Europe Shows New Resolve to Boost Economic Recovery | Lord Abbett
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Economic Insights

A very important next stage for the eurozone would be more direct support for the nonperforming loans of banks, our expert believes.

Read time: 3 minutes

Early in June, the European Union’s politicians and central bankers showed renewed resolve to overcome the deep economic shutdown caused by the COVID-19 health crisis.

Not only did European officials agree to new fiscal stimulus at the supranational level, but also Germany’s government agreed to pile on additional direct fiscal stimulus to its already large prior announcements. To cap things off, the European Central Bank (ECB) announced more bond purchases in its Pandemic Purchase Program (PEPP), among other favorable policy tweaks.

Markets have responded favorably to all these developments. And more stimulus followed as France announced a small €26 billion increase in its third revised budget announcement on June 10, according to Bloomberg.

Some commentators may argue that existing stimulus is still too small and more needs to be done, but I think the real focus should be on something Europe has been reluctant to do, but that could work in spades right now: let the ECB establish an asset management company to hold nonperforming loans and finally free Europe’s banks from their constraints.

To recap briefly, the major developments in early June included:

A More Generous European Union Budget

  • The European Union (EU) agreed to €440 billion in grants to member states, €60 billion in guarantees, and €250 billion in loans alongside a €11.5 billion increase in its standard budget. The use of more grants than loans is particularly encouraging as it means more help from wealthier countries. The additional loans help somewhat by being financed at a lower cost than typically paid by individual countries.
  • Previously, the EU had agreed to a pandemic credit line from the European Stability Mechanism that offers cheap financing up to 2% of a nation’s gross domestic product (GDP), although it seems countries are reluctant to use it because of a perceived stigma. The EU also refrained from imposing harsh conditions on those who use the facility, another welcome sign of unity. The EU also previously agreed to €100 billion to support unemployment insurance and awarded the European Investment Bank with €200 billion in extra liquidity to support lending to small and medium businesses.

Additional German Fiscal Stimulus

  • Recently, Germany agreed to an additional €130 billion stimulus. This is around 4% of GDP and is on top of its already substantial fiscal package announced weeks ago. This tranche of stimulus focused on supporting household consumption through a value-added tax reduction, outright transfers, and limits to social security contributions.
  • The new package also provides grants to small businesses and accelerated depreciation allowances.
  • The measures also attempt to help Germany address climate change by including subsidies for electric cars, various green public investments, and financial assistance for consumers with renewable energy surcharges. This last point is notable as sometimes the transition to green energy is expensive and falls hardest on low-income families.

 

Figure 1. Direct Fiscal Stimulus in Germany Begins to Rival That of the United States

 

Source: Brueghel.  Note: Brueghel calculates the ratio of the 2020 measures to 2019 gross domestic product (GDP), because the 2020 GDP outlook is very uncertain.  The category “Other Liquidity/guarantee” includes only government-initiated measures (excludes central bank measures) and shows the total volume of private sector loans/activities covered, not the amount the government put aside for the liquidity support or guarantee (the amount of which is multiplied to cover a much larger amount of private sector activity).

 

Additional ECB Stimulus

  • Although consensus expectations were high in the lead-up to the ECB meeting on June 4, the Governing Council managed to slightly exceed these expectations by announcing an additional €600 billion in PEPP and committed to using the program until June 2021. The ECB also decided to reinvest the maturing proceeds of PEPP bonds until the end of 2022.
  • Some commentators looked for the ECB to include more deposit tiering1  to ameliorate the costs of negative rates for banks, and to include “fallen angel” credits in its general purchase programs  that would effectively be grandfathered at their prior credit rating. (Read my colleague Riz Hussain’s take on fallen angel bonds in the United States.)

The Next Stage

These last concerns speak to a very important next stage for the ECB and the eurozone: more direct support for nonperforming loans (NPLs) of banks. The ECB is doing a great amount of financing support for banks by offering very attractive TLTRO and PELTRO lines of credit. However, we are moving from supporting liquidity to supporting solvency as this crisis progresses. NPLs in Europe were already high to begin with, and a sudden increase in credit lines plus a very severe contraction may only exacerbate loan performance. For example, there were some €500 billion of NPLs in Europe as of the end of last year and the European Banking Authority estimates a €380 billion hit to European banks’ capital in 2020.

One way of dealing with NPLs is through securitization, but in Europe this practice is not as prevalent as in the United States. Instead, in my opinion, Europe should consider establishing an asset management company to purchase loans from banks. There are two main drawbacks to such a proposal. First, there is the usual north-south divide over pooled costs and risks in Europe, but if the recent fiscal deal is any sign, this concern may be ebbing. Second, this type of company may be contrary to the European Commission’s laws on state aid, which usually require a resolution process first before the application of state aid.

But it could be that the proposed asset management entity or “bad bank” only targets a quarter of NPLs in Europe, perhaps allaying fears of a widespread bailout. And the structure of the “bad bank” may be designed to rely more on market funding than national treasuries. Overall it seems like these hurdles are surmountable for something that, in my view, would greatly aid Europe’s recovery.

 

1In September 2019, the ECB introduced a so-called tiered system of interest rates whereby a portion of bank deposits, currently set at six times their mandatory reserves, is exempted from the charge.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

A bad bank is one that is set up to buy the bad loans of another bank with significant nonperforming assets at market price.

Pandemic emergency longer-term refinancing operations (PELTROs) operations provide liquidity support to the euro area financial system and contribute to preserving the smooth functioning of money markets. 

The Pandemic Emergency Purchase Programme (PEPP) is a €750 billion bond purchase programme, covering both public and private securities, and was launched by the ECB to mitigate the enormous economic and financial risks to the Eurozone caused by the coronavirus pandemic

Targeted longer-term refinancing operations (TLTROs) are Eurosystem operations that provide financing to credit institutions. By offering banks long-term funding at attractive conditions they preserve favourable borrowing conditions for banks and stimulate bank lending to the real economy.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

 

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