European Recovery Package Rewrites the Rules

After five days of haggling, the 750 billion euro solidarity package, based on a proposal drafted in May by both German Chancellor Angela Merkel and French President Emmanuel Macron, passed on July 20. The fund takes unprecedented measures to help Europe’s less wealthy southern states, such as selling debt collectively and distributing funds as grants rather than loans.

While a promising sign of overall European solidarity, the aid package simultaneously highlights continued fault lines between the bloc’s wealthier north and struggling south. The EU has always been torn between maintaining control of their member states and developing more efficient joint structures that encroach on national sovereignty, and this deal is noteworthy precisely because EU nations with more resilient economies will now be underwriting loans and grants to fund the recovery of countries that would have previously been saddled with onerous borrowing costs.

While agreeing to raise capital by collectively selling bonds to distribute funds to those countries hit hardest by the coronavirus pandemic was a hard sell, a decision was ultimately made to preserve the integrity of the union. “Europe has shown it is able to break new ground in a special situation. Exceptional situations require exceptional measures,” said Merkel in a news conference. ‘‘A very special construct of 27 countries of different backgrounds is actually able to act together, and it has proven it.”

Grants to member states in need total 390 billion euros – down from the original proposal of 500 billion. Another 360 billion euros is earmarked for loans. The aid package will also increase lending and make use of existing stimulus methods to halt the economic freefall currently threatening global financial stability. A massive bond-buying programme by the European Central Bank, in combination with national stimulus plans that together are worth trillions of euros – along with other support schemes for banks, businesses, and workers – are all part of a strategy that aims to lift Europe out of a devastating recession in 2021 and kick-start a powerful recovery. The compromise also includes an agreement on the bloc’s regular budget of 1.1 trillion euros over the next seven years to fund normal EU policies on agriculture, migration, and other programmes.

“This agreement sends a concrete signal that Europe is a force for action,” said Charles Michel, president of the EU leaders’ council at a press conference. “I believe this agreement will be seen as a pivotal moment in Europe’s journey.”

While every country in the bloc is feeling the pinch, France, Italy, and Spain are expected to shoulder the worst of it. They are the EU’s second, third, and fourth largest economies, respectively, and each expect economic contractions to the tune of 10 percent this year. Other southern states, like Greece, are still recovering from the sovereign debt crisis that emerged a decade ago, with the current crisis threatening to knock their recovery off course. Greece and Italy still have heavy debt loads, making them reluctant to amass more debt to spur recovery. Overall, economists predict a recession worse than anything seen since the Second World War.

Spain is set to receive 140 billion euros in aid, over 72,000 euros of which will be in direct assistance. Spanish President Pedro Sanchez described the package as a “great agreement for Spain and for Europe,” adding that “there is no doubt that today is one of the most brilliant pages in the history of the European Union.”

Italy is likely to benefit even more, expecting about 82 billion euros in grants and another 127 billion euros in loans, which Prime Minister Giuseppe Conte said would allow his government to transform Italy for the better, and would help the bloc as a whole face the COVID-19 crisis with “strength and effectiveness”. Greece will receive 19 billion euros in grants and 12.5 billion euros in loans.

Cracks in the Alliance

The five days of negotiation, the first talks to be held in person since before the advent of the pandemic nearly six months ago, were bitter, and pooling the union’s sovereignty and resources has come at a cost. Germany, normally champion of the spend thrifty and wealthier northern nations, came out swinging on behalf of the poorer and harder hit Southern European nations – and its weight was felt as it currently holds the EU’s rotating presidency role. Britain’s absence during the proceedings was also keenly felt, as in previous summits, they were known for being fastidious about procedure and thriftiness. But other national leaders took the opportunity to be heard in their absence, with Dutch Prime Minister Mark Rutte stepping into the role of speaking for the “Frugal Four” in the absence of Britain and with Germany’s change of heart.

Both the Netherlands and Austria were hostile to lending money, much less giving it away as grants to mostly benefit southern states, fearing it would be akin to throwing resources into a bottomless pit – a move that would not aid recovery nor encourage changes to reduce bureaucracy or stimulate real growth. However, Rutte did manage to successfully wrangle larger than usual rebates for the Netherlands and other nations that contribute more to the EU budget, as well as successfully ensuring that any state that wishes to use these funds must submit a plan demonstrating how the funds will be spent. While not the veto initially sought, this does allow other EU nations three days to object to any plan and demand changes.

Ultimately, the EU was also forced to compromise on progressive goals to bring Poland and Hungary on board. And to get the package passed, the caveat of making funding conditional on certain rule-of-law benchmarks was significantly watered down. Both Poland and Hungary have profoundly illiberal governments that routinely violate this premise. Poland is also a very coal-dependent nation, so requirements that countries be committed to reaching carbon neutrality by 2050 were also dropped.

The package is now set to go on to European Parliament for ratification, and despite the deals made to get this passed, it will likely face serious challenges precisely because the deal does not challenge Poland’s and Hungary’s regular violations of the bloc’s democratic norms.

The agreement “looks like a disaster for the rule of law’’, said R. Daniel Kelemen, a scholar of Europe at Rutgers University. “Merkel and Macron were determined to reach a deal demonstrating the EU’s ability to respond to the crisis, and they proved willing to keep EU funds flowing to autocratic governments in order to close the deal.’’

The Market Responds

In response to the package passing, European stock markets opened at the highest they have been in four months. Stocks around the world recovered as well, and the euro rose to its highest worth seen in in the past 18 months. Meanwhile Italian bonds fell to their lowest yield since March, with the same thing occurring to Spanish bonds. Spreads between core and peripheral yields also tightened. The Germany-Italy 10-year yield spread was at its narrowest in four months.

“It’s a significant step towards a more integrated and united Europe, which should boost the region’s appeal to global investors and facilitate its re-rating,” said Barclays’ head of European equity strategy Emmanuel Cau.

In a letter to their clients, ING strategists credited the recovery package with prompting this financial turnaround. “With drawn-out negotiations having been avoided, we see the path cleared for the 10Y Italy-German spread going through our 150bp target this summer. The carry benefit of peripheral debt, and lower prospective volatility thanks to the ECB intervention, make it a superior alternative to core bonds, in our view,” they wrote. Portuguese, Spanish, and Greek spreads over Germany showed similar tightening.

Markets have also rebounded as investor confidence has increased, thanks to both the size of the fund and the solidarity that its passage demonstrates.

Despite compromising with Poland on carbon neutrality goals, the EU is determined to keep things green. The EU Commission plans to use a third of the fund on climate projects, and a third of the recovery package could be financed via green bonds, almost doubling the size of the global green bond market. “At a time where markets are looking for safe borrowers, this should be an example for other supranational institutions (like the World Bank) to finance badly needed investments, in particular to fight global warming,” said Florence Pisani, global head of economic research at Candriam, a pan-European asset management firm.