I first wrote about the European Recovery Fund (ERF), as part of the ‘Next Generation EU’ Recovery Plan, in early June (Next Generation EU – Testing the Water). This was agreed at the recent EU summit and is more or less in the same form as the original proposal, maintaining its ground-breaking large fiscal transfers between countries. This is transformational for the way the EU and the Eurozone is both perceived and funded, with the EU vastly increasing its presence in capital markets.
The EU will issue up to €750bn of debt over the next few years. So how big is that in comparison to other debt markets? Using the market value of the FTSE Russell World Government Bond Index (WGBI), the German Bund market is around €1.5tr – so, although the new debt will be a sizeable alternative, at approximately 50% of the size of the Bund market, it is unlikely to take over its benchmark status for the moment. It will, however, increase the amount of AAA-rated bonds available to investors, substantially eating into demand for other AAA markets.
At time of writing, we have no visibility on the maturity profile or size of immediate debt issuance. The ERF is expected to start making disbursements in 2021, but it is possible that the EU could start to pre-fund, taking advantage of current low levels of interest rates. Of course, all other sovereign nations in the EU are also increasing issuance to help fund government spending through the Coronavirus emergency, but the agreement of the ERF will mean that, for the most indebted and most effected countries, potential issuance is reduced on a relative basis. The fund also aims to boost economic growth in those countries, thus helping to contain debt-to-GDP ratios as well as debt in absolute terms. However, the nature of the crisis does mean that debt levels in absolute terms and relative to GDP will still be rising, despite the agreement.
Surprisingly, given this increase in debt, yield levels are expected to remain low for the foreseeable future. The European Central Bank (ECB) is not expected to change the level of interest rates for years to come, and remains committed to all asset purchase programmes. This new EU debt is eligible for purchase by the Euro system and is likely to feature in purchases under both the Public Sector Purchase Programme (PSPP) and Pandemic Emergency Purchase Programme (PEPP). It shouldn’t be forgotten that one of the aims of the ECB is to reduce fragmentation of markets in the Eurozone. Therefore, we would not expect ECB purchases of the new issuance to be made at the expense of purchasing from the higher-yielding nations of the currency bloc. It is more likely that future purchases of core markets are reduced.
Finally, is this the first step towards common funding? That would appear to be the case as it is easier to agree to common funding if you have common revenue – and that is embedded in the agreement with proposals for an EU-wide corporate tax, digital tax and environment taxes.
The next step may be many years away, but for the EU this is a giant one.