EU’S financial policies in post Covid era

BY: Stefano Grasso*


PEJOURNAL – The coronavirus pandemic has been causing a very strong and very hard recession. Indeed, it has been impacting on people’s health, jobs and well-being.  According the latest projections of OECD the GDP of Euro area will decrease up to -9%. The global outlook is highly uncertain. The OECD’s outlook focuses two scenarios: one in which a second wave of infections, with renewed lock-downs, hits before the end of 2020, and one in which another major outbreak is avoided.

In these weeks, in Germany and in Portugal, the Governments have limited some areas of their country because of deployment of new infected of covid. 

So, task of the European Commission will be to act quickly and strongly.

Meanwhile, one week ago, there was the reunion among Prime Ministers and Presidents of different European Countries with the presidents of European Institutions (European Commission, European Council and European Parliament).

There was no deal about period, amounts and conditionality. North European Countries kept in their own positions. South European Countries asked more flexibility and advance payment. In July there will be a new meeting among Prime Ministers and Presidents of different European Countries with the presidents of European Institutions.

On the economic side, the proposals are concerning: European Stability Mechanism (ESM), Support mitigating Unemployment Risks in Emergency (SURE), the guarantees provided by European Investment Bank on loans and the Recovery fund funded by issuing European’s bonds.

The total amount of these instruments will be nearly 1 trillion of euro.

On the Recovery Fund the challenge is still open. This fund will be composed by loans and by free contribution. The overall amount of the Recovery Fund will be 750 billion of euro. It should start at the beginning of 2021. South European Countries would get an advance at the end of this year.

To finance the necessary investments, the Commission will issue bonds on the financial markets on behalf of the EU.

To make borrowing possible, the Commission will amend the Own Resources Decision and increase the headroom – the difference between the Own Resources ceiling of the long-term budget (the maximum amount of funds that the Union can request from Member States to finance its expenditure) and the actual spending.

With the headroom as a guarantee, the Commission will raise funds on the markets and channel them via Next Generation EU to programmes destined to repair the economic and social damage and prepare for a better future.

Commission issues bonds on the markets on behalf of the EU

  • Maturity varies from 3 to 30 years
  • Commission lends proceeds to EU countries under the Recovery and Resilience Facility to finance their reform and resilience plans in line with the objectives identified in the European Semester, including the Green and Digital transformation, the Member States’ national energy and climate plans, as well as with

The funds will go to areas where they can make the greatest difference, complementing and amplifying the essential work under way in the Member States. The investments will be channelled via a variety of instruments under different pillars such as:

European Recovery and Resilience Facility: Grants and loans by implementing Member States’ national recovery and resilience plans defined in line with the objectives of the European Semester, including in relation to the green and digital transitions and the resilience of national economies.

REACT-EU – Recovery assistance for cohesion and the territories of Europe: Mechanism: Flexible cohesion policy grants for municipalities, hospitals, companies via Member State’s Authorities. No national co-financing required. Budget: 55 billion of euro of additional cohesion policy funding.
Supporting the green transition to a climate neutral – economy via funds from Next Generation EU: A proposal to strengthen the Just Transition Fund up to 40 billion, to assist Member States in Accelerating the transition towards climate neutrality. A € 15 billion reinforcement for the European Agricultural Fund for Rural Develompment to support rural areas in making the structural changes necessary in line with the European Green Deal and achieving the ambitious targets in line with the new Biodiversity and Farm to Fork strategies.
Enhanced InvestEU Programme: including a Strategic Investment Facility Mechanism: Provisioning of an EU budget guarantee for financing of investment projects via the EIB group and national promotional banks Budget: €15.3 billion for InvestEU. Additionally, a new Strategic Investment Facility  to be equipped with €15 billion provisioning from Next Generation EU
New Solvency Support Instrument to support equity of viable companies Mechanism: Provisioning of an EU budget guarantee to the European Investment Bank Group  in order to mobilise private capital Budget: €31 billion  
New health programme to help equip Europe against future health threats: A new Health Programme, EU4Health, to strengthen health security and prepare for future  health crises with a budget of €9.4 billion. Reinforcing RescEU, the EU’s Civil Protection Mechanism, to respond to large-scale emergencies Mechanism: Grants and procurements managed by the European Commission Budget: A total of €3.1 billion

Beyond  the  individual  programmes,  the  crisis  has  underlined  how  important  it  is  that  the Union is able to react fast and flexibly to put in place a coordinated European response. This in turn requires a more flexible EU budget. Therefore, the Commission proposes to reinforce the flexibility of the EU budget and emergency tools for the period 2021-2027.

  • Enables swift reinforcements via budgetary transfers to EU instruments where needs arise
  • Increase to a maximum annual amount of €3 billion
  • Supports Member States in the response and immediate recovery following natural disasters such as floods, forest fires, earthquakes, storms and droughts
  • Extension to encompass major health crises and increase to a maximum annual amount of €1 billion
  • Provides support for the reintegration in the labour market of persons losing their jobs as a result of unexpected major restructuring events such as a financial or economic crisis
  • Threshold for the activation of the fund lowered to 250 redundancies and increase to a maximum annual amount of € 0.386 billion.

The situation is not easy.

At the same time, European Commission is organizing a global online pledging conference. The aim is to join forces and mobilise resources. The goal is to produce a new vaccine and spread it to every part of the world. The Commission will support efforts to accelerate the development and availability of safe and effective vaccines in a time frame between 12 and 18 months.

In addition, President Von Der Leyen in order to avoid a harmful competition has asked to collaborate with international partners to creation of vaccine procurement mechanism.

European Commission has collected 10 billion of euro in order to invest on vaccine.

The EU Vaccine Strategy will implement a joint approach going forward.

The strategy has the following objectives

  • Ensuring the quality, safety and efficacy of vaccines.
  • Securing swift access to vaccines for Member States and their populations while leading the global solidarity effort.
  • Ensuring equitable access to an affordable vaccine as early as possible.

The EU strategy rests on two pillars

  • Securing the production of vaccines in the EU and sufficient supplies for its Member States through Advance Purchase Agreements with vaccine producers via Emergency Support Instruments. Additional financing and other forms of support can be made available on top of such agreements.
  • Adapting the EU’s regulatory framework to the current urgency and making use of existing regulatory flexibility to accelerate the development, authorisation and availability of vaccines while maintaining the standards for vaccine quality, safety and efficacy.

Advance Purchase Agreements

In order to support companies in the swift development and production of a vaccine, the Commission will enter into agreements with individual vaccine producers on behalf of the Member States. In return for the right to buy a specified number of vaccine doses in a given timeframe, the Commission will finance part of the upfront costs faced by vaccines producers. This will take the form of Advance Purchase Agreements. Funding provided will be considered as a down-payment on the vaccines that will actually be purchased by Member States.

The related funding will come from a significant part of the €2.7 billion Emergency Support Instrument. Additional support will be available through loans from the European Investment Bank.

Financing criteria

When taking the financing decision on what vaccines to support, the following non-exhaustive criteria will be taken into account, including: soundness of scientific approach and technology used, speed of delivery at scale, cost, risk sharing, liability, coverage of different technologies, early engagement with EU regulators, global solidarity, and capacity to supply through development of production capacity within the EU.

There is always a risk that supported candidates fail during clinical trials. This Strategy is therefore similar to an insurance policy, by transferring some of the risks from industry to public authorities in return for assuring Member States of equitable and affordable access to a vaccine, should one become available.

A flexible and robust regulatory process

Regulatory processes will be flexible but remain robust. Together with the Member States and the European Medicines Agency, the Commission will make the greatest use of existing flexibilities in the EU’s regulatory framework to accelerate the authorisation and availability of successful vaccines against COVID-19.

This includes an accelerated procedure for authorisation, flexibility in relation to labelling and packaging, and a proposal to provide temporary derogations from certain provisions of the GMO legislation to speed up clinical trials of COVID-19 vaccines and medicines containing genetically modified organisms.

The Monetary policy

The changes to our economy induced by the pandemic are therefore in all likelihood not only temporary, but structural. Global value chains are already being put to the test, productivity in many service sectors may be permanently affected, and certain industries will probably never return to their pre-crisis levels.

The extent to which these structural changes will negatively impact the economy, and exacerbate existing divergences among euro area countries, will crucially depend on the economic policies implemented in response to the coronavirus pandemic. In this context, the question arises what is the role of monetary policy in this crisis and how to assess the measures that the ECB has taken so far.

Here, I will argue that the measures taken by the ECB since the outbreak of the crisis have been necessary, suitable and proportionate (in the narrow sense) in order to ensure price stability in the euro area. The measures have played a decisive role in allowing banks and financial markets to continue to fulfil their role as intermediaries and risk-bearers, and have thereby protected growth and jobs in the euro area from even more painful cuts.

Last March the European Central Bank launched “The pandemic emergency purchase programme” (PEPP). It was an instrumental in unlocking the transmission mechanism to ease financial conditions for all sectors in the economy. The PEPP has been successful in diminishing the intermediation frictions that arose in the early stages of the crisis. Notably, the recently-announced expansion in the PEPP has been associated with a further improvement in the transmission mechanism.

These developments show that the PEPP has been very effective against the widening of risk premia, consistent with evidence that monetary policy measures designed to release balance sheet constraints for firms and financial intermediaries tend to be particularly effective in conditions of elevated market stress.

The extraction of duration risk from the financial system is a key channel through which the PEPP supports market stabilisation. By putting downward pressure on the medium and long segments of the curve, it complements and reinforces negative interest rates and forward guidance on rates. The total PEPP envelope of €1,350 billion, in conjunction with the additional €120 billion asset purchase programme (APP) envelope for 2020, is expected to further reduce the amount of duration risk that is borne by investors, contributing to a compression of term premia.

As of the end of 2019, the net asset purchases and reinvestment policy had already led to the withdrawal of substantial duration risk from the market, in the order of 19 percent of the duration-equivalent stock of outstanding public debt in the four largest euro area economies. This is foreseen to increase to 27 percent by the end of the second quarter of 2021.

The reason for this is that central banks must keep the real interest rate below the so-called real equilibrium rate in order to increase inflation.

Here I would like to concentrate on two important potential side effects of measures: the distributional effects of monetary policy and the impact on governments’ budgetary discipline.

The first thing to note is that all monetary policy measures ultimately have distributional effects. This goes back to the very nature of monetary policy. Central banks adjust incentives for saving and investment so that they are consistent with stable prices.

By way of example, the yields on long-term government bonds would probably have been much more negative and in all likelihood the interest rates on deposits with banks would have crossed over into negative territory.

Hence, further policy rate cuts would have significantly intensified the distributional effects on borrowers and lenders.

The second potential side effect relates to the incentives that the current monetary policy creates concerning budgetary discipline among the euro area governments.

All monetary policy measures have indirect effects on governments’ funding costs – here, as everywhere else in the world. This matters for the effects of policy measures since the borrowing rates for firms and households are usually related to the level of the government’s interest rates.

However, lower interest rates can lead to governments taking on more debt, possibly even to an extent that may affect their debt sustainability.

If ECB had not announced new measures, in particular the pandemic emergency purchase programme (PEPP), we would presumably now be in the middle of a severe financial crisis with appalling consequences for the economy and employment in the euro area. Price and wage levels would probably have fallen significantly, which would have run counter to our price stability mandate.

* Stefano Grasso is graduated in master of Corporate Finance from University of Catania, Italy and he is financial consultant.