EU: Bracing for Losses, and Backstop Options

Published on November 30, 2020

The Eurozone Finance Ministers, anticipating continued economic weakness well into 2021, gave a final push towards agreement on proposed reforms to the European Stability Mechanism bailout funds today.

*** Final agreement on the ESM reforms, long forgotten by markets, is seen by EU officials as suddenly time sensitive in that the facility is being prepared to double the funding available to the banking system’s Single Resolution Fund in case of widespread loan losses and bank failures in 2021. It is also being rushed to compensate for a lack of movement on the EU recovery fund fiscal backstop. ***

*** The political impasse with Hungary and Poland over the “rule of law” conditionality attached to the 750 billion euro NGEU recovery fund fiscal backstop, and by extension to the 1.1 trillion euro EU seven-year budget, will be tough to resolve by the December 10-11 summit that is being widely touted. Of all the hard options under consideration, one intriguing solution would be to kick the “rule of law” conditionality to the European Court of Justice for a ruling on its legality, and in the process push the dispute into a two-year de facto hiatus. ***

Other options range from side-assurances that are too weak, to a nuclear threat to “go it alone” without Hungary and Poland that would deal a crushing blow to the cohesion of the European Union as a political entity.

The ESM as a Banking Backstop

While officially on separate tracks, one major reason behind the sudden drive to finalize ESM reform was, as stated off the record by one eurozone official, to pick some “low hanging fruit” to show investors that the EU can still make tough decisions at a time when internal squabbling over the conditionality linked to the EU’s 1.8 trillion euro combined 2021-27 budget and recovery and resilience package is likely to unnerve markets.

The irony that this burst of energy came only now, almost a full year after an agreement on the ESM was struck “in principle” in December of 2019, appears to have been lost in the process.

On a more substantive level, the renewed urgency for an ESM deal resulted from the growing realization among eurozone finance ministers that as the COVID crisis drags into 2021, finalizing the ESM reforms will be a critical first step towards bolstering the banking system’s defenses against mounting stress and loan losses.

Indeed, our understanding is that ESM headlines out of Brussels are likely to stress how the facility will be allowed to lend to the eurozone banking system’s Single Resolution Fund (SRF) that is set up to wind down failing banks in a major banking crisis, should the  SRF’s own resources prove insufficient.

Doubling the SRF

As a reminder, the SRF is funded by the banking sector, and is targeted to reach its full capacity of 55 billion euros, or 1% of eurozone banking deposits, by 2024. The fund’s firepower has grown steadily to over 40 billion euros this year, but officials are concerned that in case of a major crisis, even 55 billion euros will not be enough, and so they are looking to the ESM to provide another 55 billion in potential loans to the SRF, to be repaid by the banking sector over three years.

A deal on the ESM now means eurozone governments will be able to sign a revised treaty in January, national parliaments would then ratify it through the course of 2021, and the facility would come into full effect by 2022.

That would come two years ahead of a 2024 target, allowing EU leaders to hail it as an early introduction, although given that the ESM role as a backstop to the SRF was agreed to initially in 2014, with a ten year implementation plan, some might argue that “introduction” is not so terribly “early” after all.

Side-deals on Language

As to the 750 billion-euro EU Recovery Fund that was broadly agreed to in July (more properly referred to by its NGEU, Next Generation EU, acronym), final agreement and ratification, along with the 7-year 1.1 trillion euro budget, remains in limbo over the objections of Hungary and Poland to the NGEU’s “Rule of Law” conditions.

While sources believe it will stay stuck until the December 10-11 EU summit, with no “landing zone” yet in sight, that is an optimistic timeline, to say the least.

The European Parliament and the Netherlands, in particular, have stuck a hard line against the objections from Hungary’s Prime Minister Viktor Orban and his Polish counterpart Mateusz Morawiecki, and any renegotiation of the text of the regulation linking EU money to respect for the rule of law appears to have been categorically ruled out. Any compromise language would thus have to come in the form of an addendum such as a declaration, side assurance, or separate memorandum.

In the past, such side-texts from the EU have proven successful in overcoming member state objections, for example in assuring the Netherlands in 2016 that a trade deal with Ukraine would not translate into a pledge of military support for Kiev. But both Orban and Morawiecki this time around have asked for more than a side note.

A Ruling on the Rule of Law?

An alternative solution that has therefore been suggested is to submit the treaty to the European Court of Justice for a ruling on the legality of its “rule of law” conditions, accompanied by a promise from the EU not to invoke the clause before a ruling is rendered. While on the face of it that may not seem like a satisfactory solution to Warsaw and Budapest, it might carry some appeal, especially to Prime Minister Orban.

The ECJ typically takes around two years to render a decision, taking the whole process into 2022, which happens to be an election year in Hungary. Berlin, which has the unenviable task of taking the lead in these negotiations, believes quasi-immunity for these two years, while unlocking funds from the EU budget in the process, could be a tempting prospect for Orban.

Ironically, Orban, who has developed a patronage system over the years off EU funds, may in the end prove easier to deal with than Morawiecki, or more precisely, than Jaroslaw Kaczynski, Poland’s de-facto head of state.

While EU cash is also critically important to Polish farmers and small towns that constitute much of the nationalist PiS party’s political base, Kaczynski does not have the control that Orban has internally, and has to fend off a power grab from a tiny, right-wing Eurosceptic coalition partner. That is forcing him to play the fight against Germany and the Brussels bureaucrats all that much harder.

The (Unlikely) Nuclear Option

With both sides digging in, there is, finally, talk of the EU going it alone, without Poland and Hungary, at least with the Recovery Fund. That option – which also serves as a threat — we believe to be highly unlikely in that it would be highly destabilizing to the EU, at best.

But for the record, a path without Hungary and Poland could be struck either through an intergovernmental treaty between the other 25 EU countries, so outside of the EU framework, or through “enhanced cooperation,” a treaty provision that allows a minimum of nine countries to push ahead with projects that others do not wish to join. Both those options come with very serious drawbacks.

First would be yet another major delay to a fiscal back-up facility that should absolutely be in place in 2021, despite officials’ insistence that the funds were not going to be available until mid-2021 at best anyway.

Second, under either the intergovernmental or enhanced cooperation path, the EU budget would no longer be available as security for the groundbreaking joint borrowing and repayment of the 750 billion-euro facility. Furthermore, the most attractive feature of the NGEU, its ability to provide grants, would also most likely be jeopardized by an inability to draw on EU joint taxation powers (emissions, financial transactions, plastics, etc.) over the next 30 years.

Finally, and ultimately most damning of all, a split with two member states over an issue as fundamental as the budget and fiscal backstop would deal a crushing political blow to EU cohesion, and during a time of deep crisis to boot.

 

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