EU recovery plan and the Euro, will the currency be affected?

Get Minerva Analysis' take on why the stock market might not be impacted by the EU's latest recovery plan, but the euro could be knocked off course if the "frugal four" get their way. 

The EU Commission announced a new recovery plan for Europe on Wednesday, which could see a transformation of the EU’s central finances. The new plan could see the EU borrow EUR 750bn to bankroll recovery efforts after the ECB said that the currency bloc’s economy could fall between 8-12% this year as a result of the pandemic. A steep economic decline and a bailout plan – so far so normal, but these are not normal times. The plan would include EUR 500bn of grants for some of the most negatively impacted member states – Italy and Spain – which they would not have to pay back. The next EUR 250bn would be a package of low interest rate loans. For the first time in its history the EU would be borrowing money centrally to help stricken member states’ recover from the economic hardship caused by the pandemic. This could be epoch-changing for the EU and herald a new era of debt mutualisation. The FX market liked what it heard on Wednesday,  EUR/USD jumped above $1.10 on the news. 

However, while the headlines look radical, is this proposal actually that radical, and will it be enough to drive the euro higher in the long term? We take a deeper dive to see how financial markets might treat this latest recovery plan from the EU. 

There are strings attached: of course there are, this is the EU, which has typically been wary of pooling debts, especially when countries in the eurozone have different credit ratings. The grants would flow through EU programs intended to boost competitiveness, shift away from declining heavy industry, support the bloc’s green agenda and help to build a digital economy. This won’t necessarily help the struggling tourism sector that so many southern European countries rely on for income and jobs. It also takes years to turn away from things like heavy industry and build new ones, thus these grants may not be able to avoid the economic erosion and high unemployment caused by the pandemic in the short term. 

The money won’t be available until next year: this is no magic panacea for countries such as Italy and Spain. As we mention above, the EUR500bn of grants won’t necessarily go to the hardest-hit sectors, such as tourism, fashion, travel etc. The grants are designed to help create the EU economy of the future. Our concern with this is two-fold, firstly, it may not be enough to stem large declines in economic growth, and secondly, it may take a lot more cash than EUR 500bn to shift the EU’s economy in the direction that the EU Commission would obviously like it to take. Thus, this “mutually funded” programme could be a mere drop in the ocean of what is needed to transform the EU’s economy. 

It still needs to be agreed: all of the EU member states need to agree to this plan, and it has already faced some criticism from the “frugal four” nations:  the Netherlands, Austria, Norway and Denmark. They have pushed back against the prospect of paying for other countries’ debts and are also worried about higher budget contributions in the future. However, we believe that this plan will be agreed, largely because Germany and France have voiced their support. The EU Commission are hopeful of ratification in three weeks’ time, before the next EU leaders’ summit. We expect the euro to be sensitive to the outcome of next month’s summit. 

How it will be paid for: Borrowing would go through the EU budget, which the EU Commission says can be paid for by an increase in taxes and levies. Depending on your economic persuasion, some people believe that an increase in taxes dents economic growth. Added to this, some of the taxes and levies would impact some countries more so than others. Ireland could be in line for EUR2bn in grants, however, there would be a sting in the tail, as a digital tax could hurt Facebook and Google, who have based their European operations in Ireland to benefit from their low corporate tax rate. While the detail is yet to be agreed, Ireland’s era of low corporate taxes could be a thing of the past due to this plan. 

Market reaction: So far, the markets have reacted warmly to the plan, the Eurostoxx index was up 1.5% on Wednesday alongside the Dax index. The Eurostoxx index has recouped nearly 50% of the February to March declines, but it still has a long road to recovery. It is hard to see how EUR500bn of grants that won’t be distributed until next year and will be divided up between member states, will be enough to fuel the next phase of Europe’s corporate recovery. Instead, the ending of lockdowns, a strong tourist recovery this summer, combined with a vaccine for the coronavirus are likely to be the biggest drivers of recovery for the hardest hit Eurozone economies, and not these small steps towards debt mutualisation. The Dax has outperformed the Eurostoxx index in recent weeks, largely because of its focus on heavy industry and its strong links to Asia, which has opened up ahead of Europe and the US. Overall, we don’t think that the latest EU recovery plan will be enough to drive a significant stock market recovery. While it may boost some green energy companies, we doubt that it will fuel a wide-ranging rally. 

The euro: The single currency is likely to be more sensitive to this recovery programme, and it rose 90 points when the plan was announced on Wednesday. It has since given back some of its recent gains, but EUR/USD remains above the significant $1.10 level, and technical indicators are looking strong for the euro right now. $1.1060 is the 50% retracement level of the March sell-off in EUR/USD, which is a major resistance level. If EUR/USD breaks this key level, then we may see a sustained recovery in the beleaguered single currency. However, the EU recovery plan continues to pose a risk to the direction of the euro. If the “frugal four” nations that are resistant to the plan do not agree to it then the EU Commission will not be able to put it into action. This could seriously dent the recent euro recovery and may also throw into doubt the sustainability of the eurozone if the nations hardest hit by the coronavirus are left to recover on their own. Although we believe that this is a low risk event, it could limit any euro upside for the time being. In our view, the euro is a short-term trade for now. If it falls back to short-term support at $1.0985 then it could attract buying interest, with the market looking at a break of $1.1060 to see a sustained trend higher.