Global Daily – Could the European Recovery Fund be derailed?

by: Floortje Merten , Nick Kounis

Rule-of-law mechanism is major stumbling block in EU budget negotiations – EU-leaders are about to discuss and vote on the EU budget and the embedded EUR 750bn Recovery Fund in a Council meeting on Thursday. The rule-of-law mechanism has proven to be a major stumbling block in the negotiations. Further delays in the formal adoption of the EU budget and Recovery Fund may prevent the funds from being in place on January 1st, which would be a blow to the EU and potentially weaken the economic outlook for the economies in Europe hit hardest by the crisis.

Poland and Hungary are threatening to veto EU budget and Recovery Fund – The rule-of-law mechanism was adopted during a meeting of EU ambassadors last Monday by the required qualified majority (55% of member states representing 65% of EU population). This mechanism can be triggered to stop the flow of funds to a receiving country if a qualified majority of member states judges that the receiving country breaches the principles of the rule-of-law. However, whereas Polish and Hungarian ambassadors were not able to block the rule-of-law mechanism on Monday as adoption only required a qualified majority, they were able to block the Own Resources Decision, which defines the maximum amount of own resources that the EU can request from member states and creates additional headroom in the EU budget serving as a guarantee for borrowing the EUR 750bn Recovery Fund on the capital markets. Therefore, Hungary and Poland are able to block the entire EU budget and Recovery Fund by blocking the legal basis required to finance it. By doing this, Poland and Hungary aim to force the EU to drop the rule-of-law mechanism, which they call ‘ideological blackmail’ and ‘a radical limitation of sovereignty’, but which is supported by all other member states. The matter will now be discussed by EU-leaders during a Council meeting on Thursday, but Poland and Hungary already signaled that they will veto the deal in its current shape.

Not having the funds in place on 1 January 2021 would be a blow for the EU – Member states including Poland and Hungary are facing a prisoner’s dilemma. Both sides of the table are not willing to compromise, but the absence of a compromise results in a worst case scenario for the entire EU. In addition, Poland and Hungary are amongst the largest net receivers of the EU themselves, hence blocking the funds seriously damages their own economies. The Treaty of the EU states that, without an agreement before 31 December 2020, “the ceilings and other provisions corresponding to the last year of that framework shall be extended until such time as that act is adopted”. As the 2020 budget is much smaller than the budget planned for 2021, there will be much less money to spend. Moreover, many EU programmes will not be able to receive funds as they first need legal extension into 2021. In addition, as long as there is no agreement, the European Commission cannot kick-off borrowing to finance the Recovery Fund, posing a serious threat to the EU’s recovery from the coronavirus pandemic.

We expect an agreement to be reached eventually, albeit in a slightly different form – We expect an agreement to be reached before the end of the year under our base case. Since there is a lot at stake for the entire EU, we expect the parties to reach a compromise eventually. We expect such a compromise to result in a slightly weakened form of the rule-of-law mechanism, reducing its power to actually prevent funds from flowing to Poland and Hungary in case of breaches of the rule-of-law. However, there are significant risks that the EU budget and Recovery Fund will be delayed. We expect a minor delay to be manageable, as currently the borrowing of recovery funds by the EU is expected to start in Q2 2021 and the economic impact is expected to kick-in in the second half of 2021. However, we expect a delay of multiple more months to be more problematic. Recovery Fund borrowing could then be delayed until the second half of 2021, and funds may not be disbursed until the start of 2022, which would weaken the economic recovery of the EU’s most vulnerable economies.

Markets are not pricing in significant risk of a delayed EU budget and Recovery Fund – We judge that the risk that there won’t be an agreement before the end of the year has not been priced into peripheral spreads. Indeed, we expect an agreement to be reached before the end of the year. However, we judge that the market underestimates the probability that EU-leaders fail to reach an agreement within a few weeks, given the fact that peripheral spreads are relatively tight. Country spreads over Germany tightened significantly in response to the Recovery Fund proposals in July, with the strongest spread compression across the periphery. For example, the Italian spread tightened by more than 50bps on the back of the proposals. If EU leaders fail to compromise soon, then we expect country spreads to widen and spread volatility to increase, which will be most pronounced for peripheral spreads.