European recovery fund proposal breaks taboos
We were very positively surprised by the Franco-German proposal for a European recovery fund unveiled by Angela Merkel and Emmanuel Macron yesterday— not so much by its size (although €500 bn in real transfers and spending is a large number, with no complicated financial engineering or leverage involved to boost the numbers) as by the broader political signal it sends. The suggestion that the money should be disbursed as grants to countries most in need rather than as loans breaks a major taboo for Germany and marks a step closer to fiscal union—a real game changer. But as Merkel mentioned “extraordinary circumstances call for extraordinary measures”.
The European Commission will propose its own plan, probably based on the Franco-German initiative, on 27 May, with the objective to reach an agreement at the EU Council meeting on 18-20 June. All EU member states will need to agree on the way forward, including the hard-line ‘frugal four’ (the Netherlands, Austria, Sweden and Denmark) who are ready to help the countries most impacted by the fallout from the coronavirus through loans rather than what are essentially grants. While negotiations will not be easy, we believe that there is room to narrow the differences between countries. In the end, market and peer pressure could force the frugal four to give some leeway. However, that still leaves countries in eastern and central Europe, which could well try to grab a healthy slice of any new fiscal transfers before they agree to the new proposals
Even if the Franco-German proposal is accepted undiluted, it may take some time before it is implemented. In the meantime, the ECB is likely to remain in ‘preventive easing’ mode to avoid at all costs a tightening in financial conditions. We continue to expect the ECB to expand its Pandemic Emergency Purchase Programme (PEPP) by €500bn in June and to extend the programme by nine months, to September 2021.