July 2020 will likely go down in history as a pivotal moment for the European Union. After five days of intense negotiations – a relatively short time by EU policymaking standards – leaders agreed to a mammoth €1.8 trillion financial package for the 27 member states. Yet the deal, comprising a €750 billion recovery fund and the $1.07 trillion EU budget for 2021-2027, was consequential not for its size or speed. Rather, it was the precedent-setting authorization for the European Commission (EC) itself, rather than member states, to issue the recovery bonds in varying maturities over a lengthy period through 2026, that is momentous. In our view, this step signifies greater cohesion among the EU-27 and a stronger foundation both for its financial system and the common currency – which are consequential not only for European equities but also for global equity markets.
Although cause and effect are hard to identify precisely with so many fast-moving developments amid the pandemic, in our view markets embraced the deal, with European as well as US equity markets rising and the euro jumping to a nearly two-year high on the US dollar following the news. Looking ahead, the agreement may assuage a key qualm among investors about a return to euro fragility driven by the very weak financial situation among the southern and eastern member states, and reticence about fiscal spending among the European “Frugal Four.”
The EU has come to rely heavily on the European Central Bank (ECB) to keep the yields of bonds issued by the financially weaker member states (the so-called periphery) from spiking during troubled economic periods – due primarily to the ECB’s large-scale sovereign asset purchase programs, or quantitative easing (QE), following the global financial crisis. After the crisis, the financially stronger member states (the so-called core) loaned bailout funds to the periphery under strict fiscal conditions, which led to austerity plans to bring down the deficits.
It’s not surprising that the austerity measures gave rise to growing anti-EU sentiment over the years, given the pain borne mostly by the younger generation in Southern Europe. For this cohort, unemployment rates have remained stubbornly high amid a lack of sufficient economic growth and labor market reforms. And reliance on the ECB has continued amid the ballooning Covid-19-related fiscal deficits.
A key concern is the health of the European banking system, which has struggled to earn a spread between lending and deposit rates amid negative interest rates. Eurozone loan growth averaged an anemic 0.9% annually for corporates and 2.0% for households over the five years ended 2019, and the negative rate environment has resulted in low net interest margins for European banks.
Against this backdrop, European banks have struggled to deliver a decent level of profitability that is even equal to, let alone higher than, their cost of capital: for example, the ratio of the average market capitalization of eurozone banks to their expected 2020 year-end book value is just 0.5x, with an expected return on equity in 2021 of just 4.8% (according to JP Morgan European Banks Research). Eurozone banks should normally trade at a minimum 1x book value if they can deliver a return on equity in the 9%-10% range. Although capital raises have now pushed the capitalization of banks in Europe several times higher than the pre-GFC level, low profitability means that come the next asset quality crisis, losses would quickly eat into capital, causing yet another financial crisis.
The “elephant in the room” when it comes to European banks is the sovereign debt on their balance sheets, where they earn returns from the so-called carry trade – the return from higher yielding peripheral bonds over the near-zero (even negative) cost of funding. Any permanent increase in sovereign yields would be reflected as a hit to capital, making the ECB’s QE purchases vitally important for the stability of the eurozone banking system. To compound the problem, the Basel bank capital adequacy rules have declared all Organisation for Economic Co-operation and Development (OECD) sovereign debt to be technically risk-free, so banks are not required to allocate any capital toward their sovereign debt holdings, resulting in an inherent undercapitalization of the banks that are particularly exposed to peripheral sovereign debt holdings.
The circularity between the banks and the sovereign in the EU periphery has long been an issue in the European banking system. Any weakening in the sovereign debt weakens banks’ capital, which in turn causes the banks to pull back on lending, further weakening the wider economy, which in turn weakens the banks. Were it not for the ECB breaking this circularity through QE, there would already be another banking crisis; and such reliance on the central bank is, of course, not desirable as a long-term solution to the stability of the EU banking system – nor, for that matter, for the global banking system, due to the inter-linkages in the financial system.
The cumulative fiscal deficit for the euro area resulting from Covid-19 lockdowns is projected to be a whopping 20% of GDP in 2020-2022, an eye-watering shock to public finances that has the potential to cause yet another full-blown euro crisis. However, this fiscal gap is expected to be more than offset by the recovery plan grants, the ECB’s sovereign debt purchases, and other EU loans (based on Goldman Sachs Research), an arrangement that will use for the first time a central funding mechanism without resorting to the ad hoc bailout funds that were used post-GFC.
The recovery plan has far-reaching, positive implications for macroeconomic stability, the EU financial system, and global capital markets. Although many of the details of the plan are still unknown and the plan has yet to be ratified by the individual parliaments of the 27 member states, it has been widely welcomed by the market, with the euro strengthening by over 7% against the US dollar since the end of May.
The plan contains two parts: the first consists of grants totaling €390 billion, and the second is €360 billion in loans. Grant disbursements will be approved by the EU Council with a qualified majority, and member states will need to submit their individual recovery plans to the European Commission in October for approval before year-end. The underlying philosophy of the grant is to move away from the austerity approach to funding individual member states’ recovery plans with a pro-investment, pro-growth, and pro-“green” approach, which greatly strengthens the cohesion of the eurozone region.
Distribution of the grants will be skewed to the southern and eastern European member states, with an allocation far higher than their share of gross national income in the EU. Seventy percent of the grant amount will be committed rapidly over 2021-2022, on the basis of average unemployment rates over 2015-2019. The remaining 30% will be distributed in 2023, with the basis of allocation shifting to the GDP contraction that occurs over 2020-2021.
The €360 billion in loans are expected to be at very low rates that would be particularly attractive for the peripheral member states, with light conditionality – a very significant departure from the fiscal rectitude demanded by the Europe’s core on its periphery post-GFC, which has yielded mixed results at best and a lost generation of Europeans at worst.
By becoming the borrower through its issuance of €750 billion of debt, the EC sets a new precedent while becoming a major new force in the sovereign debt markets. It is also expected to demonstrate maximum flexibility in managing its debt to achieve the most favorable terms for the member states. The bonds are expected to be repaid through the EU budget through the end of 2058. New tax revenues have been proposed, such as a plastic levy, a digital tax, and a review of the EU Emissions Trading System.
The recovery plan marks a significant moment in which EU Leaders recognized the need to create a new structure for raising funds under the auspices of the EC and funded by the EU budget. This structure has a strong likelihood of becoming a permanent funding mechanism at the EU level for emergency programs and other funding needs for the fiscally weak member states. They have also acted swiftly to stem the risks to the eurozone’s stability from alarmingly high fiscal deficits, and to front-load the raising of funds in order to plug the enormous fiscal gaps into the future. They have recognized the need to move away from the failed austerity approach of the past and to adopt a pro-growth policy through grants and loans on attractive terms with light conditionality – a major departure from the past.
The recovery plan could well become a permanent feature for the EU, serving to underpin the debt issued by the periphery member states. This has enormous significance for the EU banking industry, which has become reliant on the ECB’s QE programs for its stability and capital adequacy. If the fear of default is truly removed for any eurozone sovereign debt, without assuming intervention by the ECB, there could be broader implications for financial system integration within Europe, with cross-border mergers and acquisitions within the EU finally taking place. This is sorely needed to drive greater scale in a banking system that has poor profitability compared to that of the US.
The recovery fund may not be quite as far-reaching as Alexander Hamilton’s re-ordering of the financial system in the newly born United States. However, the progress made by EU leaders this summer points to a measured yet pivotal step toward very similar ends.
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