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Summary:
• On July 21, 2020, the 27 member countries of the European Union agreed on a recovery plan in response to the coronavirus crisis, as well as on the 2021-2027 multiannual budget.
• The recovery fund, totaling €750 billion and mainly distributed in 2021-2022, provides for countries to borrow jointly and will be distributed in the form of loans and, for the first time, grants.
• The 2021-2027 multiannual budget was negotiated over several months and finally settled at €1.074 trillion.
• Eagerly awaited due to the health emergency, the agreement reassured the markets by demonstrating the EU’s capacity for coordination and agreement in times of crisis, despite internal dissent and pressure.
Usefulness of the article : This article breaks down the content of the European recovery fund and budget, analyzes the issues surrounding the negotiations, and considers the potential implications of such an agreement.
The agreement by the 27 EU countries on the 2021-2027 budget and the recovery plan in response to the coronavirus crisis had been eagerly awaited since the plan was announced in May 2020. The bloc’s budgetary response is not only record-breaking in terms of its size, but also unprecedented in some of its features, notably the mutualization of debt issuance, the payment of the recovery fund partly in the form of grants, and the announcement of the Union’s future own resources.
Opposition from some member states, such as Austria and the Netherlands, to certain measures considered unorthodox, particularly the issuance of joint debt, weighed on the negotiations. However, under the coordination of the Franco-German tandem and thanks to concessions on all sides, the 27 were able to reach an agreement, reassuring the financial markets about the Union’s ability to respond to crises in a unified manner.
1. Analysis of the European recovery plan and budget: an unprecedented agreement
1.a) A recovery fund and budget totaling a record €1.824 trillion
On July 21, 2020, after a five-day summit, the longest in the history of the EU, the leaders of the 27 member countries reached agreement on a recovery plan in response to the coronavirus crisis and a European budget. Under the leadership of Ursula von der Leyen, President of the European Commission, and Charles Michel, President of the European Council, the 27 member states agreed on a significant recovery plan and a budget that is stable compared to the previous one, despite the departure of one of its main contributors, the United Kingdom.
The recovery fund and the budget must be analyzed jointly, as the negotiations were closely linked. They are composed as follows:
• Recovery fund (« Next Generation EU ») of €750 billion, including:
o €360 billion in repayable loans
o €390 billion in grants
• Multi-annual budget for 2021-2027 (Multiannual Financial Framework – MFF) of €1,074 billion (see Appendix at the end of the article).
Presented by the European Commission in May 2020, the recovery fund represents the joint response of the single market economies, which have been severely affected by the coronavirus pandemic. At €750 billion, it represents 5.4% of the bloc’s GDP and will complement national fiscal stimulus initiatives.
1.b) Responses to the health crisis
The recovery fund has notable features designed to support the countries that have been most affected by the coronavirus and have had to implement a number of measures that are particularly damaging to economic activity, including long and strict lockdowns and a temporary, almost universal suspension of production activity. These countries are also among the most fragile in the bloc in terms of public debt, and are therefore particularly vulnerable to the economic crisis caused by health policies. These include Italy, the first European country to be affected, which already had the second highest level of public debt (138% of GDP in the first quarter of 2020), surpassed only by Greece; and Spain, also heavily indebted (99% of GDP), which is the most affected country in Europe in terms of number of cases (640,000 cases as of September 18, 2020). Both economies are among the hardest hit, having contracted by 12.8% and 18.5% respectively in the second quarter of 2020. The fund will be distributed mainly in 2021.
Firstly, more than half of the fund will be paid to economies in the form of grants, meaning that the amounts received will not result in an increase in debt beyond each country’s share of the program’s financing. Initially proposed at €500 billion by the European Commission, this share of the recovery fund was ultimately negotiated down to €390 billion due to resistance from a few countries reluctant to extend European solidarity. Grants will be based on criteria relating to economic reforms carried out by beneficiary governments, in line with set objectives.
Secondly, the portion of the fund that will be distributed in the form of loans (€360 billion) will benefit from concessional interest rates, similar to those at which France and Germany borrow, which will also limit the increase in the debt burden on other economies. Indeed, high interest rates on debt relative to nominal GDP growth rates (at current prices) would lead to a mechanical increase in debt ratios and thus future refinancing needs. By benefiting from lower rates than those at which they finance themselves on the financial markets, states ensure greater sustainability of their debt. Finally, this fund will be financed by pooling borrowing on behalf of the EU to finance coronavirus-related programs. Although EU countries have borrowed jointly since the eurozone crisis in 2010, the amounts involved have been marginal. By institutionalizing this method of financing, this fund represents a step forward for fiscal integration in the Union.
2. Review of the main issues and analysis of the implications of the agreement
2.a) Despite underlying disagreements, a desire to demonstrate coordination capabilities under Franco-German leadership
In view of the economic crisis linked to the coronavirus pandemic and episodes of stress on the financial markets during the first half of the year, the urgent need was to propose a solution to support all economies. The European Commission forecasts a recession of 8.3% in 2020, which, according to the majority of European governments, calls for a significant stimulus package. However, disagreements between countries have made this task difficult.
Four countries, which describe themselves as « frugal, » have distinguished themselves by opposing certain significant aspects of the stimulus plan. These are Austria, Denmark, the Netherlands, and Sweden. These countries, which are net contributors to the European budget, have relatively low levels of public debt and particularly favorable credit ratings. They advocate fiscal orthodoxy within the EU and are opposed to the principles of debt mutualization and transfers in the form of subsidies without controls between member states. They fear moral hazard, i.e., that these mechanisms, introduced without any conditions for reform, will only benefit countries that failed to make the necessary efforts to improve their fiscal health before the crisis, at the cost of increasing their own debt through debt mutualization.
Source: European Commission, BSI Economics
During the negotiations, these countries succeeded in reducing the share of grants in the total amount of the recovery fund in favor of loans. However, this aspect was considered critical by the Commission, as well as by the Franco-German duo, in order to limit the increase in the debt burden on the countries most affected by the external shock of the pandemic, thereby eliminating any risk of moral hazard. They also secured the right for other governments to request the suspension of disbursements from the recovery fund, followed by an assessment of whether the objectives had been achieved. Finally, they maintained the system of rebates on their contributions to the budget. Initially acquired by the United Kingdom in 1985 to compensate the country for its disproportionate contribution, the rebate system was subsequently granted to Germany, Austria, the Netherlands, and Sweden to compensate for the loss of the British contribution. These countries, along with Denmark, also receive allocations directly linked to their contribution relative to their gross domestic income. The UK’s departure from the EU was seen by some as an opportunity to overhaul this complex and arbitrary system, citing in particular the fact that these countries are major beneficiaries of membership of the single market. However, maintaining these advantages enabled the plan to be approved by these countries during the negotiations.
The EU learned lessons from the 2012 eurozone crisis and understood the importance of reassuring financial market players by demonstrating its ability to agree on fiscal policy in a crisis situation and to support the states in greatest difficulty. Thus, the overriding challenge was to avoid a lack of agreement. By agreeing to some of the demands of the « frugal » countries, in particular by linking the disbursement of the recovery fund to the achievement of economic reform objectives and by accepting larger rebates than in the previous budget, the member countries were able to reach an agreement.
Although an agreement has been reached between European leaders, this does not (yet) mean that it has been adopted. It must still be voted on by the European Parliament in the fall, which has the right to veto the EU budget. Although rejection is unlikely given the urgency of the health crisis, MEPs have shown their willingness to exert influence as direct representatives of the people. In particular, they have expressed concerns about the differences between the amounts initially proposed by the European Commission and those finally agreed upon, as well as the EU’s future « own resources. » National parliaments will also have to vote on the budget, which could delay its implementation.
2.b) Relationship with monetary policy and impact on interest rates
The agreement on the recovery fund and the European budget was welcomed by the President of the European Central Bank (ECB), Christine Lagarde, who had been calling for a common fiscal stimulus policy since the beginning of the economic crisis linked to the pandemic.
These fiscal measures complement the arsenal of monetary policy decisions that have been taken since the beginning of 2020, notably the Pandemic Emergency Purchase Program (PEPP). The latter represents a significant change from the previous quantitative easing program, the Asset Purchase Program (APP), particularly due to a significant increase in the amounts committed by the monetary institution.
In addition to monetary policy measures, the EU’s recovery plan has helped to ease concerns on the financial markets, as reflected in the widening spreads between bond yields in peripheral countries and those in Germany, which are considered risk-free. Since the initial presentation of the recovery fund at the end of May, these spreads have gradually narrowed to their pre-crisis levels.
The renewed investor confidence has also been reflected in the appreciation of the euro against the dollar since the stimulus plan was announced. While this partly reflects the ultra-accommodative monetary policy of the US Federal Reserve, it also suggests increased investor confidence in European assets. However, this phenomenon could prove detrimental if it were to penalize the price competitiveness of European exports. If the appreciation continues, it will be an argument in favor of monetary easing, to be taken into consideration by the ECB in its upcoming policy decisions.
Conclusion
Although the negotiations were marked by disagreements and compromises, the EU has emerged victorious from these discussions. The bloc has shown that it is possible to overcome internal divisions, reassuring investors about its short-term and long-term stability and setting a precedent for future crises. Individually, Italy and Spain, the European countries most affected by the pandemic and whose fiscal situation is relatively precarious, will benefit from the stimulus plan measures to boost their growth while limiting the impact of the support plan on their debt. Despite their concessions, the « frugal » countries are not being left behind, having successfully negotiated the maintenance of their rebates on their contributions to the European budget, as well as the possibility of requesting the suspension of their contributions if a country fails to meet its commitments.
While it is difficult to compare fiscal policies between different countries as they do not cover similar scopes, it is even more difficult when it comes to the EU, as it is in addition to the national policies of member countries. It is nevertheless noteworthy that the states have managed to agree on significant amounts and to adapt them to the challenges of the health crisis. Finally, the EU is once again demonstrating its leadership in the fight against climate change by proposing the world’s greenest recovery plan.
Like any recovery plan, the fund will be partly financed by debt issuance, raising the question of how this joint debt will be repaid in the future. The coronavirus crisis has caused debt levels to rise in European economies, which have been severely affected by this external shock, and although interest rates have remained relatively low thanks to the actions of central banks, the debt remains a burden that will have to be repaid in the future. The weight of joint debt must not limit the future fiscal sustainability of the EU.
1. https://appsso.eurostat.ec.europa.eu/nui/submitViewTableAction.do
2: https://tradingeconomics.com/spain/gdp-growth and https://tradingeconomics.com/italy/gdp-growth
3: https://ec.europa.eu/info/sites/info/files/economy-finance/ip132_en.pdf
4: https://www.bruegel.org/2019/12/who-pays-for-the-eu-budget-rebates-and-why/
5: https://www.politico.eu/article/sidelined-on-recovery-parliament-plans-battle-over-eu-budget/
Appendix: new multiannual budget for 2021-2027
For the 2021-2027 budget, while member countries were able to reach an agreement on a substantial total budget to address the severity of the health crisis, contributions also had to be adjusted to account for the departure of one of the EU’s largest financial contributors: the United Kingdom. In addition, compromises had to be accepted in order to satisfy all stakeholders, particularly those countries that were reluctant to pool loans and pay subsidies. This budget is also marked by the announcement of the introduction of new sources of revenue specific to the Union between 2021 and 2023.
With a budget of €356 billion, the Common Agricultural Policy (CAP) has been reduced by around €50 billion compared to the 2014-2020 budget. The majority of this amount is directly dedicated to payments to farmers, with France being the largest beneficiary (nearly €10 billion in 2019). In addition, 40% of payments will now have to be dedicated to climate-related projects, a move that responds to recent analyses indicating that the CAP has an overall negative impact on the environment, particularly on biodiversity. Secondly, the cohesion budget has also seen a reduction of around 7% compared to the previous MFF. Nevertheless, €47.5 billion will be dedicated to financing cohesion via the recovery fund, as part of the ReactEU program. In view of the ongoing health crisis, the share of the budget dedicated to health appears negligible, at €1.7 billion. However, it should be noted that a separate program will receive €3 billion for the storage of medical supplies and emergency equipment. In addition, a €5 billion fund has been set up to support the businesses and regions most vulnerable to Brexit.
Climate is an area that is benefiting from increased funding in several forms. First, 30% of the recovery fund and budget expenditure must be linked to projects that are in line with the EU’s goal of carbon neutrality by 2050. This amount represents about a quarter of the investment needed to achieve a 50-55% reduction in emissions from 1990 levels by 2030. However, this target may generate positive momentum for government and private investment. Secondly, the Just Transition Fund (€10 billion) has been set up to provide specific support to the regions of the EU most affected by the transition to a green economy, such as those whose economies are most dependent on the coal industry. Finally, despite a sharp decline in funding compared to the Commission’s initial proposal, the €5.6 billion InvestEU fund should help the European Investment Bank (EIB) redirect its investments towards greener projects, which are considered potentially riskier. Nevertheless, this budget remains insufficient to significantly expand its capacity to finance sustainable projects and is far from marking its transformation, desired by some, into a European climate bank.
On the revenue side, the agreement provides for the introduction of new sources of own resources for the EU, in order to diversify its resources and reduce its reliance on national contributions. On the one hand, a tax on non-recycled plastics will be introduced from January 2021. On the other hand, other taxes are being considered for implementation by 2023: a border tax on carbon emissions and a tax on the digital sector.
1: https://www.consilium.europa.eu/media/45109/210720-euco-final-conclusions-en.pdf
2: https://ec.europa.eu/budget/graphs/revenue_expediture.html
3: https://www.nature.com/articles/s41893-019-0424-x
4: https://www.bruegel.org/2020/07/is-the-eu-council-agreement-aligned-with-the-green-deal-ambitions/
