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What The EU Recovery Fund Breakthrough Could Mean For Eurozone Sovereign Ratings

MADRID (S&P Global Ratings) July 22, 2020--EU leaders have signed off on the Recovery Fund following extensive negotiations, complicated by the need to agree on the €1.07 trillion European Union budget for 2021-2027. S&P Global Ratings believes that, despite its temporary, crisis-specific nature, the Fund lends itself to becoming a permanent part of the EU architecture, a position supported by the European Parliament, not least because it would guard against unfair competition in the form of extraordinary fiscal support at the national level.

The EU Recovery Fund is large (at €750 billion, equivalent to just under 5% of the region's GDP), and re-distributive. It oversees grants and loans to EU sovereigns hit hardest by the COVID-19 pandemic. It is also contra-cyclical: A key feature of the plan is that the supranational body, the European Union, will depart from its previous policy of not financing deficits, and borrow in commercial markets to finance upfront transfers. By issuing debt in the market on this scale, the EU also provides the ECB, as well as investors, with a new liquid euro-denominated benchmark instrument, benefiting the euro's status as a reserve currency.

During the initial stage of the COVID-19 pandemic, EU sovereigns principally took a unilateral national fiscal approach to addressing the fallout on their economies, including on public-sector entities. Not all member states were able to provide the same level of direct fiscal support, which ranged from around 1% of GDP in Portugal to 9% of GDP in Germany. With the creation of the Recovery Fund, the EU has invested in a shared fiscal response: a key step toward becoming a fiscal union.

Yet the Recovery Fund is not perfect. One drawback is that, while there is a commitment to disburse 70% of the Fund in the first two years, transfers would not arrive as quickly as some governments would like. Moreover, the final share of grants versus loans, at just over 50%, is lower than the initially proposal two-thirds. The Recovery Fund is limited to investment spending only, so it will do nothing to counteract Europe's impending fiscal cliff as employment-protection schemes expire over the next few months. What's more, policymakers have delayed the decision on which revenues will double the EU's own resources in the future. Compared with country-level budgets, the EU's capacity to tax, while increased, remains notably low.

Nevertheless, we believe the political consensus in establishing the Fund, and endowing it with debt-raising capacity, is a major step forward for the euro area in particular and will support Europe's long-term economic and financial stability. In that respect, the EU Recovery Fund is positive for European sovereign credit quality and for the institutional effectiveness of all member states, especially those in the euro area. It complements other fiscal facilities the EU has already put in place to deal with the fiscal fallout from COVID-19, including the €100 billion SURE fund (which contributes to the cost of employment subsidies), and the ESM Pandemic Crisis Support Credit Line (equivalent to 2% of member states' GDP, to support national health budgets).

One of the reasons negotiations on the creation of the Recovery Fund took four days was the sensitive issue of whether to insist on the introduction of pro-growth reforms as a condition of access to the disbursements. In our view, the prerequisite that Fund recipients implement a national recovery plan, and show progress on executing it, shows recognition that only via a sustained post-pandemic economic expansion can the euro area shift public debt ratios back onto a downward path; we project that, by the end of 2020, the median level of general government debt to GDP in the euro area will increase by 14 percentage points of GDP compared with the end of last year.

We continue to assess member states' long-term debt sustainability in the context of highly supportive monetary policy. Every eurozone member state is refinancing its debt at market rates far below inflation and the average rate they are paying on debt. We will attempt to gauge the permanent effect of the pandemic on each economy's growth prospects and fiscal stability. Prospects for a recovery in 2021 rely on whether an effective vaccine is developed, and when. However, our ratings will also hinge on an assessment of whether the pandemic has permanently damaged Europe's households and businesses, not least small and midsize enterprises, the largest employers in most of Europe, and what that means for long-term fiscal sustainability. The story is not over yet, but the establishment of a shared fiscal mechanism is a breakthrough for EU sovereign creditworthiness.

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This report does not constitute a rating action.

Primary Credit Analyst:Frank Gill, Madrid (34) 91-788-7213;
Secondary Contacts:Patrice Cochelin, Paris (33) 1-4420-7325;
Christian Esters, CFA, Frankfurt (971) 4-372-7169;
Roberto H Sifon-arevalo, New York (1) 212-438-7358;

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