Where to next for the Eurozone

Stephanie Kelly, Senior Political Economist
Paul Diggle, Senior Economist

Will the Coronavirus battle trigger a Eurozone war?

The economic and health impacts of coronavirus have not been distributed equally across the Eurozone. In particular, peripheral countries such as Italy have been hit hardest in human and economic terms. This has reopened old fault lines between member states about a shared fiscal policy to offset negative shocks, and once again placed a disproportionate burden on the European Central Bank (ECB) to provide policy support. This note assesses the Eurozone’s existing crisis-fighting tools, the policy steps that have already been taken in this crisis to cushion the blow to economies, the options remaining on the table, and alternative policy paths available for the Eurozone in the medium term.

Shots fired: What has been deployed in the coronavirus crisis so far?

Monetary Policy

ECB action has come in three stages. On March 12, the central bank announced a €120bn increase in its Quantitative Easing (QE) purchases over the rest of the year, which implied €15bn/month of additional purchases on top of the €20bn/month it was already doing. But at the same meeting, ECB President Christine Lagarde effectively bungled the communication of this easing by saying that the ECB was “not here to close spreads”, in turn triggering a sell-off in peripheral Eurozone debt.

So on March 19, the ECB launched an additional EUR 750bn Pandemic Emergency Purchase Programme (PEPP). On top of previous measures, this works out as about €125bn/month of purchases for the rest of this year. This is well in excess of the peak run-rate of QE purchases during the sovereign debt crisis, and is set to take the ECB’s balance sheet from 40% to 60% of Eurozone Gross Domestic Product (GDP) by the end of the year.

ECB balance sheet as % of Eurozone GDP

chart 1 

Source: Datastream, ASIRI (as of 2020)

>Although the ECB’s capital key will remain as the “benchmark” for PEPP asset purchases, they will be “conducted in a flexible manner… allow[ing] for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions”. The upshot is that struggling sovereigns (like Italy) can benefit from a larger share of asset purchases during times of stress.

 

Finally, on April 30, the ECB announced more generous interest rates on it bank lending operations – allowing banks to borrow from the ECB for as low as -1%. In other words, the ECB is providing liquidity to commercial banks and in the process also making what is effectively a transfer to banks at the same time.

However, although large at first sight, the ECB’s various actions now look comparatively small in an international context. Relative to the stock of outstanding debt, the ECB’s QE run rate is around one-half to one-third that of the Bank of England or the Federal Reserve (Fed). And the overall envelope on ECB purchases contrasts with the Fed and Bank of Japan’s (BoJ)promise to buy as much sovereign debt as necessary, with no upper limit. In any case, Eurozone periphery bond spreads have crept back up, with the BTP-Bund spread (i.e. the Italian 10-year government bond spread over the 10-year German bunds) approaching its high point in March before the PEPP was announced. Meanwhile, the subsidised bank lending programme cannot offset the headwind of a very weak economy for commercial banks.

Fiscal policy at the member state level

At the level of individual member states, there has been a fairly significant fiscal expansion. Across the bloc as a whole, structural loosening is worth just over 4% of GDP – double the size of the fiscal expansion in Europe during the financial crisis. A significant aspect of the structural loosening has been the introduction of short-time work schemes designed to limit job losses. Meanwhile, loan guarantees and other contingent liabilities of the state have been much larger still.

Fiscal expansions as % of GDP

insert_chart
 

Source: UBS, ASIRI (as of 2020)

Nevertheless, the size and shape of the fiscal policy reaction has varied widely by member state. Generally speaking, economies hit hardest by the medical and economic fallout of the virus have done less in terms of structural loosening given pre-existing borrowing constraints, while those managing the crisis more successfully have done more. And nowhere is the size of structural loosening equal to the magnitude of the negative economic shock.

For example in Italy, fiscal loosening worth 2.7% of GDP includes government-funded mortgage and tax payment holidays, and funds to help firms pay workers temporarily laid off. But Italian GDP could easily decline 10% during 2020. Moreover, this structural loosening is small relative to Germany, where the 'black zero' (the German commitment to running a balanced budget) has been dropped to fund stimulus worth a much larger 5.3% of GDP including SME grants, increased healthcare spending, and higher unemployment and short-time work benefits.

Meanwhile, the European fiscal loosening again looks small in an international context. Weighting member states’ structural loosening by the size of their economy, the average Eurozone fiscal effort is about 3.9% of GDP. By contrast, the US is on course to loosen the structural deficit by nearly 10% of GDP this year, while even Japan’s structural loosening is above 5% of GDP.

Moreover, there is a risk of a premature re-tightening of Eurozone government spendingonce the initial shock has passed. The European Commission has activated the “general escape clause” of the Stability and Growth Pact, allowing member states to run much larger fiscal deficits than usual. But an important policy error in the years after the Global Financial Crisis (GFC) was that European authorities insisted on a return to the strictures of the Stability and Growth Pact and fiscal consolidation too early in the recovery – setting up one of the building blocks for the subsequent sovereign debt crisis. Our hope is that policymakers have learned the lesson of that premature turn towards austerity, and will not repeat the same error again. But our expectation is that political pressure from the core Eurozone economies will insist on reining in fiscal expansions too early in the recovery, crimping the extent of the bounce-back.

More optimistically, both Italy and Germany have announced very large contingent liabilities and loan guarantee scheme, worth 42% and 31% of GDP respectively. At the level of the Eurozone as a whole, such schemes amount to perhaps 25% of GDP. These guarantees would appear to be more proportionate to the size of the shock buffeting the economy, and look large in an international context. Of course, if even part of these contingent liabilities were realised, they would involve a significant increase in member states’ debt to GDP levels. Italian public debt is likely to rise from 136% to perhaps 160% on the basis of structural loosening and the economic contraction alone. If debt were taken close to 200% of GDP owing to potential defaults on loan schemes as well, investors’ willingness to hold Italian debt could come into question.

Fiscal policy at the European level

At the supra-national level, European heads of state and finance ministers have so far agreed to fiscal measures worth a further 5% of Eurozone GDP. These have taken three forms:

  1. Extending funding for the European Investment Bank to the value of €200bn, focused on lending to small and medium-sized enterprises.
  2. Funding the SURE (“Support to mitigate Unemployment Risks in an Emergency”) jobs programme to the value of €100bn, intended to support national short-time work schemes to preserve jobs. This is helpful at the margin, but €100bn is very small in the context of the challenges the Eurozone labour market is facing.
  3. A European Stability Mechanism (ESM) credit line to the value of 2% of GDP (€240bn for the total Eurozone economy) with the only conditionality being that the money is used for coronavirus-related spending. However, the ESM is toxic in parts of Southern Europe, particularly Italy, following Greece’s experience of Troika conditionality during the GFC.

Importantly, while the Eurogroup of finance ministers has approved the measures, member states still have to agree the technical details to get the measures in place. Things tend to move slowly in Brussels, so even these limited measures may take time to be put in place with political point-scoring likely at every stage.

Ammunition remaining: What more could be done?

Corona bonds

In response to the enormity of the economic shock, and its asymmetric distribution across the Eurozone, France, Italy and Spain have been leading calls for a mutualised debt instrument (so-called ‘corona bonds’) to fund the fiscal policy response. One proposal is that the EU issues perpetual bonds worth €1.5trn (13% of GDP), raising funds for grants to crisis-hit countries and reducing pressure on the most fragile economies’ debt-to-GDP ratios and sovereigns yields. This would go a substantial way towards the common fiscal policy that many commentators have highlighted as a necessary step for European economic integration.

Nevertheless, more ‘frugal’ Northern countries like Germany and the Netherlands have firmly refused this idea, fearing they would bear an unfair share of the cost. If this sounds like a familiar argument in Brussels, that is because it is. The crisis has brought long standing disagreements about risk-sharing versus risk-reduction to the fore.

Recovery Fund

Attempts to find a middle ground are centred on a Eurozone recovery fund, which would likely be linked to the European budget process to avoid having to build an entirely new instrument. However, countries are not in agreement on the size, scope or funding mechanism for such a fund, with talks still at an early stage. Northern countries do not want to significantly increase budget contributions and argue that funding must be in the form of loans. On the other extreme, peripheral countries argue for greater funding, with Spain calling for €1.5tn in grants rather than debt to avoid a future debt overhang for countries that draw on the fund.

To take things forward, EU leaders have “tasked the Commission to analyse the exact needs and to urgently come up with a proposal” for a fund of “sufficient magnitudes, targeted towards the sectors and geographical parts of Europe most affected”. An eventual recovery fund therefore does seem likely, but delays and disagreements about loans versus grants mean the onus for centralised Eurozone policy stimulus will remain on the ECB for now.

Additional asset purchases

If joint Eurozone fiscal actions remain underwhelming, the ECB will continue to be the only game in town. Nevertheless, the ECB’s asset purchases programme, although it dwarves previous QE episodes, looks relatively small in an international context. The ECB has committed to purchasing assets equivalent to about 15% of Eurozone GDP over 2020, but the Fed has committed to potentially unlimited asset purchases. And in any case, peripheral spreads are creeping higher again. So it’s possible that the ECB will need to expand QE, perhaps in one of two ways.

The first option is to increase the purchase envelope by another specific amount. For the ECB to match the current run-rate of Fed or Bank of England bond-buying, it would need to double or treble the PEPP, which could take it over €2 trillion. For context, the ECB began this crisis owning about €2 trillion of public debt in total.

The second, more radical but much less likely, option is to cap bond yields at a certain level. A credible yield cap would not necessarily mean buying more bonds than if the ECB set another specific target for the PEPP envelope.

However, both approaches could meet resistance. A recent ruling of the German Constitutional Court found that earlier ECB QE episodes did not contravene EU treaties against monetary financing, but only because those purchases stuck to strict issue limits (the ECB never purchased more than 33% of a given bond issue, and so never became a potential blocking minority in any restructuring) and the capital key (sovereign purchases were made in accordance with member states’ contribution to the ECB’s capital). The terms of the PEPP loosened these constraints, making the programme vulnerable to challenges in the German courts in the future, and perhaps making the ECB hesitant about a further expansion. Meanwhile, yield caps would quickly run into the difficult political decision of what level of yield to inforce across the Eurozone’s 19 different sovereign bond curves.

Firearm malfunction: What are the risks of under-delivery?

We think the current Eurozone policy response is sub-standard in a number of respects. First, it is just too small relative to the size of the economic shock. National-level fiscal expansions averaging 4% of GDP, and a supra-national fiscal response of 5% of GDP, are still dwarfed by the 25% peak-to-trough contraction (and -16% year-average growth) we are forecasting in 2020.

Second, the policy response is small in an international context. The US structural fiscal loosening now stands above 13% of GDP. And the run-rate of Fed or Bank of England asset purchases, relative to the size of the economy, is two or three times larger than the ECB’s.

Third, co-ordinated efforts will not change certain economies’ unsustainable debt dynamics. For example, the ESM credit line offers loans rather than grants to crisis-hit countries and is capped at 2% of GDP. But Italy’s public debt is set to jump from 136% to at least 160% of GDP this year.

And fourth, the “optics” of wrangling over a mutualised policy responses plays badly at the national level. In Italy, for example, Eurosceptic parties have wasted little time in arguing that there has been a lack of Eurozone solidarity and that Italy is being thrown to the wolves.

Under-delivery therefore risks a deeper contraction and more protracted recovery than might otherwise be the case, as well as potentially threatening the very cohesion of the Eurozone itself.

Admittedly, imminent break-up seems a remote possibility. For one, market proxies for break-up risk such as the “quanto spread” (the difference between credit default swap contracts on Eurozone government debt denominated in euros and equivalent Credit Default Swaps denominated in dollars), while they have moved higher, are nowhere near sovereign debt crisis-era highs. More fundamentally, so far at least, the current crisis hasn’t taken the form of a sovereign debt crisis, involving a dramatic increase in borrowing costs, a potential loss of market access, and a forced redenomination to regain the ability to issue debt.

BTP-Bund spread & “quanto spread” on 5-year Italian CDS

chart 3 

Source: Bloomberg, ASIRI (as of 2020)

But none of that is to say that a break-up couldn’t be one way in which the current shock ultimately plays out. Continued foot-dragging on a mutualised fiscal response, a hamstrung ECB that fails to increase its asset purchases for fear of future legal action from monetary policy hawks, an Outright Monetary Transactions (OMT) programme over-burdened with conditionality that struggling member states refused to accept, a premature move towards fiscal consolidation, and growing political animosities borne of an inadequate policy response and an asymmetric recovery, could all lead to increased break-up risk even once the initial shock has subsided.

Choose your weapon: Scenarios for the path ahead

For now, the recovery fund would represent a step forward and leaders are signalling they want to act. However, the devil will be in the detail; we expect the politics to be fractious in negotiating the scale and scope for a fund, and even then, it risks falling short of peripheral expectations. The scenario table below explores the various paths the Eurozone could take in addressing this crisis over the next 12-18 months.

Going beyond this initial crisis and coordinated solution phase, risks to Eurozone cohesion will continue in the medium to long term. Ongoing institutional inefficiencies and lack of true political union assumed in our 12-18 month base case will continue to create friction between Northern and Southern states, exacerbated by the inevitable debate about when and how to reinforce European fiscal rules. While fiscal rules have been relaxed for now, our base case is that Northern countries will bounce back faster than Southern countries. The fact that these are the very states that advocate fiscal discipline and enforcement of the fiscal rules means that they are likely to push for fiscal tightening when Southern states are still struggling to get back on their feet.

Furthermore, support for populist politics tends to increase when inequality rises. As unequal as the crisis has already been in terms of economic and human costs, a recovery phase marked by more prosperous Northern states trying to enforce fiscal discipline would be a fertile breeding ground for Europhobia in Southern states, with Italy the most clearly at risk in this regard. The upshot is that the Eurozone’s approach of doing just enough is likely to be pushed to its limits in the coming years if the recovery fund is too limited and if Northern countries attempt to reign in fiscal spending too soon in economies that are still under water.

While the same logic that progress in the Eurozone comes through political crisis applies in the medium term as it does in the next 12 months, a combative, domestically-focused approach risks eroding trust between Eurozone politicians and voters. This makes the downside risk of break-up larger in the long term than in 12-18 months scenarios. Investors should never forget that the Eurozone is a political project, albeit with profound economic implications. Politicians made the currency union and politicians can make it better or they can break it. The steps they take in dealing with the crisis, the shape of the recovery and policy normalisation thereafter will determine the fate of the Eurozone.

Potential Crisis Response Scenarios

table 1 

*These scenarios apply over 12-18 months. As the initial crisis fades, new challenges will emerge, altering the scenarios for the Eurozone’s future. Source: ASI Research Institute, May 2020

Appendix: Fighting the last war: A primer on the Eurozone’s crisis-fighting weapons

The ECB’s toolbox

The ECB’s conventional monetary policy tool is the deposit rate, the interest rate at which banks can make overnight deposits with the Eurosystem. This reached 0% in 2012, and currently stands at -0.5%, which may be the ECB’s perception of the effective lower bound. The ECB therefore also uses a range of “unconventional” (although by now they are pretty familiar!) tools: bank loan programmes, forward guidance, and asset purchases (aka QE) to influence financial conditions.

Starting in 2012, the ECB has been conducting various rounds of “long term refinancing operations”, essentially providing cheap loans to European commercial banks, which can then be lent on to consumers and businesses, with a view to supporting credit growth.

The ECB has been providing forward guidance on interest rates since 2013, with the current formulation stating that interest rates will remain at current or lower levels until inflation has converged to target. The intention is to anchor market expectations of the short-term policy rate path, in turn lowering interest rates across the yield curve.

The ECB began QE in 2015, purchasing a combination of sovereign debt, covered bonds, corporate bonds and asset-backed securities. Its balance sheet has since increased from 20% to 40% of Eurozone GDP, in turn lowering term premia on these assets, reducing borrowing costs and potentially supporting broader financial conditions.

Beyond these monetary policy tools, the ECB also wields “Outright Monetary Transactions” (OMTs). Launched in 2012, but never actually used, OMTs are unlimited purchases of a single member states’ sovereign debt. The programme is the principal manifestation of former ECB President Mario Draghi’s “whatever it takes” commitment. It is meant to provide the ultimate backstop to prevent a member state having to leave the Eurozone and redenominate into its own currency for lack of market access and the inability to fund itself by issuing debt in euros. OMTs are distinct from QE because they are fully sterilised, meaning there is no increase in the money supply.

European Stability Mechanism

The ESM was established in 2012, although its predecessor organisations were in operation from 2010. It is the Eurozone’s sovereign bailout mechanism, in some ways equivalent to the IMF. Funded by paid-up capital of member states and its own bond issuance, it provides emergency loans to member states in financial distress. In return, the member states have to undertake reform programmes (so-called “conditionality” – which is also attached to OMT programmes). During the European debt crisis, the ESM lent money to Greece, Ireland, Portugal, Spain, and Cyprus.

Suspending the Stability and Growth Pact

The Stability and Growth Pact (SGP) is a set of rules designed to ensure that countries in the European Union pursue sound public finances. As originally drafted, the SGP required countries to keep the government deficit below 3% and public debt-to-GDP below 60%. The rules have since become more complicated through the updated ‘Fiscal Compact’, with each country required to achieve an individual “medium term budgetary objective” set by the European Commission that supposedly ensures a sustainable path for government debt over the medium term.

Crucially, the European Commission can deploy two get-out clauses to the SGP: the “unusual events clause” allows a deviation if an unusual event outside the control of one or more member states has a major impact on the financial position of the general government, while the “general escape clause” allows deviation if the Union as a whole faces a severe economic downturn. The clauses are meant to prevent a damaging pro-cyclical fiscal tightening during a downturn, although the lesson from the GFC was that the Commission was too quick to re-inforce the SGP once the initial shock hadpassed.

What’s lacking?

Despite this armoury of tools built up during the GFC and sovereign debt crisis (as well as pre-existing shock absorbers such as the ability of citizens of one country to move to another if the economy and job prospects are better), important elements of an “optimal currency area” are lacking in the Eurozone. In particular, there is an incomplete banking and capital markets union, and almost nothing in the way of fiscal union.

Banking and capital markets union concerns the ability of banks to operate, and capital to flow across the Eurozone with little heed of national borders. It is an important shock absorber in times of crisis within a single country – diversification across national borders would limit losses for banks, businesses, and savers. Although progress has been made on this front over the past decade – for example, all European banks are supervised at the supra-national level – the task is far from complete.

Fiscal union is the integration of fiscal policy, including transfers between member states. It works well in optimal currency areas like the US (think taxes collected in California being spent in Mississippi). By contrast, Eurozone fiscal policy operates at the level of individual member states, rather than across member states. This hampers the ability of the bloc to absorb asymmetric shocks, as relatively better off countries don’t transfer resources to the less well off. Progress towards more “mutualisation” of fiscal policy has been stymied by political differences. The more frugal core or Northern countries want “risk-reduction” (lower non-performing loans, more prudent management of public finances) before they will take steps towards fiscal union. By contrast, the poorer periphery or Southern countries want “risk-sharing” (transfers and even common debt issuance) as a first step.

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