The Art of the Possible

Political Commentary

The RFF represents, without a doubt, a political milestone within the framework of the EU, insofar as it revalidates the regional project based on solidarity and consolidates the Franco-German leadership (the initial architects of the project), at a time when doubts were emerging about the European project and the risk of fragmentation was once again looming.

The agreed plan will not only help stabilise and redirect the region’s economy, but will also be key to diluting the growing Euroscepticism (Italy and Eastern Europe); a scepticism that would undoubtedly grow if the welfare gap within the region widens (which could increase if the effects of the pandemic are not mitigated).

On the other hand, although this movement is far from being a “Hamilton moment” and will not result imminently in the creation of a common fiscal policy, it is a first step towards achieving certain intermediate objectives: (i) establishing centralised budgetary objectives consistent with the needs of each region, (ii) setting an acceptable degree of tax harmonisation, and (iii) starting the transfer of some powers necessary to create a European Treasury in the future. Although this is a purpose that remains on the long term horizon, there is no doubt that it is a fundamental sign to legitimize the EU project.

Economic Commentary

• Resources

The RRF will be endowed with 750 billion Euros which, added to the 540 billion Euros from the SURE, represents an additional fiscal impulse for the EU of more than 10% of the GDP; an impulse that more than doubles the financial capacity established for the EU during the next 7 years. Together, the RRF (‘750 billion), the SURE (‘540 billion) and the Long-Term Budget (‘1,074 billion) account for 17% of EU GDP, which is more than the financial capacity mobilized by the United States to deal with the pandemic (15% of GDP). Moreover, if we add to this effort that made by the European Central Bank (ECB), the monetary and fiscal ammunition available to deal with the effects of Covid-19 exceeds 25% of the EU’s GDP.

• Composition

The RRF will be composed of EUR 390 billion in non-refundable transfers and EUR 360 billion in credits. 360 billion in loans. Of this total, 90% will be dedicated to the resilience fund (i.e., resources oriented towards productive transformation and employment generation) and the remaining 10% to other investment items such as digital adoption, agricultural transition and the sectoral consequences of the Covid-19.

• Frontloading

An important aspect of the program is that it is designed to overweight the short term in aid (frontloaded). Thus, 70% of aid will arrive in 2021/2022, and the remaining 30% in 2023. In addition, a pre-concession of 10% of the money will be made so that it is ready for drawdown in 2021. In this way, all the fiscal effort is concentrated over the next three years and therefore represents more than 1% of the EU’s GDP per year in complementary fiscal effort.

• Consistency with the principles of the EC proposal

Despite the complex negotiation process that involved its approval, the agreed version of the RFF is consistent with a large part of the principles contained in the original EC proposal of early June, although it substantially reduces the objective of encouraging private investment through co-participation (PPP), the items of which disappear. In fact, the RFF differs by EUR 110 billion less in the form of transfers and guarantees, which have been brought under the heading of loans.

• Conditionality

The RRF proposal establishes that the RRF will be limited in time (so as not to generate perverse incentives), limited in magnitude (to avoid displacing private initiative) and measured in scope (according to the damage caused by Covid-19 and the need to repair it). However, the de facto nature of the proposal is to transform the production system (in favor of the sustainability, digitalization and equity agenda), a criterion to which the recipients of the funds must submit. For this reason, the funds will be disbursed after the approval and review of each country’s transformation and investment plans, with the possibility of vetoing their financing by a qualified majority in the Council if these plans and their development do not exceed the opinion of an EC technical committee.

In this way, although there is no unilateral right of veto, the programme will be subject to the risk of political deadlock, which could generate a certain degree of uncertainty in its implementation.

• The keys to distribution

The distribution of the funds will be made taking into account, for 70% of the funds to be distributed between 2021/2022, in a predominant way the situation of the labour market (according to the unemployment registered in 2015-2019), which benefits countries like Spain and Italy. The remaining 30%, to be distributed in 2023, will be distributed using as a reference the lost product (the fall in accumulated GDP) in 2020/2021, which benefits Central Europe.

• The power of RFF is not the nominal

One aspect that should be stressed is that the maximum level at which Member States will be able to borrow is 6.8% of GDP, not forgetting that many of these credits will compete with similar credits given under the SURE at lower rates well before. For this reason, it is foreseeable that part of the RRF’s firepower will not be exactly the nominal one, and that part of this EUR 360 billion will not actually be used.

• The Financing of the RFF

The financing of the spending programme will be done through borrowing on the capital market (an unprecedented mechanism so far), i.e. through the issuance of top-quality sovereign bonds worth EUR 750 billion at 2018 prices. All net borrowing will have to be done before 2026 (which implicitly introduces a grace period), and repayment will be fully predictable and stable until 2058.

This means that a new long-term instrument will be created with a predictable and assured profitability, of maximum quality and totally liquid; an instrument that, due to its characteristics, may be ideal to complete the balance sheets of the financial system in the current situation (the insurance sector could be an abundant buyer of this type of asset).

On the other hand, this asset could also be acquired in the balance sheet operations of the ECB (and other central banks), giving greater power to quantitative expansion exercises and eliminating pressure on traditional top-quality assets (such as the Bund). Furthermore, the greater abundance of euro-denominated assets will necessarily increase the need for liquidity in this currency, which could have a significant effect on the behaviour of the exchange rate.

• Fiscal Implications

The RFF has a redistributive character, insofar as the countries most affected by the Covid-19 pandemic will be the ones that will benefit most from the programme; countries that, for the most part (except for the case of Italy), are net recipients of funds from the European budget.

Furthermore, the programme is designed to prevent it from shifting to an obvious additional tax burden. This could have undesirable Ricardian-type effects (depression of consumption today with the expectation of a higher tax burden in the future); however, the mechanism reserves the right to extend the own resources ceiling for each Member State’s contribution to the EU budget to 2%. This would be a measure of last resort and would be used primarily with the creation of new tax figures. The only way not to increase the tax burden in the EU would be to tax non-European sources of income, the digital levy, borderline CO2 adjustments and a possible financial levy would meet this requirement. In this context, it would seem desirable to take advantage of the possible additional tax structure to create the necessary incentive mechanism to adopt the digital and green transformation in the EU. Thus, to the extent that taxes are instruments to internalise negative externalities, the RFF could have a transformative character on the side of tax incentives, if the right ones were created.

In short, the RFF is a giant step forward in the project of European construction on a political and economic level. Without a doubt, it is an instrument that can help actively transform the productive model and the economic structure of the EU, making it fairer, more competitive, more balanced and sustainable if it is correctly implemented in terms of its uses.  Furthermore, on the resources side, its financing will involve a first step in the creation of joint financial instruments that offer a new world of possibilities for financial development. And, on the fiscal side, the programme represents a still distant but firm step towards future coordination; a decisive move towards European solidarity.