The European Union’s new Recovery Fund is the most significant development in the Eurozone since former European Central Bank President Mario Draghi pledged to do ‘whatever it takes’ to save the euro during the 2012 debt crisis.
The €750B fund was approved by EU leaders last week to support member states worst hit by the Covid-19 crisis. It still needs to be approved by the European Parliament and by EU members’ national parliaments. Moreover, it will only start disbursing money from 2021 with €390B in grants and the rest in loans. But the fund is likely to be a ‘game changer’ for the Eurozone.
First, the EU will now have significant resources to counter economic shocks - for the first time since the euro began trading in 1999.
Until now, EU member countries could only rely on the European Central Bank and their own budgets to offset economic downturns. The European Commission - the executive arm of the EU – only had limited resources to help countries in distress.But during the 2012 Eurozone debt crisis, the strains on member states’ finances almost caused the euro to break up. In future, countries hit by the Covid-19 crisis will be able to apply for substantial external funds from the EC.
Second, the Recovery Fund is large.
At €750B, the fund is equivalent to 5.4% of the Eurozone’s 2019 GDP. It will distribute money during 2021, 2022 and 2023 and borrowings will only have to be repaid by the end of 2058. Third, the fund will be financed by EU member states jointly issuing bonds in significant amounts. This will also be another first for the Eurozone.
Source: Bank of Singapore, Bloomberg, IMF
Thus, member countries with weaker public finances will benefit from lower funding costs through borrowing together with countries with stronger credit ratings.
Fourth, the Recovery Fund’s bonds are likely to be viewed as safe-haven assets and thus attract strong demand.
Currently, the EU has triple AAA ratings from two of the three major credit rating agencies. Future EU bond issuance to finance the fund is also likely to attain similar ratings.
Last, financing the Recovery Fund will allow the EU to establish a yield curve of debt issuance - thus creating an alternative to US Treasuries.
This will help deepen liquidity in Eurozone debt markets and attract foreign central bank reserve managers from Asia and the Middle East seeking to diversify their US dollar holdings and reduce their underweights in the euro (see chart).
The euro has jumped on the news as forwardlooking financial markets price in the Recovery Fund’s significant long-term benefits. The news is also timely as the Eurozone is just emerging from its Covid-19 outbreak.
For almost the last two years, the euro has traded in a 1.06-1.15 range against the dollar. But last week’s Recovery Fund agreement has caused the euro to hit our 1.17 target now. If the fund is approved by the European Parliament and by the EU member states’ legislatures - as we expect - then the currency will likely trade in a sharply higher range with the euro supported on dips below 1.15 and bounded by its last cyclical high in early 2018 of 1.25 against the dollar.Disclaimer applicable to recommendation
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