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More than any crisis in recent years, COVID-19 has focused Europe’s attention on the need for a unified and collective call to financial action. As a result, the European Central Bank (ECB) unleashed powerful monetary stimulus earlier in 2020, helping member states to finance a big fiscal response, while EU leaders took an unprecedented step toward fiscal integration with a new €750 billion jointly funded facility for investment loans and grants to member states, known as the Next Generation EU project.
Lately, however, that progress has been disrupted by the complacent refusal of some of the most indebted member states to participate fully in the rescue. Because of unfounded concerns over “reform conditionality,” several countries in Southern Europe are refusing to apply for any loans from Next Generation EU. Spain, Italy, and others seem oblivious to the peril to their own finances. Their obstinacy makes the ECB less likely to continue to purchase large amounts of their sovereign bonds, which in turn will cause their rates to rise, resulting in the very budget pressures they fear.
The EU has begun raising the hundreds of billions of euros for postpandemic recovery grants. The European Commission has offered €17 billion in new 10- and 20-year debt. Private investors have signed up a staggering €233 billion, despite –0.24 percent negative yields for the 10-year bonds and barely positive 0.13 percent for the 20-year bonds. This successful sale benefited from the forceful presence of the ECB in the markets (it can buy up to half of all EU-issued bonds). Most importantly, the interest rate achieved by the EU is below what Spain, Italy, Greece, and Portugal enjoy, despite their already historically low debt costs.[1]
The EU’s ability to borrow money at lower costs than the already low borrowing costs of Southern European countries means these EU members could still save money by participating in the €750 billion Next Generation EU package.
In contrast to the more innovative investment grants agreed by EU leaders, loans financed via EU-issued bonds will have to eventually be repaid by the recipient member state, counting toward its national sovereign debt, Each member state has to carry the same debt burden, but it does save on interest rate costs. The Spanish and Portuguese governments’ resistance, along with possible opposition by the Greek and Italian governments, constitutes a serious political mistake.
Southern Europeans’ fear of strings attached to EU loans is unfounded
Their stated fear of conditionality is baseless, for example.[2] It is a legacy of the stigma of such conditionality during the earlier euro debt crisis relating to loans by the European Stability Mechanism (ESM). The Next Generation EU loans are administered by the European Commission, which has no incentive to punish loan recipients and has a clear interest in issuing as much EU-financed debt as possible to ensure that Europe’s economic recovery succeeds, especially now that it is in the midst of a devastating “second wave” of the COVID-19 plague. Ensuring economic recovery is thus more urgent than carrying out long overdue economic reforms in troubled countries.
The Commission’s own definitions of “investments” and “reform” as criteria for its grants and loans programs are broad in scope. Per the Commission itself, funds disbursed are “consistent with a broad concept of investment as capital formation in areas such as fixed capital, human capital and natural capital…. Reforms should also be…aimed at making lasting improvements to the functioning of markets, institutional structures, public administrations, or relevant policies, such as the green and digital transitions.” By refusing to apply, is Spanish Prime Minister Pedro Sanchez saying there are no schools in Andalusia that could benefit from this assistance?
The very broad scope of country-specific recommendations (CSRs) for eligibility of member states, issued in May, tells the same story. These CSRs, which member states must adhere to in order to qualify for loans and grants, state that member states must “…take all necessary measures to effectively address the pandemic, sustain the economy and support the ensuing recovery. When economic conditions allow, pursue fiscal policies aimed at achieving prudent medium-term fiscal positions and ensuring debt sustainability, while enhancing investment.” Surely that is not much of a “reform constraint” on any Spanish government.
Unless member governments access EU funds, the ECB will be less likely to continue its pace of asset purchases
The record low interest rates in Southern Europe, moreover, reflect the intervention of the ECB in bond markets and the belief among investors that such interventions will continue. By not accepting EU-financed loans, Southern European governments jeopardize the ECB’s ability or willingness to continue its pace of asset purchases. Yes, the ECB is legally completely independent, but there is an implicit political link between the scope of ECB asset purchases and the agreement among governments to pool EU fiscal resources. The political agreement on Next Generation EU effectively created the political space for the ECB to immaculately expand its pandemic emergency purchase program (PEPP).[3]
For Spain and other Southern governments, refusal to accept the “above the line” fiscal support makes it harder for the ECB to continue to provide the critically needed “below the line” monetary support through bond purchases. Unless available Next Generation EU funds are actually accessed by member state governments, a strong majority on the ECB governing board will likely be less willing to continue aggressive asset purchases into the second half of 2021 and beyond. EU governments cannot expect to be able to pick and choose among different sources of essentially unconditional financial support.
Indeed ECB President Christine Lagarde has suggested that the crisis-specific Next Generation EU vehicle will “remain in the European toolbox so it could be used again if similar circumstances arise.” As a former politician, Lagarde knows very well that the more governments promote fiscal integration in Europe, the more opportunities she has to provide support at the ECB. That linkage matters, as financial markets anticipate further expansion of the PEPP to deal with the second COVID-19 wave. Frankfurt’s failure to fully do so soon could cause current benign Southern European financial conditions to deteriorate quickly. It is, therefore, not good enough for Madrid, Lisbon, Rome, and Athens to hedge now and just be willing to perhaps take some loans by 2022-23.
If Southern European governments want the ECB to continue to intervene at the same rate as it has to date, they must commit now. If they don’t, they are likely to regret not taking up the generous EU loan offer.
Notes
1. The EU bond is roughly 100 basis points below the cost of 10-year bonds of Italy and Greece and 35-40 basis points below those of Spain and Portugal.
2. A detailed discussion of why Commission “reform conditionality” will be lacking is available here.
3. The PEPP was increased in early June 2020, before the agreement among the 27 EU member states in late July, but the ECB acted only after the French and German governments and the Commission had made proposals for additional fiscal integration in the EU.
