Yesterday, Germany and France announced a €500 billion fund to help the Eurozone deal with the crisis.  Could this be the first step towards resolving the structural flaws in the single currency, and will this provide crucial support for EURUSD?

Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.

– Jean Monnet, Founding Father of the European Union, 1976

The point is that we act responsibly and so wisely that the euro can, should and will continue to exist.

– Angela Merkel, German Chancellor, May 2020

The German Constitutional Court will not tolerate the supremacy of EU law.

Peter Huber, German Constitutional Court Judge, May 2020 

The euro has struggled since the onset of the COVID-19 crisis.  By the end of last week, it was down about four cents, or 3.5%, against the US dollar (YTD).  In March, EURUSD seemed to be testing long-term support, approaching 10-year lows below 1.07.  This weakness was accompanied by increasing doubts about its continued viability. The sentix Euro Break-up index has almost tripled since the turn of the year, and now shows a 15% risk that at least one Eurozone member will leave the single currency within the next year.  It is probably unsurprising that Italy is deemed the most likely nation to depart, at a 13.2% probability.

Chart: sentix Euro Break-up Index
Source: Bloomberg

Yesterday, however, there was some welcome news.  The €500 billion recovery fund announced by President Macron and Chancellor Merkel not only represents a much-needed economic stimulus, but more importantly, the proposed fund will be backed by joint borrowing.  In other words, the EU will seek to ensure that the financial burden will be shared.  On the surface, this looks like it could be a game-changer for the Eurozone.  Finally, the foundation of a sustainable currency area might be emerging.

The markets reacted immediately, if cautiously.  The spread between two-year Italian bonds and two-year German bonds narrowed by about 20 basis points, and EURUSD bounced by over a cent, to 1.0950.

Chart: EURUSD (yellow, LHS) vs 2Y Italy / German bond spread (blue, RHS):
Source: Bloomberg
Is the deal a game-changer for the Euro…?

The potential importance of these proposals, should they be agreed, is immense. This could be revolutionary for the European Union, and for the euro.  These proposals incorporate two elements which are critical to the operations of a currency area, and which will drive Europe towards faster and closer financial integration:

  • The EU, as opposed to the member states, will raise (huge amounts of) debt; and
  • Funds will be provided to member states via grants rather than loans.

In order for a currency to work, it needs to have a mechanism for transferring money to where it is needed without creating unsustainable levels of debt.  If a country or region is hit with a crisis, and it no longer has an independent currency as a shock absorber, such transfer mechanisms are crucial.  The Eurozone has no such transfer mechanisms, and it is these deficiencies, which have ensured its continued fragility.

As Jean Monnet predicted, (the COVID) crisis has forced the EU to address these structural flaws.   In other words, this is the mutualisation of debt that many in southern Europe have been calling for since the Greek crisis, and that many in Northern Europe have been terrified of.

…It is too early to tell

It is one thing to make grand pronouncements.  It is quite another to implement effective and politically awkward policy.  The €500 billion reconstruction plan faces three major hurdles:

Unanimous acceptance

The Franco-German plan will need to be unanimously approved by all 27 EU countries, and none of them will think it is perfect.  Countries like Italy and Spain were asking for a lot more than €500 billion, although it is unlikely they will look this particular gift horse in the mouth.  The Italian government has already endorsed the plan as an ‘important first step’ – which perhaps hints that this issue is far from resolved. 

More trouble is likely from Northern countries like Denmark, the Netherlands and Austria.  Austrian Chancellor Sebastian Kurz was quick to throw cold water on the deal: ‘We will continue to show solidarity and support countries that are most effected by the Corona crisis, but this must be done through loans and not through grants…our position remains unchanged’ he tweeted immediately following the Merkel / Macron announcement.

German politics

Merkel’s support of these proposals is already being referred to as a ‘180 degree turn’ by the German media.  In the aftermath of the recent German constitutional court ruling questioning the legality of the ECB’s subsidization of European government debt, it is far from clear how this will go down amongst the German electorate, at a time when Merkel’s influence is waning. 

Germany places great importance on the EU’s debt ban.  It is hard to see this proposal as anything other than a refutation of this cornerstone principle.  Merkel’s argument that while it is technically debt, this can be overlooked because it will be paid back over a very long time horizon, seems unlikely to assuage concerns.

Implementation   

It is one thing to announce a package of goodies, and another to distribute them.  It is much easier to support the idea of grants and subsidies (who doesn’t like handouts?) than it is to agree how these funds will be allocated.  Each country will want to make sure they are being treated ‘fairly’ and the definition of fair is hardly universal.

The headline is that these funds will be used to deal with the effects of the COVID crisis, and will be distributed according to need.  It will not be that simple.  Even yesterday, the paper which accompanied the Merkel / Macron news conference suggested that some of the funds may be used for ‘digital and green transition and to strengthen research and development’, which sounds a lot like a euphemism for pork-barrel politics. 

This should support the Euro (for now)

EURUSD is approaching resistance at 1.10, and in the short term, yesterday’s announcement should provide a tailwind for the single currency.  Should this plan work, then it will be a platform from which the Euro could claw back some or all of its fair value discount (10-15%) against the USD.  But there is a long way to go before this is clear.  The first test will be next month when the heads of European governments are expected to meet at the EU summit.

Author: Kevin Lester