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.