Fiscal Union 1.0

At first sight you might rub your eyes in disbelief. Italy is sometimes the country in Europe that has been hit hardest by the Corona crisis. Economic output is expected to fall by a double-digit percentage this year, while the debt-to-GDP ratio is rising almost by leaps and bounds. Italian government bonds, on the other hand, appear to be hardly affected by the crisis. The yield on ten-year paper is around 1.5%, and the premium over Bunds with the same maturity is around 180 basis points. By way of comparison: at the height of the dispute between the Italian government and the EU Commission in autumn 2018 the yield was still around 3.7% and the spread around 320 basis points. However, the additional expenditure planned by Rome at the time, which accounted for a large part of the dispute, was almost negligible compared with the fiscal programmes currently under discussion.

Two key influencing factors are responsible for a rethink among investors and have almost completely overridden the mechanisms that have been in place to date in the eurozone government bond market: The ECB bond purchase program PEPP and the emerging European fiscal union. With the introduction and now even the increase of the PEPP to EUR 1,350 billion, the ECB has nipped in the bud, at least in the short term, any discussion as to whether the euro states can also refinance the crisis management programmes. Not only has the ECB created a huge demand that can absorb any supply, but unlike the still existing PSPP programme, the PEPP is so flexible that there are no limits on the purchase of certain countries or even individual bonds. In this way, the ECB not only secures the refinancing capability of the countries, but has also indirectly created the possibility of controlling spreads within a corridor. The ECB has thus equalised risk in the euro zone, at least for the coming months. For investors, risk considerations have made it almost irrelevant whether they buy Italian bonds or German government bonds.

However, the ECB will terminate the PEPP sooner or later once the Corona crisis has subsided. In the absence of an alternative solution, the lack of ECB demand would almost certainly trigger a new discussion about Italy’s debt sustainability and thus become a massive problem for Rome and thus for the entire Eurozone. Since this danger is so obvious, it increases the pressure, especially on the core states, to abandon their resistance to an EU fiscal union. The new name of the old idea of a fiscal union is „reconstruction fund“ and will change European finances in two ways at once. On the one hand, there will be an extensive transfer mechanism within EMU in favour of the periphery, and on the other hand the EU can even finance financial aid by credit, for which the states are jointly liable. From a market perspective, this means that the formula that has applied up to now, namely that risk premiums for government bonds primarily reflect country-specific risks and fiscal parameters, will become less and less valid. Ultimately, this could even lead to the fact that, in spite of considerable variations in the debt ratios of the states, major differences in yields between government bonds in the euro zone will sooner or later be a thing of the past. The logic of the market is being overridden for the overriding political goal of eurozone stability. We can already see the beginning of this development.

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