EU Debt: The Only Way is Up
■ The Recovery and Resilience Facility (RRF) entered its main stage where every additional disbursement by the EU to a Member State must be preceded by the achievement of the relevant milestones and targets. It is therefore essential to track the actual implementation of structural reforms and investments in order to forecast upcoming EU debt issuance.
■ While Hungary, the Netherlands and Poland have either not submitted or not received approval on their National Recovery Plans, Southern Europe is leading the implementation of the RRF. Under our assumptions of less than complete implementation of the RRF in 2022, we expect related EU debt issuance to reach EUR 148bn and EUR 167bn in 2022 and 2023, respectively. Moreover, the EU will consolidate its position as the main global issuer of Green bonds with roughly EUR 160bn of funding already eligible for this purpose.
■ The persistent challenge due to elevated energy prices is pushing European policymakers to consider additional ﬁscal initiatives. In preparation of the May and June meetings of the EU council, the President of the EU Commission announced a proposal to repurpose toward REPowerEU the spare ﬁnancial capacity existing within the RRF (nearly EUR 220bn). While this proposal would secure cheaper sovereign funding for most EU Member states, its potentially sizeable impact on EU debt issuance would depend on the implementation timeline to be determined in the upcoming EU Council.
18 months after the EU Parliament approved the Recovery and Resilience Facility (RRF), the main programme within the Next Generation EU framework (NGEU), the EU Commission announced a proposal to repurpose and accelerate its implementation. This Daily provides an update of its implications for EU debt issuance.
The Financial Implications of the Recovery Fund
Following the disbursements of the ﬁrst unconditional tranches of EU funding to the member states (13% of each National Recovery Plan – NRP), the RF entered its main stage. From the end of 2021, every additional disbursement from the EU must be preceded by an application for funding where the Member State shows the achievement of the relevant milestones and targets agreed within its NRP. In order to gauge the timeline of EU debt issuance, it is therefore essential to distinguish between the commitment of each Member State in its NRP in a given ﬁscal year, and the actual achievement of structural reforms and investment projects that a Member State is able to accomplish in that year. It is the latter that determines the actual disbursements to a member States and, therefore, EU funding needs and debt issuance.
In general, the RF is well on track: all 27 Member States but the Netherlands have submitted their NRPs; only two countries – Hungary and Poland – in addition to the Netherlands, have not received an approval of their NRP and are still waiting to receive the ﬁrst disbursement. Meanwhile, Southern Europe is leading the process, with Spain already applying for the second conditional disbursement. Under our cautious assumptions of less than complete uptake of the RF in 2022, we expect RF-related EU debt issuance to reach EUR 148bn in 2022, well below the maximum ﬁnancial commitment (EUR 203bn) that would be reached if all Members States achieved 100% of their milestones and targets and the remaining three countries started their NRPs (Exhibit 1).
While the remaining 2022 ﬁnancial commitments will be shifted to 2023, the incomplete implementation that we also expect next year will almost compensate the shift in funding needs, setting our expectations for 2023 EU debt issuance above 2022 (EUR 167bn). Moreover, the EU will continue to remain the main issuer of Green bonds globally, increasing the appetite for its debt in international markets. Since 40% of the total RF spending is classiﬁed to be climate expenditure related, the current estimate for Green bonds eligibility at nearly EUR 160bn is likely to underestimate the ﬁnal issuance of these types of bonds by the EU (Exhibit 2).
EU Debt Structure: Constructive Ambiguity
Following the pandemic, the EU leveraged its budget to allow bond issuance under NGEU and ensure repayment. The NGEU framework has triggered the shift of the EU funding strategy from back-to-back funding, that has historically been sufﬁcient to achieve an AAA median rating, to diversiﬁed funding. The EU debt necessary to fund the disbursements to Member States is guaranteed by the EU budget and – should an extra ﬁnancial contribution be needed – by a temporary and proportional ﬁnancial backup by all Member States in the maximum amount of 0.6% of their GNI until repayment is completed. Since no reimbursement of EU debt will start before 2028 and the EU will ensure a smooth reimbursement over time until 2058, the RF allows member states a favourably long repayment schedule.
In line with the rest of the European sovereign space, EU debt yields have been rising in anticipation of the ECB hiking cycle. Notwithstanding the uncertainty regarding upcoming EU debt issuance and the lack of clarity regarding the intention to build up a complete yield curve, EU bonds are currently trading at a premium relative to French bonds from the 5Y and longer tenor (Exhibit 3).
Under the new funding strategy for total RRF ﬁnancial resources at EUR 723.8bn, EUR 338bn are earmarked for grants and EUR 385.8bn for loans. While every Member State has a clear incentive to take advantage of its share of grants, access to RF loans is a less clear-cut option. By taking an RF loan a member state commits itself to some form of conditionality, while it might beneﬁt in terms of reduced borrowing costs. The latter beneﬁt varies sizeably across EU Members and – not surprisingly, loans uptakes also differ quite markedly across the EU (Exhibit 4, left). Taking into account the latest announcement that Spain will draw nearly EUR 70bn in RF loans by amending its NRP, there is still around EUR 160bn of available ﬁnancial capacity in the RF (exhibit 4, right).
New Challenge, New (EU) Debt
The persistent economic challenge due to elevated energy prices is the main motivation behind the policy discussion regarding the additional ﬁscal instruments that the EU can deploy. When last March the EU Commission announced the new initiative REPowerEU, the prevalent market view leaned toward a renewed ambition to adopt a new bond issuance programme to increase EU autonomy in the energy space. The initial expectation was sizeably downgraded once it became clear that REPowerEU only laid out a set of coordinated actions and shared objectives across EU Members that could reduce EU dependency on Russian fossil fuels.
Today, in preparation of the May and June meetings of the EU council, the EU Commission has laid out a proposal to repurpose toward REPowerEU the spare ﬁnancial capacity existing within the RRF (nearly EUR 220bn, or EUR 160bn deducting Spain’s share following last week announcement). The policy proposed by President von der Leyen would require amending the existing NRPs, then submitting the amended plans to the EU Commission for vetting and, ﬁnally, receiving the approval by qualiﬁed majority within the EU Council.
This process would allow the available RRF funds to be earmarked to the goals set by REPowerEU by the end of 2022. By securing cheaper borrowing costs, the EU Commission proposal could also facilitate scaling up the ﬁscal efforts to offset the impact of energy prices. The main uncertainty regarding this proposal is about its timeline: if the policy focus of the new programme was 2022 and 2023, the front-loading of funding could scale up EU debt issuance in 2022 and 2023 by up to EUR 60bn and EUR 90bn, respectively (Exhibit 5).
Given today’s proposal by the EU Commission, the alternative option put forward by few policymakers – most recently PM Draghi in his address to the EU Parliament – to start a new lending programme in line with the pandemic programme SURE seems far less likely. The EU Commission proposal also includes increasing the RF ﬁnancial envelope with an additional EUR 55bn in grants. Since the funding of such increase would come from the sale of EU Emission Trading System allowances and the reshufﬂing of funding from the cohesion programme and the Common Agricultural Policy, it has no impact on EU debt. In contrast, the extension of a macro assistance programme to Ukraine and the existing EU lending tools could increase further the issuance of EU debt, adding up to EUR 265bn.
Although we think that an enhanced EU bond issuance programme linked to climate transition is likely to come in the next years (possibly contributing to make the RF a permanent facility), it seems premature to speculate in light of today EU Commission proposal. Meanwhile, the increased likelihood that the suspension of EU (ﬁscal and state-aid) rules will be extended to 2023 and a closer link of the country-speciﬁc recommendations by the EU Commission to the projects within NRPs will allow space and ﬂexibility in national public budgets.