(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)
By Mike Dolan
LONDON, May 19 (Reuters) – Inevitable caveats aside, this week’s Franco-German push to mutualise European Union debts to help countries worst hit by the COVID-19 slump is a political and financial game changer that goes well beyond the pandemic.
In one fell swoop, the proposal addresses the long-term hit from the coronavirus, smouldering concerns about European fragmentation and the over-reliance on the European Central Bank (ECB) for economic support.
Financial markets, punch drunk from the pandemic shock and jarred this month as Germany’s top court questioned the validity of the ECB’s bond purchases, suddenly sat up and took notice.
Sovereign borrowing costs on the euro zone periphery tumbled, blue-chip euro stocks surged 5% in their biggest daily gain in two months while the euro staged its highest one-day jump against the “safe haven” Swiss franc in eight months.
But if the proposals become EU policy after the bloc’s executive outlines its plans on May 27, they look set to have more far-reaching effects than a curious up-day on the bourses.
Jacob Funk Kirkegaard at Washington’s Petersen Institute described the move as Europe’s long-awaited “Hamilton moment” -reference to the move by the first U.S. Treasury Secretary Alexander Hamilton in the 1790s to have central government assume the debts of individual states after the American War of Independence and sell Treasury bonds to fund them.
“This is a really, really big deal. In both debt mutualisation and common expenditure, a taboo has broken – this is not something the German government has been willing to do before,” he said. “It’s precedent setting and it offers the EU project an entirely new set of powerful tools.”
On Monday, French President Emmanuel Macron and German Chancellor Angela Merkel proposed a 500 billion euro ($550 billion) Recovery Fund offering grants to EU regions and sectors hit hardest by the pandemic.
The leaders, whose agreements traditionally pave the way for EU deals, proposed that the European Commission borrow on behalf of the whole bloc and spend the proceeds as a top-up to the 2021-2027 EU budget which already stands at one trillion euros.
“A system purely based on grants marks a more substantial and powerful transfer of resources than financing largely based on loans,” Morgan Stanley told clients on Monday. “The timing and targeting may help better mitigate the risk of a southern slump without adding to their considerable debt burdens.”
Investors and financial analysts have been following this saga for months, with initial calls from France, Italy, Spain and others for centralised pandemic relief finance from common euro zone debt sales – so-called coronabonds – seemingly dashed by resistance in Berlin, Vienna and The Hague last month.
Germany’s apparent change of heart, albeit in the guise of EU-wide borrowing and not just by members of the single currency zone, was the “lapel-grabber” for investors.
For typically sceptical markets, initial reactions were couched in “ifs” and “buts”, calls for more details on the split between borrowing and contributions to the fund, doubts about the spending time frame and wariness of the machinations of European politics in the run up to the May 27 presentation.
“There is still opposition within the EU and the scale is relatively small,” cautioned Paul Donovan, chief economist at UBS Wealth Management. But he said, “markets are focusing on the principle rather than the scale”.
There was no disguising market awareness of the significance – mostly in potentially averting an acrimonious slide towards euro disintegration over a lack of solidarity but also in addressing sticking points in euro integration that existed before the pandemic and will resonate long beyond.
“For the first time, the EU is allowing some sort of debt mutualisation,” Japanese bank Nomura told clients. “It could be a big moment in eventually lowering EU/euro break up risks.”
It’s a coup for pro-integrationists, such as Macron, who have long argued the euro can only be sustained long term if a single monetary policy and central bank are complemented by a common fiscal policy and treasury authority.
The pandemic has only sharpened that view.
It’s also potentially a big win for ECB chief Christine Lagarde in her mission to get euro members to rely more on fiscal policy for lifting the bloc’s growth than the almost exhausted single engine of the ECB’s monetary policy.
While 500 billion euros may seem small compared with the trillions in pandemic relief around the world, it’s still 3.5% of EU annual output and is earmarked as future fiscal stimulus rather than instant healthcare or lockdown relief – probably targeting existing priorities such as greener energy and the digital transformation of Europe’s economy.
What’s more, the AAA-rated Commission, backed by the EU’s 27 members, can probably borrow on the bond markets for free – or at least close to Germany, where prevailing 10-year bond yields are minus 45 basis points.
The bonds can also act as a long-sought common “safe” asset in Europe as well as being eligible for ECB purchases in its quantitative easing operations.
“Crucially it will take some pressure off the ECB from being the only backstop for markets, which should give investors some more comfort in re-engaging in European risk and not fearing as much the surge in issuance we are set to get from peripheral countries,” said Mohammed Kazmi, portfolio manager at UBP. ($1 = 0.9151 euros) (By Mike Dolan, Twitter: @reutersMikeD; Editing by David Clarke)
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