Global Daily – Will the Frugal Four kill the Recovery Fund?

by: Floortje Merten , Nick Kounis , Aline Schuiling

Euro Macro & Rates: Frugal Four want EC plan to be watered down – The Eurogroup is meeting today and will debate the shape of a European Recovery Fund following the European Commission’s proposal. Although the majority of member states – including Germany and France – appear to broadly support the proposal, the so-called Frugal Four states (Netherlands, Austria, Denmark and Sweden) have been much more sceptical and all countries need to agree for the proposal to go through. Can the Frugal Four kill the European Recovery Fund? We think that they will not kill the proposal, but will likely succeed in watering it down.

Dutch cabinet remains in favour of loans instead of grants – Earlier this week, the Dutch Minister of Foreign Affairs, Stef Blok, and the Dutch Minister of Finance, Wopke Hoekstra, welcomed in a letter to the Dutch House of Representatives the temporary nature and the importance of structural reforms within the EC proposal. However, they criticize the size, allocation and financing of the recovery instrument, and stress they hold on to their previously published proposal with Denmark, Austria and Sweden.

The EC proposal consists of a EUR 250bn loan component and a EUR 500bn grant component. Of the latter, EUR 310bn will offer financial support for investment in the hardest hit Member States through a Recovery and Resilience Facility (RRF), and the rest will be spent via EU-programmes.

The Dutch cabinet wants to see the grant component adjusted for the following three reasons. Firstly, it deems it ‘neither appropriate nor essential’ for the EC to borrow in order to finance regular EU spending, but instead prefers a reprioritization of the EU budget for this purpose. Secondly, it judges that the allocation of funds needs to relate to a financing need caused by the economic impact of Covid-19, and needs to contribute to economic recovery from the Covid-19 shock. In relation to this, the Dutch cabinet is critical about the top-up of the cohesion budget by EUR 55bn and the reinforcement of the Agricultural Fund for Rural Development of EUR 15bn. Thirdly, it is critical about the use of grants under the RFF in general, since they will have to be financed on the capital market and paid back from future EU budgets. The EC proposes new own resources to repay the Recovery Fund, but this is opposed by the Dutch cabinet due to the lack of predictability and transparency. According to the cabinet, a clear rationale for the necessity of grants instead of loans is lacking, as the EC said earlier this month that euro area national public debt levels are sustainable due to historically low interest rates.

Chances of still significant grant component slightly increase with Denmark and Austria softening – Austria, Sweden and Denmark also want the EC plan to be drastically changed, and oppose the relatively large share of the grant component. However, despite Denmark being sceptical about the use of grants and wanting them to be downsized, it is not completely opposed to the inclusion of grants in the Recovery Fund, as appeared last Tuesday from documents circulated in the Danish Parliament. Instead, its priority is to keep its rebate within the next Multiannual Financial Framework 2021-2027. In response, Austria said it may agree to the EC plan under a similar arrangement. Despite each Member State’s ability to veto the EC plan, with the modest shift in the stance of Denmark and Austria, the inclusion of a downsized but still significant grant component in the Recovery Fund becomes more likely. In return, the Frugal Four will demand concessions in terms of rebates and stricter conditionality on the take up of recovery funds by the hardest hit Member States. Overall, it looks likely that the EC’s plan will be watered down and a possible compromise outcome could be a more even split between the grant and loan facility.

Peripheral bonds might be disappointed if we see less grants – Peripheral government bond spreads came down significantly on the back of the initial French-German Plan and the subsequent EC proposal. If we take Italy’s 10y spread, we judge that it compressed by around 50bp on these developments as well as more positive risk appetite in markets more generally. Currently, the spread is only around 30bp above pre-Covid-19 levels. Given this background, and given that both plans contained a predominant grant component, we judge that EU agreement on a watered down plan could prove to be a disappointment to investors. (Floortje Merten & Nick Kounis)

Euro Macro: Two years of France’s job growth wiped out in one go in Q1 – France’s statistical bureau INSEE published its report on Q1 payroll employment today. It showed that at the end of the first quarter of 2020, payroll employment dropped by 2.0% (more than 502 thousand jobs; equal to around 1.7% of the labour force) compared to the quarter before. Following this drop, the level of payroll employment returned to its level at the end of 2017. The payroll numbers include all people who have worked for at least one paid hour during a certain period, but also persons who have not worked for certain reasons, such as sick leave, paid holidays or temporary part-time employment. During the corona crisis, an unprecedented number of employees have found themselves in a situation of partial unemployment or sick leave and these people are considered to be in employment. The details of the report show that the sharpest drop in payrolls was in temporary employment (-40.4% qoq), which is registered as employment in the services sector, followed by non-temporary jobs in market services (-1.3%), manufacturing (-0.4%) and construction (-0.4%). Within market services, employment in accommodation and food service activities dropped the most, with a 4.6% slump. As France moved into lockdown around mid-March, the drop in payroll employment in Q1 will probably be followed by a much sharper drop in Q2. We expect France’s unemployment rate (which stood at 8.7% in April) to jump to levels above 10% by the end of the year. (Aline Schuiling)