Sovereign ESG Risk: Eastern Europe, CIS, Middle East Most Exposed to Transition Risks

Scope Ratings says climate-related transition risks are distributed widely among differing regions, with the euro area, overall, less exposed than the Anglosphere countries – US, Canada, UK, Australia and New Zealand – according to scoring of the categories of environmental risks facing 132 sovereign states.

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Differences in economic structure, and specifically, the varying dependence on fossil fuels to produce a unit of GDP, drive the divergent scores when we assessed environmental risk relevant to sovereign credit ratings.

Transition risks are already credit-relevant today given the international political commitment to reduce global carbon emissions over the coming decades.

Scope’s evaluation of environmental risk factors that are relevant and material for sovereign creditworthiness also include physical and resource risks. Here, it is low-income countries – mostly African economies along with Asian, Latin-American and Caribbean countries – that face the highest physical risks, whether these are event-driven or arise from longer-term shifts in climate patterns.

However, even within regions including those made up of mainly advanced economies, the level of physical environmental risk varies significantly, pointing to idiosyncratic factors being present.

Transition and physical risks are likely to materialise to differing degrees

Transition and physical risks are intertwined globally but are likely to materialise in different regions to differing degrees. Governments that are slow or unwilling to adapt their economies may face higher costs from increasing physical risks while the policies to limit carbon emissions, such as a carbon tax, might increase transition costs, particularly if introduced abruptly.

The impact of climate change is set to intensify. There is a high degree of certainty that some combination of physical and transition as well as resource risks – e.g., potential natural resource constraints – will ultimately materialise longer term, informing our Agency’s decision to incorporate these environmental risks into the sovereign rating methodology last year more explicitly.

By incorporating environmental risks explicitly into the sovereign rating model as independent variables, we determine exogenously the extent of the impact that these variables can have on credit risk.

The variables Scope Ratings uses for assessing environmental risk include transition risks, captured via CO2 emissions per unit of GDP, physical or natural disaster risks, as measured by the World Risk Index, and resource risks, measured via a country’s ecological footprint of consumption relative to its biocapacity. In our study, all 132 sovereigns are assessed under a 100-point scale, whereby a score of 100 (1) implies low (high) credit risk.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Covid-19 Economic Impact: Lasting on Government Debt, Mixed for Growth and Mostly Transitory on Unemployment

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Scope Ratings says the impact of the pandemic on global economies varies widely, reflecting differences in the severity of the health crisis, underlying economic structures and the policy response.

Many uncertainties remain before it is possible to definitively assess Covid-19’s economic impact on individual countries and the global economy: the virus continues to spread, vaccination programmes are still building momentum, and fiscal and monetary stimulus has varied in scope and effectiveness. Still, there are some initial signals of the pandemic’s impact on government balance sheets, economic recoveries and the labour market.

For 36 countries it covers, Scope compared the IMF’s updated forecasts from last week for these countries for 2024 growth, public debt and unemployment forecasts with 2019 pre-crisis levels as well as against the IMF’s forecasts for 2024 back in October 2019 – the last full IMF forecasting round before the pandemic hit.

Scope’s analysis shows that the Covid-19 shock will have a lasting impact on most sovereigns’ balance sheets.

Some sovereigns mostly unaffected, others unlikely to reverse balance-sheet damage long term

We see evidence of sovereigns whose balance sheets are mostly unaffected, such as that of Russia and Norway, those who could reverse balance sheet deterioration absent further immediate shocks, such as Greece and Cyprus, and finally, those sovereigns that are set to see public debt levels rise markedly without a likely prospect of reversal over the coming years.

The latter group of economies includes the UK, Spain, Belgium, Italy and France.

China, the US and Japan are forecast to continue displaying higher public debt levels in the coming years, but the debt trajectory is now only slightly worse compared with the adverse trajectories already forecasted two years ago.

Economies will recover output lost from crisis at different speeds

Looking at growth, the analysis shows that Ireland, China and Turkey did not experience a growth decline in 2020 while it will take Spain, Greece and the UK three years, and Italy even four years, to return to and surpass 2019 GDP levels.

The US, the Nordics, the Baltics and most central and eastern European sovereigns should see their GDP levels exceed those of 2019 this year, while most euro area sovereigns will have to wait until 2022.

Impact on the labour market likely to be comparatively mild

Contrary to the experience during the great financial crisis, the impact on the labour market is likely to be significantly milder this time around, particularly for advanced economies.

Greece and Turkey are forecast to see their unemployment rates decline by 4-5% compared with levels in 2019 while the impact for most other Scope-rated sovereigns is below 1pp, reflecting, in part, the effective use of furlough schemes reducing job loss and mitigating the crisis impact. Italy’s unemployment rate is the most adversely affected, with a forecasted rise of around 2pp by 2024 compared with the rate in 2019 while Spain’s unemployment rate is now forecast to be 2pp higher in 2024 compared to the forecast made by the IMF two years ago.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.


US: Biden’s Stimulus to Raise Growth Prospects, Tackling Economic Disparities at High Fiscal Cost

The American Rescue Plan worth USD 1.9trn (around 8.5% of 2020 GDP) will provide a significant front-loaded boost to economic activity in the United States, with GDP exceeding pre-crisis levels by end-2021, well ahead of some of Europe’s largest economies including France and the United Kingdom.

The fact that the Biden administration was able to implement this sizeable stimulus plan less than two months after his inauguration is positive for the United States’ AA credit ratings.

The largest near-term push to aggregate demand is expected to come via payments to households, which represent around one-fifth of the total package.

In addition, continued accommodative US monetary policies are likely to raise the near-term multiplying effects of the package, lifting US growth in 2021 and 2022 to around 5-6% from our earlier estimate of around 3-4%.

Composition of stimulus matters, not just size and timing

Biden’s new deal addresses two inter-related credit weaknesses – medium-term growth potential and troubling social outcomes – at the expense of the third, the US’ structurally deteriorating public finances.

In addition to direct payments to households and extension of jobless benefits and tax credits for families, the package provides support for federal and local government, schools, transport and Covid-19 vaccination plus help for households on rent, utility and mortgage payments. The fiscal impact this year is around USD 1.2trn, then around USD 500bn in 2022, with the remainder in the coming years, according to CBO estimates.

These measures should help tackle entrenched economic disparities, ranging from a high proportion of people depending on federal programmes for food, health care, education and housing to widening levels of income and wealth inequality.

Such structural weaknesses weigh down on aggregate demand and productivity growth. Addressing the challenges, which will also require substantive structural reforms, could ultimately increase medium-run growth potential, which we estimate at around 1.9%.

US fiscal fundamentals to remain structurally weaker for years

Still, with the additional stimulus, following the USD 900bn package approved in December last year, the US’ fiscal fundamentals will remain structurally weaker for years. The overall budgetary cost is likely to be lower than the size of the stimulus, with higher nominal activity offsetting around one-quarter of the initial discretionary stimulus measures according to the OECD. However, government debt-to-GDP is set to increase by around 6pp by 2023 and reach around 135-140% of GDP by 2025. That would be almost 30pp above 2019 levels, and about 15pp above debt ratios of France and the UK.

Full long-term impact of stimulus on US output is uncertain

The full impact on US output from the stimulus is uncertain as is the degree to which it will raise inflation. Inflationary pressures are likely to be short lived and remain manageable – 5-year, 5-year inflation expectations are still around 2% – while some inflation could even help ease the rising debt-to-GDP ratio.

The acid test of the stimulus plan remains its success in improving longer-term US potential growth given the country’s polarised politics, which we expect will continue to prevent bipartisan agreement on fiscal consolidation even when the economy is again running at full steam.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

European Supranationals Outlook: Path Clears for Euro-Denominated Green and Social Safe Assets

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We believe the momentous shift in availability of safe assets in Europe reflects the national and supranational European fiscal stimulus to counter the Covid-19 shock, providing comprehensive safety nets for households, businesses and governments amid the pandemic, and financing a sustainable recovery in the coming years.

A sustainable recovery, green transition are Europe’s main policy priorities

European supranationals are adapting mandates and operating guidelines to ensure carbon neutrality by 2050, which, given the weight they carry in capital markets and policy making, will influence industry standards and affect investors and the private sector globally.

The EIB and EBRD, for example, are aligning their financing activities with Paris Agreement terms and raising their climate-finance-related objectives, while the EU, via its EUR 750bn Next Generation EU recovery fund of which about EUR 225bn will be issued in green bonds, will play a pivotal role in providing a safe, green asset in Europe.

Social bond issuance is also set to rise

But EU safe assets will not only be green. Social bond issuance is also set to rise markedly. The EU’s Support to mitigate Unemployment Risks in an Emergency (SURE) scheme of up to EUR 100bn has completely changed the landscape for supranational social bond issuance.

Of the EUR 100bn, EUR 53.5bn has already been borrowed and disbursed to 15 member states since an inaugural bond issue on 20 October 2020. With EUR 90.3bn requested overall, EUR 36.8bn is still to be raised, which is likely to be mostly concluded by the end of Q2 2021.

These programmes underpin the EU’s emerging role as a major contributor to sustainable finance in capital markets and, depending on varying investor demand for the different types of programmes, there is a possibility of distinct social, green and conventional curves in the future.

Open questions remain

Open questions remain: how much will the EU ultimately issue in bonds, how much will be green or conventional, and to what extent will it be more than matched by a greener greenback under the new US administration?

The Covid-19 outbreak also entails risks through possible deterioration in asset quality and higher leverage.

Still, while risks remain, European supranationals have strong credit profiles based on robust balance sheets and sizeable buffers, as well as rock-solid shareholder support. We expect credit profiles to remain resilient in 2021 as reflected in our current Stable Outlooks for supranational borrowers.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Spain: Reform Momentum Key for Facilitating Recovery after Historic Economic Contraction

The economy in Spain experienced the largest recession among major euro-area economies in 2020. GDP contracted by 11%, slightly better than Scope’s estimate of a 12% contraction, but significantly worse than the 8.9% GDP decline in Italy, 8.3% in France and 5% in Germany.

Significant monetary policy support has helped the financing of sizeable countercyclical fiscal measures to protect the economy. Spain is set to have recorded a double-digit fiscal deficit estimated at 11% of GDP last year, despite better-than-expected tax revenues, resulting in debt rising to nearly 120% of GDP from 96% in 2019.

Despite the deterioration in public finances, the government’s financing costs remain low, with the yield on the 10-year Bono close to 0%. The Bank of Spain holds now more than 25% of Spain’s government debt.

Tackling labour-market inefficiencies, raising productivity vital for sustained recovery

Any fundamental improvement in Spain’s public finances depends on a sustained economic recovery, government efforts to address inefficiencies in the labour market and raise productivity, together with a credible medium-term fiscal consolidation strategy.

The uncertainty on the recovery this year is visible in diverging forecasts, ranging from 9.8% growth by the government, which expects a 2.6pp uplift from EU funds, to the Bank of Spain’s baseline forecast of 6.8% assuming a 1.3pp positive impact from EU funds. Our forecast, in line with the IMF, is for a more modest rebound of 6%.

The government is prioritising growth over budgetary discipline, which for the moment is appropriate given the large output gap. Spain will run a wide budget deficit for some time. For 2021, the authorities forecast a deficit of 7.7% of GDP, which is based on a rather optimistic economic scenario. Thus, should growth be weaker than expected in the coming years, Spain’s public finances would deteriorate further.

Sustainable growth over the coming years will depend, among other factors, on the effective spending of at least the EUR 78bn in grants Spain is set to receive as part of the Next Generation EU recovery fund as well as labour and product market reforms that raise the country’s growth potential. Spain has the highest structural unemployment rate in the euro area (14%) and almost 25% of employment is on temporary contracts, which has adverse effects on job security as well as on companies’ willingness to invest in human capital.

Pension reform would contribute to more sustainable government finances

In addition, reforming the pension system would also contribute to the sustainability of Spain’s public finances as the social security fund has run a deficit for the past 10 years and given the country’s ageing population.

The dire state of the economy and the European Commission’s conditions for access to the funds might spur the minority government’s reform efforts despite Spain’s fragmented politics. Indeed, the government has obtained parliamentary approval for the first full-year budget since 2016.

Given these politically costly reforms, tensions are likely to persist, challenging the minority government’s ability to facilitate Spain’s economic recovery and strengthen the country’s public finances. This uncertainty is captured in our A-/Negative sovereign rating for Spain.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is deputy head of Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Associate Analyst, contributed to this commentary.

US Elections: Political Polarisation, Governance, Fiscal Challenges Weigh on Credit Outlook

We rate the United States at a below-consensus AA credit rating. This rating level considers the country’s wealthy, competitive and diversified economy, its transparent and accountable institutional framework, as well as the dollar’s unparalleled global reserve currency status as credit strengths. The latter allows the country to run fiscal and current account deficits with limited concern regarding the sustainability of public debt.

In the near term, the most credit-relevant factor is the health of the country’s transparent and accountable institutional framework. While legal battles over results in tightly contested states are occurring, it would be credit negative if a judicial ruling on the outcome – should it be needed to determine the next US president – is not accepted by the losing party.

Reduced growth potential and rising debt are the biggest medium-term challenges

Over the medium term, the incoming administration’s economic, fiscal and social policies, and ability to implement them alongside a possibly split Congress, are the most relevant to the outlook. The US’ credit rating is constrained by two principal factors. First, the outlook for the economy’s long-run growth is worsening.

Secondly, public debt is high and rising after the current administration’s strongly procyclical fiscal policies before the Covid-19 shock in addition to the sizeable, albeit appropriate, fiscal stimulus this year and the federal government’s significant contingent liabilities from pension and healthcare-related obligations.

The economic impact of the Covid-19 pandemic, which led in the second quarter to the deepest recession in US post-war history, is being mitigated substantially by the Federal Reserve’s low interest rates and policies providing credit support to households and firms, alongside a government fiscal package totalling USD 2trn (9% of GDP) in direct spending and USD 860bn (4% of GDP) in liquidity support.

As a result of these forceful fiscal and monetary policy actions, the US is among G10 countries where economies will see the smallest contractions in 2020. The change in real GDP in 2020 is estimated at -4.3% by the IMF, versus -9.8% for the UK and France and a G10 average of -6.5%.

Troubling social outcomes constrain growth potential

Still, the US’ growth potential has been declining from about 3% in the previous decade to around 1.9% for the next decade. An incoming administration needs to adopt policies to raise growth by addressing troubling social outcomes. These include a persistently high share of the population depending on federal programmes for nutrition, healthcare, education and housing, the erosion of socio-economic mobility, stagnating incomes among many households, and widening income and wealth inequality.

These structural weaknesses are likely to constrain labour-force participation, diminish human capital formation, and suppress aggregate demand as well as future productivity growth, ultimately reducing potential output growth.

In addition, the US’ fiscal fundamentals are deteriorating and will remain structurally weaker over coming years, with the IMF projecting the public debt-to-GDP ratio rising to 131% in 2020 and further to 137% by 2025, almost 30pp above 2019 levels, and about 15pp above those of France and the UK.

The government’s failure to pass extra fiscal stimulus in the run-up to the November elections, due to disagreements between Democrats and Republicans over the design and intended beneficiaries of the package, highlights how political polarisation is impeding effective macroeconomic policy despite the urgency of addressing the pandemic.

In the short term, a Biden presidency would also likely face resistance in legislative negotiations of a potentially split Congress, potentially getting in the way of the timely implementation of a much-needed fiscal support package, thus reducing the stimulus’ overall positive economic impact.

Over the longer term, the declining ability of US politicians to achieve bipartisan political compromise raises doubts on the government’s ability to form and implement a fiscal consolidation strategy once the economy returns to full potential.

Overall, the US outlook depends on its governance framework in the short term as well as the ability to implement effective policies that address structural growth and fiscal challenges over the medium term.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Spain: Covid-19 resurgence heightens risks to optimistic growth and fiscal forecasts in 2021 budget

The Spanish government’s projection of a downward trajectory for debt-to-GDP next year as outlined in the 2021 Draft Budgetary Plan (DBP) assumes a vigorous and sustained economic rebound supported by transfers from the Next Generation EU (NGEU) recovery fund.

We see significant downside risk to the government’s anticipated economic outlook, which also informs its fiscal and debt projections.

The Spanish government expects an economic recovery of 9.8% of GDP in 2021, which includes the positive impact of EU recovery funds, after a contraction of 11.2% this year. The government’s assumption is that the recovery fund will shift the trajectory of real GDP back to 2019 levels by the beginning of 2022. By 2023, the growth path would be the same as it would have been in the absence of the pandemic due to a permanent, positive impact from resulting investment, which is assumed to raise the country’s growth potential to 2% from current estimates of around 1.5%.

Covid-19, low investment, slow deployment of EU funds are risks to the economic outlook

We see three principal risks to the Spanish government’s economic forecasts.

First, the extended second wave of contagion is forcing Spain to reintroduce limits on economic activity, which will likely reverse the recovery in Q4, after the very robust growth in Q3 (16.7% QoQ). The fall in Q4 output and probably only a gradual recovery in early 2021 will result in lower growth next year.

Secondly, as the crisis persists, Spanish corporates and households will not shift their focus towards investments and expenditure as assumed under a V-shaped recovery, but rather focus on their own survival and savings, undermining private demand in the coming quarters.

Thirdly, EU resources, via grants from the recovery fund, need to be effectively channelled into public investment projects and support growth-friendly structural reforms. Spain has a weak track record of converting EU funds into fiscal stimulus.

To be sure, the Spanish government has strengthened the governance of EU recovery funds through centralisation within the Cabinet Office and by advancing reform plans to streamline administrative processes and public procurement. Still, the administrative capacity to utilise such a large amount of funds efficiently and in a timely fashion may represent a significant challenge for the Spanish public sector. In fact, at 39%, Spain has the second lowest cumulative 2014-20 absorption rate of European Structural and Investment Funds among the EU-27, in line with Italy’s but below that of Portugal (54%).

The budgetary outlook hinges critically on a large tranche of EU funds – about EUR 27bn, or around 2.2% of 2019 GDP – being effectively channelled into growth by next year. The government assumes that these funds, mostly allocated to productive investment expenditure, will raise Spain’s GDP growth by around 2.6pp, given their forecast of a 9.8% growth rate in 2021 compared with 7.2% in a no-policy-change scenario.

Scope forecasts wider fiscal deficits than the government does

For this year, the government expects a fiscal deficit of 11.3% of GDP, with improvement to 7.7% in 2021. This compares with our more conservative forecasts – also based on a less favourable growth outlook – of fiscal deficits at 13% of GDP in 2020 and 8.5% in 2021, broadly in line with the IMF’s forecasts of 14.1% and 7.5%.

Risks to the public debt trajectory but favourable funding conditions

Further risks from less robust economic recovery include the crystallisation of contingent liabilities on the public balance sheet. According to the DBP, the maximum amount of public guarantees on loans that can be taken up amounts to about EUR 160bn, or 13% of 2019 GDP. Under the government scenario, it expects stock-flow adjustments to contribute to increasing debt-to-GDP by 2.5pp in 2021.

Overall, we expect public debt-to-GDP to remain on a slightly increasing trajectory over the medium term, rising from 122% this year to 125% by 2025. This compares with government projections of 118.8% for this year and a short-term reduction to 117.4% in 2021. On the plus side, strong market access and favourable funding conditions continue to support the government’s fiscal response to the pandemic.

The Treasury has so far carried out about 90% of its 2020 funding programme. Via the ECB’s purchases programmes, the Eurosystem now holds over 23% of Spanish government debt, ensuring low funding costs, with the yield on 10-year government securities at around 0.1%.

Also, in view of favourable borrowing conditions, the government has so far requested only the grant portion of the NGEU package, in addition to the EUR 21.3bn loan requested under the unemployment scheme, SURE, of which EUR 6bn has been transferred, reducing the government’s borrowing needs.

We expect the government to pass a 2021 Budget under the emergency situation

Finally, due to recurring failures in securing parliamentary backing for government budgets, Spain is still operating under the 2018 budget. However, we expect the government this time around to pass its budget, even if the ruling minority coalition between the PSOE and Unidas Podemos will depend on external parties’ support to do so.

The emergency situation has triggered a State of Alarm, which temporarily strengthens government powers and increases the political price of being perceived as placing party interests above those of the state.

The failed attempt from far-right party Vox to pass a no-confidence motion in the government shows how the majority of opposition parties is likely not to risk jeopardising the country’s prospects of receiving EU recovery funds, which depend on passing the budget. Failure to pass the budget would be credit negative as highlighted in Scope’s rating action on Spain in August, when the Outlook on the A- sovereign rating was revised to Negative.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Euro Area Safe Assets to Rise by Almost EUR 2.5trn Over Coming Years, Boosting the Euro’s Standing

The European fiscal response to the Covid-19 crisis – including national and EU-wide counter-cyclical fiscal stimulus – will indeed increase the availability of euro-denominated safe assets in coming years by almost EUR 2.5trn, an increase of about 50%.

“We expect the combined national and European fiscal response to the Covid-19 shock to increase the availability of highly rated euro-denominated securities from around EUR 5trn in 2019 to almost EUR 7.5trn by 2024,” says Alvise Lennkh, deputy head of sovereign and public sector ratings at Scope.

“The scarcity of euro-denominated safe assets particularly relative to the depth of the markets for US Treasuries and Japanese government bonds has been on the academic and political agenda since the global financial and sovereign debt crises,” says Lennkh.

“The coming significant jump in issuance, which will result in higher public debt levels overall, may boost the euro’s credentials as a global reserve currency,” he says.

Two drivers for the increase in euro-denominated safe assets

There are two main drivers for the increase in euro-denominated safe assets:

  • An estimated increase in debt securities by highly rated sovereign governments by around EUR 1.6trn, driven by France (~EUR 700bn) and Germany (~EUR 600bn); and
  • Issuance at the supranational level, particularly from the European Commission, will increase significantly to fund the “Next Generation EU” recovery plan (EUR 750bn) and the SURE unemployment scheme (EUR 100bn) over the coming years.

Much higher levels of government and supranational debt are to be expected, albeit financed at lower cost, mostly driven by the ECB’s crisis response, which will result in greater interdependence between the ECB and euro area member states given the increasing share of sovereign bonds on the ECB’s balance sheet.

In addition, the greater supply of euro-denominated area safe assets, particularly those issued by the EU, could address some of the adverse effects resulting from the shortage of safe asset supply in the euro area, notably banks holding large portions of domestic sovereign bonds on their balance sheets, which could now diversify some of their sovereign bond holdings, possibly reducing the vicious so-called doom loop in sovereign debt crises.

Benefits should, however, not be overstated at this stage

However, the benefits should not be overstated at this stage as EU issuance amounts only to slightly above 5% of EU-27 GDP. Still, having a deeper pool of euro area safe assets may affect sovereign creditworthiness in various ways.

“A sufficiently high supply of highly rated euro-denominated bonds would facilitate integration between the still-fragmented financial systems and ensure liquid markets for refinancing.”

Implications of enhanced reserve currency status for euro area sovereigns include the prospect of more limited exchange-rate risks and reduced government borrowing costs, and thus the ability to increase spending without materially raising debt-sustainability concerns.

For a look at all of today’s economic events, check out our economic calendar.

Read the full Scope Ratings report at this link.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

EU Budget and Recovery Fund Deal: a Significant Step to Boost Europe’s Integration and Recovery

Scope Ratings’ Alvise Lennkh, deputy head of the sovereign and public sector group, reviews the new EU budget deal.

1. What does the outcome of the EU budget deal mean for Europe?

First, politically, it is a very important signal that leaders agreed – already in the first month of the German EU Presidency – on the budgetary resources and objectives to facilitate Europe’s recovery from 2021 on. Once again, European leaders have demonstrated that in times of distress, compromise and action are possible, not only to tackle an emergency, but also to support a more robust recovery. This decision sets a confidence-building precedent that extraordinary financial measures are available from the EU to cushion against future economic and social shocks.

Secondly, economically, the potential for a more durable recovery has been strengthened. The EU’s recovery fund is the first significant common European counter-cyclical fiscal response to an economic crisis, to be comprised of EUR 390bn in grants and EUR 360bn in loans, financed by bond issuance backed by the EU budget, which comes on top of EUR 1.1trn via the next seven-year budget, bringing a total budget size of EUR 1.8trn. However, the macro-economically relevant element for Europe’s recovery in terms of additional fiscal stimulus relates predominantly to the recovery fund. At EUR 750bn, the fund is slightly above 5% of EU-27 GDP, assuming that all grants and loans are disbursed.

The direct fiscal stimulus will mostly derive from the grants, which will be committed, on average, at around EUR 130bn a year between 2021-2023. The resulting additional stimulus amounts to near 1% of EU GDP per year – although the actual impact is likely to be somewhat lower as some commitments may only be disbursed after 2023. Still, a productive use of such grants, supported by careful project and investment selection as well as appropriate reforms in the context of the European Commission (EC)’s Country Specific Recommendations, could facilitate a faster and more even economic recovery.

Third, geopolitically, and longer term, the European Commission’s significant increase in capital market borrowing of up to EUR 750bn will increase the availability of safe assets denominated in euros, which could further support the safe-haven role of the euro in the global financial system.

2. How significant is the agreement on the EU budget in the context of Europe’s forceful and evolving policy response to the impact of Covid-19 on EU economies?

The decision critically shifts the focus from emergency measures adopted over recent months to Europe’s recovery over coming years. While the first measures provided a safety net for sovereigns and corporates, which avoided the near-term risk of any immediate liquidity crisis, the deal on the recovery fund and the EU budget provides important longer-term growth incentives.

In addition, the agreement underlines the important coordination of fiscal and monetary policies in Europe, setting a precedent for future crisis response at the EU level. Additional steps toward the completion of the banking and capital markets unions will also be key to facilitating an even and sustainable economic recovery in the EU, which will enhance the EU’s global economic and political objectives as well as the attractiveness of euro-denominated assets.

3. The deal for the Recovery Fund is the result of tough negotiations and includes a number of compromises. What are the key political implications?

The hard-fought negotiations highlighted significant divisions within the EU between more “frugal” northern countries and the southern countries. As a result, the deal includes a number of important compromises such as an increase in budget rebates for some northern countries and the adoption of an ‘emergency brake’ mechanism, which allows any individual member state to oppose disbursement of recovery monies, requiring then a decision by EU finance ministers and, in case of disagreement, by the EU Council.

Such a governance structure may postpone payments in the case of non-productive usage of recovery fund resources, reinforcing the incentives to allocate the Recovery Fund’s resources for projects related, for example, to addressing climate change and the digital economy.

In addition, leaders have also agreed on the implementation of additional European-wide taxes, including on non-recycled plastic waste (effective January 2021), a carbon border adjustment mechanism and on a digital levy (both to be effective January 2023). As the proceeds will be used for early repayments of the forthcoming EUR 750bn in borrowings, these new instruments could, depending on final design and implementation, gain in importance over time, underpinning the joint nature of this fiscal effort.

Overall, we believe that the negotiations highlighted the willingness and ability among EU leaders to reach an agreement. We expect the parliamentary ratification process, including that by the European Parliament, to be completed by end-year with the Recovery Fund becoming operational in 2021.

4. What is the impact of the deal for Central and Eastern Europe (CEE) and Southern Europe?

CEE economies, alongside economies in southern Europe, are key beneficiaries – economically and from the perspective of debt sustainability.

First, both regions have been the largest beneficiaries of EU funds relative to their economic size in the EU budget of 2014-20, with EU funds accounting for more than half of all public investment in many economies. The Next Generation EU fund and EU Budget for 2021-27 present an opportunity for such countries as budget allocations remain large – and in some cases have even increased – which can facilitate a recovery in the coming years. While the ‘regime of conditionality’ still needs to be introduced, going forward, in case of breaches of the rule of law, measures can be taken by the Council on the basis of a qualified majority as opposed to unanimity. This change in governance alone may incentivise all member states to avoid any such procedure related to the adherence to the rule of law.

However, the ability for such economies to deploy additional EU funding will be crucial. EU fund absorption rates vary markedly among CEE and southern European countries, reflecting variation in the co-financing capacity of governments as well as institutional factors such as governance quality and long-term planning capacity, the control of corruption and the extent of decentralisation. For example, the cumulative absorption rate of 2014-20 EU funds is currently well above 50% in the Baltic countries and Poland, but only around 40% on average in Italy, Spain, Romania, Croatia and Bulgaria.

Secondly, the EC loans are highly concessional with lower interest rates and longer maturities compared to what governments could in many cases issue on their own. This will positively impact government debt sustainability over the medium term. Under the Recovery Fund, EU members can borrow up to 6.8% of gross national income, or about EUR 120bn in the case of Italy and EUR 85bn for Spain.

5. What impact will this agreement have on European sovereign ratings?

Sovereign credit rating outlooks from Scope depend on a complex interplay of monetary, fiscal and economic factors, including the social and political repercussions of this pandemic. We acknowledge that decisions on the EU budget and recovery fund are supportive regarding EU sovereign ratings and form a good opportunity to facilitate and support Europe’s economic recovery and transformation in 2021 and beyond alongside continuing the enhancement of the overall EU economic architecture.

Still, we will assess individual sovereign government credit profiles selectively to account for varying fiscal adjustment capacities and underlying degrees of economic resilience and abilities to absorb and reverse the significant economic and fiscal impact from this shock over the medium term.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH.

United States: Public Health, Labour Market and Social Crises darken the Fiscal Outlook

“The Covid-19 shock is exposing and exacerbating US social, fiscal, economic and institutional weaknesses and at the same time highlighting the benefit the US government draws from issuing the world’s reserve currency,” says Alvise Lennkh, director at Scope Ratings.

“For now, these contrasting credit relevant forces remain balanced at an under-consensus AA rating level assigned by Scope, but the longer the healthcare, labour market and social crises persist, the greater the materiality and irreversibility of their medium-term impact on the US credit outlook will be,” says Lennkh.

Three simultaneous crises state-side

The US faces three simultaneous crises, which are mutually reinforcing due to the country’s weak social safety net.

First, the Covid-19 crisis, which has resulted in more than 100,000 reported deaths, or 28% of the global total. Second, the labour market crisis, which, even after better than anticipated payrolls in May, has still resulted in over 20mn unemployed, or at least a 13% unemployment rate. Third, the latest wave of mass anti-racism protests despite pandemic-related lockdowns risk exaggerating the health and economic crises in addition to already existing socio-political tensions.

These inter-related developments are rating relevant in so far as they are likely to:

  1. postpone the gradual lifting of containment measures, delaying the return of economic activity in the near-term,
  2. extend the financial stress of households, businesses and local governments, which will need additional federal fiscal support to compensate for lost income, weakening the country’s already worrisome fiscal outlook over the medium-term, and
  3. further polarise Congress, impeding bipartisan solutions to address the country’s structural challenges and increasing risks of future government shutdowns and/or politicised misuses of the debt ceiling, the suspension of which ends in July 2021.

Comprehensive budget response and fiscal challenges

So far, the US government has implemented a comprehensive fiscal package to counter the Covid-19 crisis. All told, the approved fiscal support amounts to around USD 3trn, of which about USD 1.8trn (8.3% of GDP) is related to direct fiscal costs.

Moreover, on 16 May, the House of Representatives passed an additional USD 3trn stimulus through the HEROES Act, which, if approved, would increase fiscal spending by another 10% of GDP. While it is unlikely to pass in its current form in the Republican-held Senate, a further significant fiscal support package is likely to be finalised this year to provide much-needed support to the US economy.

As a result, conservatively assuming a GDP decline of around 6-8% this year, the overall fiscal deficit for 2020 is likely to range between 20-25% of GDP. This will increase US gross financing needs to above 40% of GDP and lead to a significant jump in the debt-to-GDP ratio, from 107% in 2019 to around 135-140% in 2020. This compares with expected debt ratios of around 115% for France (AA/Stable) and around 100% for the United Kingdom (AA/Negative) by the end of this year.

US continues to benefit from the dollar’s status and Federal Reserve action

Still, despite this significant deterioration in the economic and fiscal outlook, the US continues to benefit from the dollar’s unparalleled reserve currency status and the associated perception that US treasuries are the world’s safe asset. “This unique strength allows the government to run sustained fiscal deficits with limited concerns over the sustainability of its public finances,” says Lennkh.

In addition, the Federal Reserve is expanding its balance sheet to unprecedented levels, as is also the case in the euro area, Japan and the UK. Since August 2019, the Fed’s total assets have increased from USD 3.8trn to above USD 7trn (around 32% of GDP) at the end of May 2020, which, however, remains below the respective levels of the ECB (40%) and the Bank of Japan (110%).

Thus, despite a significant increase in US funding needs, even if private sector actors do not fully absorb the additional supply of US treasuries, financing conditions will remain accommodative over the forthcoming period given the open-ended purchases of public sector debt securities by the Federal Reserve.

The current yield on the 10Y US Treasury Bond is 0.9%, markedly below the 2019 year-end yield of around 1.9%. In addition, almost 72% of government debt is held domestically, with 11% held by the central bank as of end-2019, a share that will increase given the expansion of the asset purchase programme. “Barring legislative limits to federal borrowing via future use of the debt ceiling, refinancing costs and risks are likely to remain negligible despite the country’s poor fiscal trajectory,” says Lennkh.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Public Finance at Scope Ratings GmbH.

The EU’s 750bn EUR Recovery Fund Proposal aims to Balance Loans, Grants and own Resources

Scope Ratings deputy head of public finance Alvise Lennkh takes stock of the proposal to create an EU recovery fund by answering three questions.

Do you expect the EU recovery fund to look like the EC’s proposal or be substantially watered down?

The EC’s proposal provides the starting point for intense negotiations over the coming months. Some aspects will certainly change while others still need to be agreed upon. The EC’s proposal of a 2/3 split of grants and 1/3 of loans of a total EUR 750bn fund volume carefully balances the Franco-German proposal, which included direct grants of EUR 500bn, and the strong preference of the ‘frugal four’ to rely on loans only.

The final share of funds between grants and loans is one of the main remaining areas of negotiation and could end with a somewhat higher share of loans than currently proposed. This will also depend on other characteristics of the fund, including its temporary nature, the eligibility criteria to access the fund as well as the purpose/projects for which the monies can ultimately be used.

We thus expect the final result to change somewhat. Still, the overall direction, including the proposal to use substantial grants as per the EC’s proposal, is likely to form part of the EU’s economic recovery strategy going forward.

What impact will the additional borrowing required by the recovery fund and SURE programs have on the European Union’s credit quality?

The EU’s rating is primarily driven by its highly rated key shareholders. In addition, the EU has a strong institutional setup ensuring de facto joint and several support, a legally enshrined debt service priority combined with significant budgetary flexibility as well as its conservative cash management resulting in very high liquidity buffers.

The impact of the additional borrowing will primarily affect the EU’s liquidity metrics, specifically its liquid assets ratio, depending on the amount of annual disbursements the EU conducts via the recovery fund and SURE. While more details are needed to assess the impact on the EU’s liquidity metrics, the EU’s AAA rating would be resilient to a significant increase in annual disbursements, assuming that the other parameters of the EU’s budget remain broadly the same, including cash buffers (which hover around EUR 20bn per year) and the budgetary margin (which refers to the resources the EU can draw from member states without requiring parliamentary approval).

Depending on the final parameters of the next multi-annual financial framework for 2021-27, including a possible increase in the EU’s own resources, these disbursements could be around EUR 100-150bn per year without necessarily risking the AAA status. This reflects Scope’s mandate-driven approach in assessing supranationals, which acknowledges that institutions like the EU have a mandate to act counter-cyclically, increasing activities precisely when their member states most need support.

What impact will these programmes have on the credit quality of the euro area periphery, particularly Italy?

The final impact will depend not only on the amounts transferred but also on their use.

Here, the eligibility criteria for the funds will be key. A productive use of such grants could help foster a quicker recovery and avoid further sharp rises in explicit public debt levels, thereby potentially reducing risks to sovereign ratings, especially for weaker member states.

For Italy, the key rating relevant aspect is whether the recovery fund could facilitate a faster economic recovery, by raising actual and potential growth, without further adversely impacting the country’s public finances through raising government borrowing.

In the case of grants of around EUR 82bn (4-5% of Italian GDP) as proposed by the EC, such disbursements would be spread across 2021-24, meaning support would be incremental, and the total economic impact would ultimately also depend on the growth multiplier. Even with the support of a recovery fund, Italy is, however, unlikely to reverse much of the severe increase in its debt stock of at least 20pp in 2020.

Still, recovery fund grants are credit-positive if financed projects support higher economic growth and/or if the government were to implement additional growth-friendly reforms induced by associated eligibility criteria to access the fund. The EC proposal emphasises the twin green and digital transitions as well as national investment and reform priorities to guide the allocation of funds.

Finally, in the case of Italy – as well as in other member states – challenges also relate to effectively implementing these projects given poor track records in fully utilising EU funds. Here, overcoming administrative inefficiencies to identify and co-fund EU projects will be an important hurdle to make the most of funds.

For a look at all of today’s economic events, check out our economic calendar.

Alvise Lennkh is the Deputy Head of Public Finance at Scope Ratings GmbH.