AXA IM's Gilles Moec: A four-day ordeal to a deal

Gilles Moec, Group Chief Economist at AXA Investment Managers comments on the approved European recovery debt plan:

A deal on the Commission’s proposal finally came through. After 4 days of tough negotiations, this is probably what matters in the short run from a market perspective, since once again the usual “existential concerns” about the future of the EU have been put to bed. Initial positions were very far apart. Issues pertaining to the very principles of the union were raised. But ultimately a deal was done and some important taboos – in particular debt mutualisation - have been broken. In the year of Brexit, it is reassuring. Now, beyond the powerful symbols, from a macroeconomic point of view, the package is less ambitious than the initial Franco-German proposal, and is laden with future difficulties, given its complex governance and the negative financial spillover effects on other areas of EU expenditure.

The overall figure of EUR 750bn is safe, but the grants (the key item) are reduced from an initial EUR 500bn to EUR 390bn. Since the negotiation focused on a round figure of 400bn (anything below was unacceptable to France and Germany, anything above unacceptable to the “frugals”) a “trick” was found: it is 390bn “at 2018 prices“. So with a bit of inflation it will end up above EUR 400bn in current euros.

The “frugals” wanted a “veto right” on the way money is used by the member states. They failed to secure it, which would have been a deal-breaker for the most fragile states, but the governance process is going to be cumbersome.

The “recovery and resilience programme” produced by each member state describing their planned use of the resources will need to be endorsed by the EU council at a qualified majority on a proposition from the Commission which will take macroeconomic issues into consideration. This may open the door to the sort of macroeconomic conditionality the peripheral countries did not want. Expect the populists in the South to focus on this to denounce the deal.

Then, if one member-state considers another one is not delivering on the program’s targets, it can refer the matter to the next EU council. Ultimately the European Commission seems to have the final word, but it will still have to take on board the discussions at the Council. In practice, if only one member-state objects to a program implementation, odds are the Council will ultimately reject its concerns. Yet it seems that the deal offers the possibility for the “frugals” to slow down the process and potentially trigger some volatility – a dissuasive weapon. Separately, the rebates to the frugals’ contributions to the EU budget are significantly increased and enshrined in the deal. This was expected but again likely to play in the hands of the populists in the south.

In order to protect as much as possible the share of the grants which will go to the member states directly, the share of the grants going to the EU-wide funds is reduced relative to the previous proposals. This will hurt for instance the Just Transition Fund which was intended to help deal with the social consequences of the green transition in the regions. This is likely to be hard fought by the European Parliament. The Green parliamentary group will probably play a key role on this. The fact that the Commission managed to protect the pledge that 30% of the spending through the RFF will need to contribute to the green transition may help keep them on board and our baseline is that the EP will ultimately endorse the deal, given the absence of credible alternatives (chances of achieving a better outcome in the European Council are slim).

Fundamentally, the deal is another sign of the dominance of the inter-governmental, rather than “federal” nature of the EU:  the Commission and the EP have been largely sidelined. The power broking capacity is firmly in the European Council, with a key role for its President, and of course in the national governments.

The deal is probably more important from a political and symbolic point of view than from the chances to affect cyclical conditions quickly. We are talking about a quantum of expenditure for the grants below 0.4% of the EU GDP per annum until 2027, with a slow build-up. It can’t be a full substitute to national fiscal efforts, far from it.

 On the key issue of the allocation of the funds, 70% will be allocated (although not actually disbursed) in 2021 and 2022 following the Commission’s initial proposal : the lower the GDP per head and the higher the unemployment rate before the pandemic the bigger the share of each country, so a very favourable allocation for the peripherals. From 2023 however the unemployment criteria will be replaced by the actual post pandemic GDP loss. This is another reason why the actual disbursements will be slow.

It is very important that the taboo of debt mutualisation is finally broken and that in the end member states managed to come to a deal providing concrete financial solidarity. This will help keep the sovereign spreads in check. But even on the symbolic side, this has been a very painful process.

A key question is whether this is only a “first step” on which the EU could build a more proper federal budget. It is not obvious. The conclusions of the council make it crystal clear that it is a one-off, and since the new scheme is enmeshed in the EU’s multi-annual budget process - covering 2021-2027 - no further push is likely before the end of this round. Given how difficult the process has been, appetite for more rounds will probably be low. True, there are some “Hamiltonian” aspects in the deal – the confirmation that the EU will benefit from more direct resources, e.g. a border tax and tax on plastic, but it is too early to conclude that fiscal federalization is really on its way.