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A European Game-Changer?

29th May 2020

May 2020 could go down as the month that changed the course of the euro, and ensured the currency’s longer-term stability, with EU leaders inching closer to agreeing a deeper fiscal union as part of the coronavirus recovery package.

Since inception, the euro has been a political currency without a fiscal union underpinning it – hence the reliance on the ECB to constantly backstop things. Now, however, we are moving closer towards a much greater degree of fiscal integration among EU member states, with plans for common debt issuance to make up a significant proportion of the €750bln “Next Generation EU” fund.

In true EU fashion, however, the plan is a little bit of a fudge, aimed to please both the ‘frugal’ northern member states, and the more fiscally expansive southern nations. As a result, the plan includes €500bln in grants – to please the south – and €250bln in loans – to please the north. One must hope that the plan is approved by each and every national government, which could prove to be a major stumbling block.

The plan is important as, if implemented, it would provide investors with reassurance about the future of the bloc. It is as much about symbolism as it is about the recovery package in itself.

While the funds will likely arrive too late, and be too little, to significantly alter the course of the economic recovery, implementing the plan would be a major step towards securing the longer-term future of the bloc. This is due to the plan removing a significant degree of doubt in investors’ minds about the sustainability of the bloc, and the fact that the ECB will no longer be the ‘only game in town’ when it comes to being the glue holding everything together.

Furthermore, the recovery package should allay significant concerns over how nations with higher debt burdens – such as Italy – will finance the relief and stimulus packages needed to bring their economies out of the coronavirus recession. Raising debt at an EU-wide level would immediately remove any worries about nations being able to finance spending, and should bode for a quicker and more resilient economic recovery as social distancing measures are lifted.

The market reaction to the recovery package was largely as expected, a stronger euro, a fall in periphery bond yields, and a narrowing in core-periphery yield spreads. All textbook signs of a market that has become more confident about the eurozone holding together.

While I am not prepared to go as far as ECB President Lagarde and state that “there will be now new euro debt crisis” after the pandemic, it is clear that the recovery package – if and when it is approved – will be a major step towards greater harmonisation of the eurozone.

The bloc faces significant challenges this year, with GDP set to fall by as much as 12%, but this is an important step towards facing up to that challenge.

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Michael Brown, Senior Market Analyst, Caxton FX