Should the European Union turn to financial markets to finance its programs?

Posted On: 30 September 2022

Cofunded by the European Union. Views and opinions expressed are however those of the author(s) only and do not necessarily reflect those of the European Union. Neither the European Union nor the granting authority can be held responsible for them.

1. Learn the ropes

What is NextGenerationEU?

NextGenerationEU is the recovery plan to overcome the Covid crisis and its consequences. With €806.9 billion in funding, its ambition is to boost and strengthen the European economy, making the continent healthier, greener, and more digital.
Part of the funds, up to €338 billion, are being provided in the form of grants, which Member States will not have to repay for. The other part, up to €385.8 billion, are going for Union loans to individual Member States. These loans will be repaid by those Member States.
Spain and Italy are the two biggest beneficiaries of NextGenerationEU. As such, the recovery plan also aims to reduce imbalances and inequalities between the different European regions.

NextGenEU also brings an important innovation : a common debt. Indeed, the recovery plan will be financed via debt issued from the EU on financial markets but backed by guarantees of the member states. Although the EU has financed inself on financial markets for over 40 years, the amounts were smaller than those planned to fund NextGenEU. Moreover, Member States would determine the volume, maturity and timing of the funding transactions, not the European Commission itself.

How do EU borrowings on financial markets work?

To finance NextGenerationEU, the European Commission, will borrow from capital markets through bonds. The borrowing will occur between mid-2021 and 2026. This would translate into borrowing volumes of on average roughly €150 billion per year, all of which will be repaid by 2058.

To issue those bonds, the EU has for the first time created a common European debt. Implementing common EU borrowing was a very important signal sent to financial markets during the COVID-19 crisis. It showed EU solidarity and generated confidence in the resilience of the euro area. Thanks to the EU’s high credit rating, the Commission can borrow on advantageous conditions. The Commission will pass the benefit on to the EU Member States directly when providing them loans or to the Union budget in the form of low interest rate payments on borrowings to finance recovery spending.

The EU budget, which is financed by its own resources and contributions from all EU Member States, backs the borrowing. Repayment of the borrowing will start as of 2028 and take place over a long-time horizon, until 2058. The loans will be repaid by the borrowing Member States while grants by the EU budget.

What are the consequences of borrowing on financial markets?

The borrowing will eventually have to be repaid, with additional interest linked to the bonds. European common debt is mainly bought by banks, States and investment funds. However, some economists believe it is better to focus on European own resources. The EU possesses several kinds of own resources, but due to not levying taxes on a European level, Member States have to contribute to own resources. The contributions include: (1) So-called traditional own resources (customs duties collected by Member States on behalf of the EU and agricultural duties, i.e. import duties collected on agricultural products). (2) The resource based on value added tax (VAT). (3) The GNI-based resource (gross national income). This resource is levied as a uniform rate in proportion to the GNI of each Member State.

To increase its own resources and pay back its debt, some argue that the EU should adopt a common fiscal policy (i.e. a fiscal union) in specific sectors: taxes on single-use plastics, and the Carbon Border Adjustment Mechanism (CBAM). These new resources would thus be used to pay NextGenEU back and diversify revenues to make the EU less reliant on Member States’ contributions.

As a consequence, NextGenEU and its funding on financial markets raise the question of a deeper European integration.

2. Choose your side

The idea behind the Rift is simple: for each topic of debate, we provide you with an expertise based on a pro-con approach, written by competent and legitimate experts. We want to help you make your own opinion, and guide you on first steps to civic engagement.

Are you in favor of the creation of an European common debt?

FOR

EU Public Debt is an EU Public Good

Rebecca Christie

Non-resident fellow, Bruegel economic affairs think tank

website

The Covid-19 pandemic brought the European Union many challenges and at least one unexpected gift: a fast-track path to joint borrowing. Thanks to the €750 billion Next Generation EU program and its public financing component, Europe found both the money and the political will to backstop the pandemic economy. The indisputable collective shock – and corresponding absence of any perceived moral hazard – allowed conservative member states like Germany and Finland to overcome historic reluctance to merge more of their finances with their neighbors. The payoff has been a strong financial infrastructure that, if managed wisely, can set the EU and the euro on a strong course for decades to come.

Well-designed public debt strengthens a developed economy and its currency

Risk has dominated discussions of whether and how much the EU should borrow collectively. This is like talking only about fire threats when it comes to electricity. While power lines can be dangerous, they also keep the lights on and the houses warm. Likewise, well-designed public debt strengthens a developed economy and its currency. In building NGEU, the EU joined the ranks of the U.S., the U.K. and Japan in being able to borrow money safely, reliably and efficiently. Creating a permanent channel to invest confidently in the euro would raise the relatively new monetary union to a new level.

The European Commission has what it takes

Public debt has to be well-managed to work well. The underlying economy needs to be strong and sturdy, to build investor confidence. Government financial managers must work with the banks, insurance companies and investment firms that buy the securities to make sure the system works reliably and in all financial weather. NGEU has shown that the European Commission has what it takes. In 2021, the EU ramped up its public borrowing dramatically while earning a AAA top rating from major credit-rating companies.

The euro area has long had a strong central bank

The dollar leads the world because it is backed by a strong central bank, a stable and well-regulated banking system, and the security provided by an ecosystem of easily tradeable US Treasury bonds. The euro area has long had a strong central bank. During the global financial crisis it created a strong and credible joint bank regulator. To progress further, it needs to complete its banking union project and take the leap toward creating a permanent safe asset in the form of public debt. Europe and the US are economic partners and global leaders. It’s time for them to become financial market peers as well.

AGAINST

The EU is not (yet) sovereign and financial markets know it

Cinzia Alcidi

Director of Research, Centre for European Policy Studies (CEPS)

website

Issuance of EU common debt was taboo until 2020. Since its inception, the EU common budget was designed to be small (about 1% of the GNI) and balanced. EU expenditure is driven by long-term spending plans that always meet the resources available. The pandemic broke this taboo. To rebuild a post-COVID-19 EU, on top of the usual EU budget, the Commission introduced Next Generation EU (NGEU), a plan worth €750 billion. To finance it, the EU is expected to raise up to €800 billion by the end of 2026. The first NGEU bond issuance was a success with a huge final order book. Easy as it was, should financial markets become a recurrent source of financing for EU spending? It is tempting to say yes, but it is more complicated than that.

It is not clear yet which resources will be used to repay debt when the time comes

This idea of EU debt implicitly assumes that the EU needs a larger budget. It is not just because of the pandemic; additional funds should permanently be available. This may be a sensitive point but the purpose and the scope of more extensive EU interventions should be defined, and decision powers allocated. The EU would not have much credibility vis-à-vis financial markets without a federal state or a political union. Neither of them is in sight.

Funding expenditure through debt is not an alternative to increasing EU own resources. Financial markets proved very benevolent during the EU first issuances. But demand largely above the supply and very low interest rates should not be taken for granted. While the current debt is jointly guaranteed by EU member states, the debate on own resources is stalling. None of the current options to increase UE own resources seems to be politically feasible. As a result, it is not clear yet which resources will be used to repay debt and interests when the time comes. The good news is that there is a lot of time until then.

Common EU debt is not impossible but it is a complicated business

The macroeconomic environment has worsened dramatically since 2021. The COVID-19 crisis and the war in Ukraine have hugely increased uncertainty and inflation has reached a 40-year high. Interest rates are increasing and overall market conditions are unlikely to be as favorable as they were a year ago. Greater guarantees may be required to borrow the same amounts, and at the moment they are not readily available. They depend on the willingness of member-states with sound public finances to do so.

Common EU debt is not impossible but it is a complicated business. EU wider issues, related to its design and functioning, should be fixed before assuming that the EU can turn to financial markets in a systematic manner, just like a sovereign state.