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EUR 750 billion spending plan to boost economies of southern Europe, but challenges remain

On 21 July, after five days of tough negotiations, EU leaders finally agreed on a EUR 750 billion coronavirus recovery fund. The fund’s central aim is to underpin the EU economy and will help the recovery ahead, mitigating the fallout from the pandemic on the most fiscally troubled and worst-hit countries by supporting their government spending, thus reducing the likelihood of a future debt crisis. Moreover, the plan will likely contain financial tensions and reassure markets over the political will to back the common currency. However, the relatively soft control mechanisms could translate into little progress in the adoption of reforms to liberalize markets, cut public spending and streamline bureaucracy in southern European countries. Moreover, the fund could act as a drain on future EU budgets due to debt repayments, while there are concerns in some quarters that debt mutualization could potentially undermine fiscal responsibility. In addition, the deal still needs to be ratified by both the European Parliament and the 27 national parliaments.

The fund includes EUR 390 billion of grants and EUR 360 billion of low-interest loans which will be allocated according to the economic damage caused by the pandemic. The recovery fund will become effective on 1 January next year, and money will likely start flowing into the economy around mid-2021. About 70% of the grants will be disbursed in 2021–2022, with the remaining 30% in 2023. The plan will be financed through the first ever issuance of common debt by the European Commission (EC). Italy and Spain—whose fiscal room for maneuver is severely limited by vanishing public revenue, counter-cyclical spending and already-frail public finances—stand as the main recipients, and are poised to receive about 5% of their GDP in grants over three years. In addition, leaders agreed on the 2021-2027 EU budget worth around EUR 1.1 trillion, with a key focus on infrastructure and other public investments, as well as funding to meet the bloc’s climate targets. Moreover, the EUR 750 billion recovery fund comes on the top of a EUR 540 billion coronavirus emergency loans package already adopted by EU institutions and the ECB’s quantitative easing program.

The deal represents a hard-fought compromise between, on the one hand, northern countries (the “frugal four”), which pushed for strict conditionalities and increased fiscal responsibility, and against grants and the issuance of common debt, and, on the other hand, southern European countries, which entered the pandemic with already elevated levels of debt and were urgently looking for the largest possible fiscal support. In order to receive funding, member states will have to submit reform plans along the EC’s country-specific recommendations; moreover, an emergency brake was included which will allow any government to question a country’s commitment to reforms, thus blocking financial transfers for up to three months. That said, the EC retains the final say, a much softer form of control compared to the national veto over spending plans that the Netherlands had demanded initially. As a further compensatory measure, Austria, Denmark, the Netherlands, and Sweden saw their rebates on budget contributions increased, while Germany’s discount was untouched. One element missing from the deal is the ability for the EC to raise its own revenue to finance its borrowing: While leaders committed to a plastic tax, other more substantial taxes were dodged, and as such, debt repayments could drag on future EU budgets.

Commenting on the deal, Aila Mihr, Senior Analyst at Danske Bank, stated:

“Overall, we think the recovery fund deal is an important part of the euro area’s road to recovery, despite it being a watered-down version of the original proposal. While not solving the issue of high debt levels, it will help reduce the risk of an asymmetric recovery.”