EU: More Fiscal Flooding

Published on March 22, 2020
SGH Insight
For those who will remember, the OMT facility was established in 2012 as an emergency facility where credit could be extended to sovereigns but only with stiff conditionality attached, under either a Precautionary Conditioned Credit Line (PCCL), or Enhanced Conditions Credit Line (ECCL), modeled after the IMF.

A new, less stringent line can, however, be established we understand either in revising the existing ECCL standards, or by coming up with a new dedicated instrument created solely for the COVID -19 crisis response.

The creation of an entirely new instrument, if proposed by the Commission, can be done through a vote of the ESM’s Board of Governors, meaning the Eurozone finance ministers. Some ministers/governors would need to then obtain national parliamentary approval – which under normal circumstances might be an issue in for example Germany, the Netherlands, and Finland. But these are far from normal times.

The ESM epidemic-focused tool, and its trigger mechanism, is being designed in a way where al Eurozone members would be eligible to tap the line. With the understanding that budget surplus countries Germany and the Netherlands, for example, would likely never need to tap such a line, its availability to everyone would be intended as a signal to remove stigma akin to the US Federal Reserve’s pressure on all US banks to tap the Fed’s Discount Window lines.

The borrowing the ESM would do on the open market if the need were to arise may be called “Corona-bonds,” but they will likely fall along similar fiscal rules as the current ESM and fall short of some hopes that they might represent a first step to full capital markets union “mutualization” of debt.
Market Validation
(Bloomberg 3/23/20)

Germany Ready to Back a Rescue Plan to Help Italy Weather Virus
Berlin sees ESM credit line for Italy with minimal conditions
Finance ministry not ready to move on joint coronavirus bonds
By Birgit Jennen and Viktoria Dendrinou

German officials are ready to help Italy get through the coronavirus pandemic and are prepared to support an emergency loan from the euro area’s bailout fund.

The preferred option in Berlin would see Italy granted an enhanced credit line by the European Stability Mechanism with minimal conditionality, according to a German official with knowledge of the government’s thinking. While Chancellor Angela Merkel has said she’s happy to discuss Italy’s request for jointly issued coronavirus bonds to shore up euro members’ finances, the official said Germany isn’t ready to move forward with that idea.

BTPs Extend Gains; Germany to Help Italy Combat Virus Crisis
By James Hirai

BTPs rise, extending outperformance over peripheral peers, after Germany says it is prepared to help Italy weather the impact of the coronavirus.
Italy’s 10-year yield falls as much as 7bps to 1.56%, paring its underperformance over bunds to 2bps at 197bps

As Washington rushes to mitigate the coming devastation of the COVID-19 pandemic on the US economy with the largest fiscal stimulus package ever on record, the European Union, devastated even worse now than China by COVID-19, has been rapidly opening its own fiscal floodgates as well – on both the pan-European and, especially, the national levels.  

*** Fiscal measures include a proposal by European Commission Executive Vice President Valdis Dombrovskis that will be presented to EU Finance Ministers tomorrow, Monday, to tap a portion of the European Stability Mechanism’s (ESM) 410 billion euros of unused credit lines for liquidity.*** 

*** With the European Central Bank having already blanketed the markets last week with a massive step up in its bond purchase program, this facility – which may or may not be rolled out as a form of “Coronabond” – will be more for market confidence than to address any imminent need for liquidity from EU sovereigns.*** 

*** The European Commission can also dust off a ten-year old “Balance of Payments” bond issuance program against unused parts of the EU budget for non-Eurozone member states if needed. The potential size of such a facility is, however, limited and unclear. ***

***But perhaps most critical on the pan-European side in the near term is that from what we understand, the Commission is also likely to bring forward a temporary version of an unemployment re-insurance scheme that was originally intended for roll out in Q4 of 2020. That will be designed to provide loans to member states that will inevitably now be swamped with unemployment benefit claims. *** 

*** But the biggest fiscal stimulus by far will still come from the national side, where Germany, after crisis hit Italy and Spain, is now galvanized into aggressive and urgent action. Over the weekend, Finance Minister Olaf Scholz has proposed measures totaling 750 billion euros, and our understanding is that these will be swiftly approved by the cabinet of Chancellor Angela Merkel tomorrow, on Monday. *** 

The EU ESM/Coronavirus Line

European Commission Executive Vice President Valdis Dombrovskis has prepared a proposal to present tomorrow to Eurozone finance ministers for how to tap the European Stability Mechanism’s (ESM) 410 billion euros of unused lending capacity. Dombrovskis’ effort was in direct response to a request last week from the finance ministers, the ESM, and the European Central Bank to look for additional pan-EU sources of stimulus. 

As there is not nearly enough money in the ESM to help every sovereign in a meaningful way – if it were to ever come to that – the objective of Dombrovski’s plan is to use some ESM funds to establish a credit line that could be used to unlock the ECB’s emergency Outright Monetary Transactions (OMT) set up in July 2012 as part of the now famous “whatever it takes” pledge by then ECB President Mario Draghi. 

Thanks to the announcement of two new waves of bond purchase programs by the ECB, a whopping 750 billion euros on top of a 120 billion increase in asset purchases that was rolled out at the last Governing Council meeting on March 12, all Eurozone national governments can currently access markets easily, and cheaply, despite a now reversed initial communication mishap by President Christine Lagarde that temporarily slammed Italian BTPs. 

The Commission’s exercise with the ESM is therefore more about boosting confidence in jittery markets, and less about any real demand from sovereigns to borrow more – at least at this point in time.

Waiving Moral Hazard and Conditionality 

For those who will remember, the OMT facility was established in 2012 as an emergency facility where credit could be extended to sovereigns but only with stiff conditionality attached, under either a Precautionary Conditioned Credit Line (PCCL), or Enhanced Conditions Credit Line (ECCL), modeled after the IMF.  

A new, less stringent line can, however, be established we understand either in revising the existing ECCL standards, or by coming up with a new dedicated instrument created solely for the COVID -19 crisis response.   

The creation of an entirely new instrument, if proposed by the Commission, can be done through a vote of the ESM’s Board of Governors, meaning the Eurozone finance ministers. Some ministers/governors would need to then obtain national parliamentary approval – which under normal circumstances might be an issue in for example Germany, the Netherlands, and Finland. But these are far from normal times.

The ESM epidemic-focused tool, and its trigger mechanism, is being designed in a way where al Eurozone members would be eligible to tap the line. With the understanding that budget surplus countries Germany and the Netherlands, for example, would likely never need to tap such a line, its availability to everyone would be intended as a signal to remove stigma akin to the US Federal Reserve’s pressure on all US banks to tap the Fed’s Discount Window lines.

The borrowing the ESM would do on the open market if the need were to arise may be called “Corona-bonds,” but they will likely fall along similar fiscal rules as the current ESM and fall short of some hopes that they might represent a first step to full capital markets union “mutualization” of debt.

But that is a debate for another day….

Other EU Facilities – BoP, and Unemployment Insurance

Were the European Union’s non-Eurozone members to fall deeper into financial crisis, the EU has the option of also tapping into what is known as the “Balance of Payments Facility.” Under that mechanism, funds are raised through bonds issued by the Commission against the collateral of the EU long-term budget.  

The last time this BoP facility was used was a decade ago, where roughly 50 billion euros was raised to help Latvia, Hungary and Romania weather their then respective banking/debt crises. The size of any funds potentially available under this mechanism is currently, however, unclear as there is little visibility on how much is left unused in the last year of the expiring 2014-2020 EU budget, or how much there could be in the next 2021-2027 one.

Finally, on the pan-European side, in anticipation of massive layoffs, the Commission will very soon fast track what had been penciled in originally for Q4 of 2020 – a European unemployment re-insurance scheme.

This will, in all likelihood, not be the permanent new institution originally planned, but rather a temporary/emergency version rushed through to address the immediate fallout of the COVID crisis. The facility would provide loans to countries swamped by unemployment benefit payouts – loans that would get paid back once their economies recover. There is currently little additional detail on that. 

Berlin Kicks Into High Gear

The biggest action, on the fiscal front, is however still on the national side, with Berlin, following Rome and Madrid, now aggressively taking the lead.

On Saturday, Vice-Chancellor and Finance Minister Olaf Scholz announced, as increasingly expected, that the “debt brake” ceiling on new government debt issuance enshrined in Germany’s constitution would be suspended due to the exceptional, unprecedented circumstances. Without the “natural disaster/emergency” exception, Berlin would have been allowed to take on only 0.35% of GDP in new debt for normal, cyclical reasons. 

Germany, Scholz said, is preparing an emergency budget worth over 150 billion euros to shore up jobs and businesses at risk from the economic impact of the coronavirus outbreak, and according to a draft law seen by sources, a supplementary budget will include 100 billion euros for an economic stability fund that can take direct equity stakes in distressed companies, and 100 billion euros in credit to public-sector development bank KfW to provide loans to struggling businesses.

In addition, the stability fund will offer 400 billion euros in loan guarantees to secure corporate debt at risk of defaulting. All together the measures add up to 750 billion euros.

Germany’s Chancellor Angela Merkel vowed, in an impassioned speech, to do for her part whatever it takes to counter the epidemic’s economic impact, and her cabinet is set to back the package of fiscal measures on Monday.

On a more personal note, the rather devastating news has just come out that Germany’s Chancellor Angela Merkel has been quarantined for exposure to a COVID positive individual.

We wish “mutti” a speedy return at a time when her leadership is needed more than ever by Europe – as we wish to all who have been infected or exposed to this terrible disease.

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