remember that negotiations on the EU’s regular seven-year budget have been deadlocked for more than two years. The task of getting all sides to reach agreement will fall to the President of the European Council. This is Mr Michel. He has to prepare a summit, which is not planned yet.

Positive market reaction so far

The spread between Italian and German yields has narrowed significantly. Since the announcement the potential risk premium in the Euro has narrowed. Progress is being made, in contrast to the GBP, where this premium is rising as the Brexit talks stutter.

After the European common currency has remained flat for nearly two weeks without any significant movement, the EUR/USD rose through several strong resistance levels to its biggest daily gain in the past six weeks. The upward momentum has now improved. But the breaching of the 1.1017 high reached in early May may be the key to further gains. On the downside, the USD 1.0825 level acts as a strong support.

Merkel und Macron mit der Idee für den EU Wiederaufbaufonds
Merkel and Macron. Photo: CC BY 4.0
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