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EU Recovery Fund Is a Step Towards a More Resilient Eurozone

Fitch Ratings-London-23 July 2020: The EUR750 billion recovery fund agreed by EU leaders is net supportive for EU sovereign ratings, Fitch Ratings says. We think it could become a more permanent feature of the EU’s institutional set-up, which would bolster the architectural underpinnings of the eurozone.

The agreement on 21 July to create the ‘Next Generation EU’ fund authorises the European Commission to borrow in the capital markets on the EU’s behalf. The additional funds raised will be disbursed to member states as grants and loans. EU leaders also agreed the 2021-2027 multiannual financial framework (MFF), setting a budget of EUR1.074 trillion.

Next Generation EU will mutualise part of the cost of the coronavirus response at the EU level, thereby introducing some fiscal risk-sharing and central debt issuance. It also opens the door to some central tax collection.

The European Council called the fund “an exceptional response” to “temporary but extreme circumstances”, meaning the Commission’s borrowing power is “clearly limited in size, duration and scope.” Next Generation EU still is a long way from complete fiscal union and is moderate in size relative to the EU economy and national debt levels. Nevertheless, the fund will create a precedent for future crises that could boost the capacity for counter-cyclical policy.

We view the fund as a net supportive factor for EU sovereign ratings over the medium term, particularly for the main beneficiaries. These are poorer member states and those hardest hit by the pandemic, and are mostly located in southern and eastern Europe. Our assessments of the effect on individual sovereign creditworthiness would reflect benefits from a more robust economic and monetary union, the impact on public finances and growth, and how these might reduce the pandemic’s impact.

The main difference between this week’s agreement and the European Commission’s initial proposal is the balance of grants and loans. The initial proposal was for up to EUR500 billion of grants. In the agreement, this is lower, at EUR390 billion, with EUR360 billion of loans.

A fuller assessment of the fiscal impact will be possible once the EU releases all the fund allocation details. However, changes from the original proposal are moderate. Loans will be capped at 6.8% of a recipient’s Gross National Income and will only feed through to headline government debt once countries borrow to repay the debt to the EU from 2028, other things equal. We would assess the potential additional increase in debt/GDP in the context of an economic shock that is already causing debt to grow, and with regard to the potential positive impact on recipients’ growth prospects, funding costs and debt structure.

The direct fiscal effect of additional EU debt creation would be negative for net contributors including Germany and France, although the impact on headline general government debt would not be felt until EU debt repayments begin in 2028. However, this would need to be set against the benefit from the eurozone’s greater resilience and from trade gains with member states that are net recipients.

Our analysis will also consider how effectively Next Generation EU funding is deployed to support economic recovery. Initial indications may come when member states set out their reform and investment plans for the Commission to assess before funds are disbursed. A conditionality mechanism would allow a qualified majority in the European Council to hold up the flow of funds to member states that fail to follow through on reforms. Another provision could block disbursements from the fund and the EU budget to countries that fail to uphold the rule of law. How effective these mechanisms will be remains unclear.

In central and eastern Europe, Next Generation EU funds could offset the loss of other EU funding and help smooth the dip in economic growth seen between MFFs. Achieving the full benefit would depend on boosting some countries’ absorption rates.
Source: Fitch Ratings

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