After four days of negotiations the European Union (EU) council has come to an agreement on a EUR 1,074 billion Multiannual Financial Framework and a EUR 750 billion Next Generation EU recovery fund. These amounts are in addition to the EUR 540 billion of Covid-19 safety nets which were already in place, bringing the EU’s total response to EUR 2,364 billion or 17% of the EU’s gross national income.

How does the agreement differ from the draft recovery fund proposal?

To reach a final agreement and consider the requests of the so-called “Frugal Four” (Austria, Denmark, Netherlands and Sweden) countries the initial Franco-German proposal of the recovery fund was subject to some changes.

• The Council of the European Union has validated the size of the Next Generation EU recovery fund at EUR 750bn but changed the split between grants and loans. The agreement is for EUR 390bn of grants (originally EUR 500bn) and EUR 360bn in loans (originally EUR 250bn), with the solidarity transfers between member states maintained.
  
  
• To address the concerns of several member states regarding its governance and conditionality, the EU Council has decided that in order to use the recovery fund, member states will have to prepare national recovery and resilience plans for 2021-2023, which will need to be approved by the Council, by a qualified majority vote.
  
  
• In addition, a sort of emergency brake mechanism was introduced and the Commission can investigate based on milestones and targets in investment plans. This would stop the disbursement for a period of three months in which the Council can evaluate the progress.
  
  
• It was also decided to keep, and in many cases raise, the rebates that have traditionally favored the frugal countries. The rebate for Denmark has been increased from EUR 197mn to 322mn, for the Netherlands from EUR 1,576mn to 1,921mn, for Austria from EUR 237mn to 565mn and finally for Sweden from EUR 798mn to 1,069mn. For Germany the rebate remains unchanged at EUR 3,671mn.
  

What was agreed as part of the Multiannual Financial Framework (MFF)?

The MFF is a seven-year framework running from 2021 to 2027, regulating the annual budget of the EU institutions:

• A budget of EUR 1,074bn has been agreed, which is larger than the “Frugal Four” countries wanted, but they – along with Germany – are set to be compensated with rebates continuing through to 2027.
  
  
• This year’s budget negotiations were particular complex since it was the first budget without the EUR 75bn contribution of the UK. The EU's budget is funded by contributions from member countries (based on VAT and Gross National Income and reduced by eventual rebates), import duties on products from outside the EU and fines imposed when businesses fail to comply with EU rules.
  
  
• To put the size of the budget into perspective, EU GDP stood at EUR 13.9 trillion in 2019. On an annual basis the budget is roughly 1.1% of European GDP.

Are we on the cusp of euro bond issuance?

The EU Council confirmed the ability of the European Commission to borrow via financial markets, with the Own Resource Decision setting out the provisions for the Commission to attain the resources to finance the recovery fund. Though this borrowing has been granted on an exceptional/one-off basis, this clearly creates a symbolic precedent for common bond issuance.

To address member states’ concerns about the fact that repayments of this debt would only start at the beginning of the next budget cycle (2028), the EU Council has decided to place the repayments over the period 2026-56. The Council will also explore several possibilities to use ‘new own resources’ such as a plastic waste tax, a carbon border adjustment mechanism or an emission trading system extension to sectors such as aviation and maritime, in order to repay the debt.

These ‘new own resources’ are not only important to repay the debt issued to finance the recovery fund, but given their structural nature, they give new financial means to the European Commission, independent of member states’ contributions, resulting in a step towards further integration.

Last but not least, to make sure that the EU achieves climate neutrality by 2050 and meets its 2030 climate targets, and its commitment to the Paris Agreement, the EU Council has decided that 30% of the expenses under the MFF and the recovery fund will be directed towards climate-related projects.

Why are these decisions perceived as a game changer for Europe?

While the amounts agreed on by EU leaders are important, it is the way in which it will be financed that is considered as a game changer. Indeed the fact the EU will be allowed to issue bonds to finance the Next Generation EU fund and that it will be able to benefit from ‘new own resources’ to repay this debt could be considered as the first steps towards issuance of Eurobonds. In addition, the EU clearly wanted to address the critics over the lack of solidarity within the Union. The Recovery and Resilience Facility will focus on the countries and sectors most affected by the crisis regardless of their contribution to EU budget and/or GDP weight – a message that you won’t be left behind, in the wake of this pandemic, as part of a unified EU. But we should also not forget about the medium-term risks of fiscal policy that opens the door to transfer payments, given the risk that the receiving countries show less ambition to reform if market pressure recedes. Fiscal integration will only succeed in the long term if spending and accountability are fully aligned.

What are the investment implications of these decisions?

Many investors have demanded a higher risk premium on European assets since the sovereign crisis. In the eyes of the most eurosceptic investors, the eurozone was fatally flawed because the monetary union was not complemented by a fiscal union. In this regard these policy developments represent a significant step forward and should reduce risk premia across the region’s asset classes. The massive fiscal response to the crisis, including transfers from core countries to peripheral countries, should benefit peripheral bond markets relative to bonds of the core countries. The recent success in containing the pandemic and the possibility of more stimulus and EU integration could allow European equities to finally catch up with their international peers. The declining probability of euro area break-up risk and an improving investor perception over the outlook for the region could also be supportive for the value of the euro.

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