Date published: Aug 2020
SUERF Policy Note, Issue No 186
by Reza Moghadam, Jacob Nell, Joao Almeida, Bruna Skarica and Markus Guetschow1
Morgan Stanley & Co. International plc
We see the Recovery Fund as a gamechanger for Europe and the euro. But many investors are not yet convinced. We set out some of the pushback we have gotten, and explain why we still think the scepticism is overdone.
We have argued that the EU Recovery Fund is a potential game changer for the periphery, and thus for the overall stability of the euro area. But that is not to say that the Recovery Fund will necessarily deliver as intended; financial and economic stability is always a work in progress. In this note, we share some of the more sceptical questions and reactions we have heard from investors, as well as possible responses. Notable doubts include:
Not everyone is convinced that the fund is a game changer for the periphery countries and for European stability more generally. In this note, we comment on some of the more sceptical reactions we have heard from investors.
It is true that the Recovery Fund does not mutualize past debt and, for now, proposes only modest forms of common EU taxation to service debt. Worse, the Recovery Fund is in principle a one-time response to a once-in-a-lifetime shock, limited in scope, purpose, and duration – i.e., not a permanent instrument of common fiscal policy. As such, comparisons to Alexander Hamilton’s 1790 reforms to assume state debts and establish a US federal budget and debt market seem hyperbolic.
But all reforms since the inception of the EU have taken place incrementally. The Recovery Fund is a very large step in the direction of establishing a union level fiscal policy, and even if it does not achieve Hamiltonian perfection, it is of signal importance. Four observations in this regard:
Highly rated sovereign bonds in Europe
Note: Includes outstanding issuance by European sovereigns and supranationals that are rated AAA by at least one agency, or AA+ by at least two agencies. Agencies considered are S&P, Fitch and Moody’s. Source: Bloomberg, Morgan Stanley Research
Periphery allocations as share of GDP
Source: European Commission, Morgan Stanley Research
Periphery allocations as share of total funds
Source: European Commission, Morgan Stanley Research
The Recovery Fund effectively targets the hardest hit countries in Europe’s southern periphery – Greece, Italy, Spain, and Portugal. Relative to the size of those economies, the amounts being made available in grants and lowinterest/long-term loans are substantial. Fiscal stimulus ranging from over 2% to around 7% of GDP per year for four years is assuredly a big deal for the growth and sustainability prospects of those countries.
Markets certainly have taken note of the Recovery Fund. Ever since the word got out of the core political compromise underlying it – the Merkel-Macron proposal in mid-May – risk spreads on periphery debt have fallen back substantially; Italy’s spread has fallen by over 100 bps since that time, and is now below the level at end-2019.
Italy 10Y yield spread vs Germany
Source: Bloomberg, Morgan Stanley Research
That said, the sceptics might still ask why all this has not translated into broader strength in euro assets? Fair enough. Although the euro has appreciated, the performance of Eurostoxx pretty much tracks the S&P500. However, as the Nobel-prize winning economist Robert Shiller has argued, it may take time for the market to absorb new information and for a new narrative to take hold, especially in the context of a pandemic.
European and US stock market performance YTD
Source: Bloomberg, Morgan Stanley Research
The EU Council did introduce political oversight and review of countries’ spending plans, which is understandable given the unprecedented scale of cross-border transfers. But formal rules were also put in place to avoid undue delays. Two points:
The Recovery Fund will only start operating in 2021, and while 70 percent of the funds are expected to be committed during 2021-22, actual disbursements will be made later, likely peaking during 2022-23. So, it is certainly correct to say that the main impact of the Recovery Fund will not be felt for some time. On the other hand:
That said, we do agree that more thought needs to go into Recovery Fund spending. As we have argued elsewhere, in the time horizon of the Recovery Fund (2022-24), it would make more sense to target spending to unconstrained sectors (e.g., green and digital, where supply can readily respond to demand) than to constrained sectors (e.g., tourism and transportation, where public spending is unlikely to provoke strong supply and demand responses).
In targeting the hardest hit economies, the Recovery Fund also happens to be targeting the most fiscally constrained ones – Greece, Italy, Portugal and Spain. For sure the grants element of the Recovery Fund is additional spending because it does not add to national governments’ debt and does not have to be paid back. However, there is no way of proving a counterfactual.
The reality is that there are no fiscal adjustment paths agreed or even specified by either the Commission or any member state with and without the Recovery Fund to assess the additionality argument. The Stability and Growth Pact (SGP) has been rightly suspended to allow governments to respond to the crisis as needed. The SGP will be reinstated at some stage but not necessarily in its pre-crisis form. Indeed, a review of SGP was already under way before the crisis hit.
Ultimately, the growth path out of the crisis will be a more important determinant of debt sustainability than any fiscal adjustment path. In that sense, the Recovery Fund, with its focus on spending in the hardest hit countries for the next few years, can provide additional spending and a transition to the post crisis SGP.
This is a sophisticated political economy critique. But whether it is a priori correct is not obvious. Without taking too pointed a stand, we would note the following:
About the authors
Reza Moghadam is Morgan Stanley’s Chief Economic Advisor. His mandate spans global macroeconomic policy research, as well as advising clients across the banking, capital markets and investment franchises on global economic and policy issues. Prior to this role, Reza was Morgan Stanley’s Vice Chairman for Sovereigns and Official Institutions from 2014 to 2019. Before joining Morgan Stanley, Reza served for 22 years at the International Monetary Fund, spending much of his career as a key IMF crisis manager. Given his expertise, Christine Lagarde appointed Reza to head the IMF’s European Department during the Eurozone crisis, where he was responsible for leading the IMF’s response to the crisis and acting as the interlocutor with European policymakers from 2011 to 2014. Before this, Reza helped spearheaded the IMF’s response to the Global Financial Crisis, having been asked to head the Strategy, Policy and Review Department by Dominique Strauss-Khan. Reza also held a number of different senior roles at the IMF including Head of the Managing Director’s Office under both Rodrigo de Rato and Strauss-Khan, and senior positions in the IMF’s Asian Pacific Department during the Asian financial crisis. Drawing on his experience both in the public sector and with markets, Reza is a regular contributor to the global policy debate, with a particular focus on Europe.
Jacob Nell is a Managing Director at Morgan Stanley, and chief UK economist. He joined the firm in December 2010 and worked for four years as the Russia economist, based in Moscow. Prior to joining Morgan Stanley, Jacob worked for over five years in the oil industry at BP in London, where he worked on strategy for Lord Browne, and at BP and TNK-BP in Moscow, including as commercial director for greenfield projects. Previously, he worked for ten years at the UK Treasury, including a stint in the Prime Minister’s Policy Directorate at No.10 Downing Street (2001-03). He has also worked for extended periods at the Russian (1995-97), Azerbaijani (1999-2001) and Iraqi (2003-04) Ministries of Finance, and worked for two years as assistant editor of the journal Central Banking. Jacob has a BA degree in PPE from Balliol College, Oxford, and an MSc in Economics from Birkbeck College, London.
Joao Almeida is a member of the European economics team, with coverage focussed on the EU periphery, including Italy, Spain, Portugal and Greece, as well as the euro area and the ECB. He joined Morgan Stanley after completing his studies. Joao holds both a master’s degree in financial economics from the Libera Universita Internazionale degli Studi Sociali Guido Carli and a master’s degree in finance from the NOVA School of Business and Economics. He holds a bachelor’s degree in economics from the University of Aveiro. He has received multiple awards for his academic performance from the academic institutions where he studied, private financial institutions and the Bank of Portugal.
Bruna Skarica is a member of the European economics team, covering UK and Ireland. Before joining Morgan Stanley, Bruna worked for KPMG UK, as an econometrician in the company’s Macro Strategy consulting team and providing research assistance to KPMG’s Chief Economist in the UK. She has a master’s degree in economics from the London School of Economics and Political Science, which focused on macroeconomics and monetary policy. In addition, she has a postgraduate degree in econometrics from Birkbeck, University of London.
Markus Guetschow is an economist at Morgan Stanley, primarily covering Europe. Prior to joining the firm in April 2019, he worked as an investment consultant at Cambridge Associates in London, advising European and UK pension funds on asset allocation and alternative investments. Markus has a BA in International Relations from Queen Mary, University of London, an MSc in Economic History and Development from the London School of Economics, and an MSc in Finance and Economics from the University of Warwick.
SUERF Policy Notes (SPNs) focus on current financial, monetary or economic issues, designed for policy makers and financial practitioners, authored by renowned experts. The views expressed are those of the author(s) and not necessarily those of the institution(s) the author(s) is/are affiliated with.
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