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ANALYSIS: Is EU bailout the first step to fiscal integration?

Jigsaw pieces floating.

After some tortuous negotiations, EU leaders have struck a deal on the EU recovery fund, designed to direct cash to those nations hardest hit by the covid-19 outbreak.

It came in spite of significant opposition from the ‘frugal four’; Austria, Denmark, the Netherlands and Sweden; and in a watered-down version – but has been seen as an important first step towards fiscal integration for the bloc.

The recovery plan includes €390bn of grants and €360bn of loans, funded by joint debt issuance.

This is the first time the European Commission has borrowed money in the capital markets on its own account and as such, is an historic moment.

It can now hand this out as budgetary support to member states.

The plan was controversial and only agreed after the four dissenting countries saw their EU budget rebates increased.

Not to prop up struggling nations

The deal allows for fiscal transfers between nations, which is good news for struggling, indebted countries such as Italy and Greece; and may come at the expense of Europe’s economic powerhouses.

It allows for a levelling out of economic fortunes across the EU and would decrease the risk premium demanded by investors to compensate for the threat of political disintegration.

However, there have been warnings against seeing this as the start of a clear path to fiscal integration.

It is worth noting that this is a specific bailout in response to a specific crisis.

It has not been designed to prop up nations struggling as a result of their own economic mismanagement.

No common tax base

As such, Ed Smith, head of asset allocation research at Rathbones, says it may not herald closer integration.

“It will only be truly stabilising – decreasing the risk premium demanded by investors to compensate for the threat of political disintegration once and for all – if it is extrapolated across time and space in a way that the text of even the original Franco-German proposal appears to rule out in principle.

“Discussions around common debt issuance beyond the pandemic, or about the establishment of a European Treasury, appear to have receded from the conversation altogether.

“A proposal to establish a common corporate tax basis has also been dropped. The amounts available for direct transfer to national Treasuries has been lowered from €500bn to €390bn.

“The remaining €360bn are loans that will be paid back by the receiving member state, and so are not risk-sharing.”

Equally, he says the language on conditionality attached to disbursements from the recovery fund has stiffened: recipients will have to prepare ‘recovery and resilience’ plans and draft annual budgets, which could become controversial and lead to the sort of political clashes that have unnerved markets in the past.

Genesis

Ella Hoxha, senior investment manager, global bonds at Pictet Asset Management, admits there is still much to be done to achieve closer fiscal ties across nations, including, “a banking union; deposit guarantee across the EA and functioning capital markets union across borders.”

However, she believes it creates the genesis of a fiscal union and may lead to a reduction in the risk premium attached to periphery spreads and the Euro.

She adds: “We have a transfer mechanism and joint issuance at the European level.

“Sovereign bonds would benefit from cheaper borrowing rates under the ESM AAA-rated umbrella.

“This would disproportionally favour the periphery which should continue to see a compression of spreads versus Germany.”

Bill Dinning, chief investment officer, Waverton Investment Management, also believes the new bonds suggest further integration down the line: “It implies that there will be pan-European taxes to finance the payback of the debt.

“Such taxes may include further pushing the “green agenda” that is an overt plan across the continent. So, taxes on emissions and carbon are possible, as are such things as a Financial Transactions tax.”

Raising exposure

The sheer scale of the recovery fund will have a positive impact for the Eurozone economy in general, boosting GDP significantly next year and accelerating the region’s recovery, says Jeremy Gatto, investment manager at the Cross Asset Solutions team at Unigestion.

“The agreement is also yet another confirmation that leaders from both a fiscal and monetary standpoint stand ready to do whatever it takes to support the economy.

“In light of this extraordinary stimulus, improving sentiment and macro picture, we are constructive on growth-orientated assets and believe in the V-shaped recovery scenario.”

He is raising European credit and equity exposure, while reducing his government bond exposure.

Gatto believes there are still risks but many are coming from outside: “The recovery is not uniform, and there is increasing political risk with the approaching US election, and a recent increase in geopolitical tensions.”

Lacking elements

There are other disappointing aspects to the deal. Rathbones’ Smith points out that it is not as ‘green’ as had been hoped.

“ESG schemes were the subject of some of the biggest cuts. For example, the Just Transition Fund, a climate-action war chest, was downgraded from the €40bn to just €10bn.

“Germany and France’s own ‘green’ stimulus packages have been impressive, but perhaps ESG isn’t as high up the collective EU pecking order as we thought.”

The EU recovery fund is a step towards fiscal integration, but there is much left to be done.

It undoubtedly supports the economic recovery across the region, but it is perhaps not as ‘game changing’ as it has been billed.

Part of the Bonhill Group.