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COVID-19 prompts a step change in European public finances

With most European countries now easing COVID-19 related lockdowns, the EU is taking an active role to deal with the unprecedented impact of the pandemic on economic activity across Europe.

Extraordinary monetary and fiscal measures have already been taken, but there are growing concerns over the potential longer-term repercussions for both economic and political stability across the continent. This is all feeding into critical discussions on the nature of and funding for Europe’s post-pandemic recovery.   

A first reckoning

The coronavirus has led to the deepest economic recession in the EU’s history. Economic output is expected to collapse in the first half of the year with the worse of the contraction happening in the current quarter. The EU economy is predicted to contract by 7.5 percent this year, with unemployment rising to 9 percent. Rebound projections, suggesting growth of around 6 percent in 2021, remain very tentative with the risks – according to the European Commission – being ‘extraordinarily large and concentrated on the downside’.

The impact on public finances has been immediate. Fiscal deficits are expected to surge from an aggregate of 0.6 percent of GDP in 2019 to 8.5 percent of GDP in 2020. The steep increase reflects the kicking in of automatic stabilisers accompanied by the sizeable discretionary fiscal measures (approaching 3.25% of GDP) taken by governments across the EU.  In the euro-area, governments have provided extraordinary state guarantees for loans to businesses and other liquidity support for almost 24 percent of GDP. This is additional to liquidity support agreed at European level, amounting to 22 percent of EU GDP. Other EU budgetary measures account for a further 4.5 percent of EU GDP.

Having fallen to 86 percent in 2019, the euro area’s aggregate debt-to-GDP ratio is now expected to climb to close to 103 percent this year. Despite some decrease next year, the ratio is expected to remain above 100 percent in several countries (Belgium, Greece, Spain, France, Italy, Cyprus and Portugal) and above 60 percent for several others (Germany, Ireland, Croatia, Austria, Slovenia, Finland and Hungary).

€3.4tn mobilised across the EU

Taking all European and national measures in aggregate, current estimates suggest that €3.4tn has been already mobilised across the EU. While the bulk has consisted of national measures, rapid action at European level has provided greater flexibility under EU rules for governments to act.

Several decisions stand out as key.

In March, the Commission activated, for the first time, the ‘escape clause’ in the European fiscal framework. This gave governments maximum flexibility under EU rules to take all necessary measures to tackle the pandemic and its impact.

The European Central Bank has also taken a broad range of monetary and credit policy measures with a view to keeping sovereign bond yields under control while preventing temporary liquidity shortages from evolving into a solvency crisis. The €750bn Pandemic Emergency Purchase Programme (PEPP) announced in mid-March could yet grow further.

After some acrimony, euro area countries also agreed to activate support measures through the European Stability Mechanism. The ESM Pandemic Crisis Support provides credit lines of up to 2 percent of each euro area country’s GDP to use for direct and indirect healthcare costs. If taken up by all euro area countries, the combined volume would amount to €240bn.

EU state aid rules have been upended.  Temporary changes to the existing framework have cleared the way for the Commission to give a green light to measures adopted by governments across the EU in support of businesses, including direct grants or tax advantages of up to €800,000 per company, subsidised public loans, deferrals of tax payments and social security contributions, wage subsidy schemes and (more recently) public recapitalisation of companies.

A panoply of other measures have been adopted. A temporary unemployment scheme (SURE) – signed off in 30 days – will provide €100bn in loans to countries to underwrite national short-time work schemes. The European Investment Bank Group is providing a €25bn European guarantee with a goal to deliver up to €200bn liquidity support for businesses, particularly SMEs – this in addition to extra funding for the healthcare support and other similar measures via the European Investment Fund. Making full use of all existing budgetary options, the Commission has redirected funds between programmes and regions to fund a wide range of COVID-19 response related actions.

By EU standards, the level of support and the number of initiatives agreed in a two-month period have been unprecedented. But the real challenges lie ahead.

Increasing distortions

The coronavirus crisis may have hurt all – but not in the same way. The severity of the impact and the stringency of quarantine measures have differed from country to country. So too have the policy measures, also reflecting more limited fiscal room for manoeuvre in some countries. Recovery looks set to be uneven across the continent.

To take the example of state aid measures, recent figures provided by the Commission show that more than 150 notifications from all countries have been waved through by mid-May for a total of €1.95tn.  Over 50 percent of the subsidies are German (€994.5bn) – far beyond the volume of measures being taken in France (€331.5bn), Italy (€302.2bn) and the (still in Brexit transition) UK (€78bn). The remaining 24 countries together account for 12.5 percent of the approved state aid support (€243.7bn). There is a growing and real fear that individual governments’ crisis and recovery responses could lead to widening and deepening divergences across the EU.

The recent controversial ruling by the German constitutional court questioning the legality of ECB bond buying casts further shadows, challenging both the supremacy of EU law and the independence of the ECB. In the case of the ECB, it raises new questions about the potential for further monetary policy action ahead.

A failure to better coordinate national measures and an insufficient European level response could well distort the internal market, creating an un-level playing field for EU businesses. Arguments over how to fund immediate response and future recovery measures – resurfacing some of the rancour seen during the 2010-12 sovereign debt crisis – highlight the fragility of stability, particularly in the euro area.

A ‘European’ recovery?

Recognising that incomplete recovery in some parts could spill-over and undermine growth elsewhere, attention is now focusing on the nature of and funding for Europe’s economic revival. Central to such plans will be a new recovery fund within a revised EU multi-annual budget due to be published by the end of May. Arguments over how to raise and disburse funds have been ongoing. 
A way ahead may now have been outlined by the recent, significant Franco-German proposal to allow common EU borrowing so that recovery grants to the tune of €500bn can be provided to those countries, regions and sectors hardest hit. While the Parliament has asked for funding in the order of €2tn, the plan presented by Paris and Berlin would still double the ceiling on the EU’s budget to about 2 percent of EU27 GNI. It comes with some strings attached, including calls for a closer look at tax frameworks.

The rejigged multi-annual budget will likely include other initiatives, including a Strategic Investment Facility targeting key value chains and a Solvency Instrument to help recapitalise ‘healthy’ companies. Importantly, all such funds will be disbursed through EU programmes, under parliamentary scrutiny and subject to standard financial controls. The recovery fund, in particular, may well be linked to a strengthening of the EU’s economic coordination tools (the so-called ‘European Semester’). Governments and stakeholders will also be closely scrutinising the budget plans for other reallocations of monies between policy areas – including what this might signal for the EU’s stated ambition to ensure a green, digital and fair recovery.

Seen as a significant shift by many, the Franco-German announcement has had a lukewarm reception in Austria, Denmark, The Netherlands and Sweden. The ‘frugal four’ continue to advocate lower EU spending and tighter fiscal discipline – and are due to present an alternative proposal. Central and Eastern Europeans, on the other hand, are concerned that they may lose out on future funding. With unanimity required for budgetary decisions, further concessions and compromises will be needed. Timing is tight. Failure to agree carries growing risks for European economic and political stability.

Susanna Di Feliciantonio, Head of European Affairs, ICAEW