Point/Counterpoint: The Case for the Euro

© Reuters.  © Reuters.

By Geoffrey Smith and Liz Moyer

Investing.com — Europe’s relative success in beating back the novel coronavirus and its economic damage, plus a hotly debated plan in the region to inject stimulus into the recovery effort, may be signaling a buy opportunity in the .

The region has not suffered the same magnitude of problem that the U.S. faces, particularly as states and cities return to business only to confront a fresh round of cases and fears that more U.S. lockdowns are in the future.

Geoffrey Smith argues the bull case for the euro, saying the massive scale of the recovery fund being considered suggests that European leaders are putting budget balancing on the back-burner for the time being and that the mindset around burden sharing in the region has changed. 

Liz Moyer, on the other hand, says the outlook isn’t so rosy. Europe continues to struggle with growth, and the Covid-19 shutdowns have only exacerbated the eurozone’s issues with zombie companies and negative interest rates.

The Bull Case

The euro is a buy for one big reason: the pandemic has changed the face of eurozone fiscal policy and, quite possibly, the course of the European Union.

For one thing, the scale of the budgetary support being required means that austerity as a doctrine has been firmly canned. The chorus of hawks calling for a return to balanced budgets as soon as possible will be small and faint.

Germany, whose years of budget surpluses have acted as a brake on eurozone growth, is now on course to run a deficit of 7.5% of GDP this year. France’s will be north of 11%. The Netherlands’ may hit 12%. Evidently, austerity is enjoyed more as sadism than as masochism.

Just as importantly, the pandemic has made it impossible to sustain the fiction that Italy, Greece and maybe others can rescue themselves from sovereign bankruptcy by tightening their own belts.

This is the calculation behind the European Commission’s proposal for a 750 billion-euro Recovery Fund, to be raised by joint borrowing and distributed according to need, rather than economic weight. It’s the biggest step yet to acknowledging that a single currency needs a single treasury, backed the full faith and credit of its members. 

There is even talk – albeit so far just talk – of the ECB dusting off plans for a eurozone ‘bad bank’ that would take billions more in risks off the balance sheets of a stressed banking system. Finally, Europe gets it. The fat tail risks are visibly thinning. The lack of agreement at this week’s EU summit doesn’t change that – the EU doesn’t agree on anything without a good deal of haggling first. The key factor is that German Chancellor Angela Merkel has changed her mind – and is not reaping any backlash for it in domestic politics (her approval ratings, after 15 years in power, are at 80%).

That hasn’t spared the euro zone a sharp recession. But recent data suggest that the euro zone has at least as good a chance of a V-shaped recovery as the U.S., with new infection rates picking up only marginally as lockdowns come to an end across the continent. Data over the last two weeks have shown German business sentiment, French household consumption and eurozone car sales all rebounding faster than expected, helped by generous and effective measures to ensure job preservation.

Even doubts about the effectiveness of the ECB’s own policy appear less well-founded after this week’s events. The huge take-up of new ‘targeted long-term refinancing’ at rates as low as -1% on Thursday – the biggest operation in the ECB’s 21-year history — has ensured a net injection of over 540 billion euros into the system. If a second wave of infections can be avoided, the economy is primed for a rebound. 

The Bear Case

The trouble with the euro is Europe has too many zombie companies, it still suffers from deeply negative interest rates, and there is major execution risk with the EU recovery fund.

A zombie company is one that doesn’t earn enough to cover interest payments and would otherwise go out of business. More than a decade of low interest rates have benefited over-leveraged firms in Europe, creating these zombie companies, and they have feasted on cheap credit and government intervention in capital markets. 

Those at the lowest end of the credit spectrum now risk default amid a steep drop in consumer spending owing to Covid-19 lockdowns. They represent a broad cross section of sectors, such as transportation, cyclicals and industrials, not to mention travel and leisure companies. The latter won’t come back until consumer confidence returns and the virus is subdued.

Meanwhile, central banks are already against the fence when it comes to rate cuts, as rates in the eurozone are already below zero. Negative rates were introduced in Europe around six years ago and have persisted as the eurozone struggled to come back from the 2008 financial crisis and its aftershocks, including the debt crisis of a few years later. Despite efforts to reverse course, the EU has had to instead further stimulate the economies to encourage growth, with uneven results.

While negative rates make borrowing cheap, they don’t restore confidence. A lack of spending by consumers and businesses can’t be helped by central bank intervention. And they punish savers at a time when spending has been curtailed, forcing people into risk assets like stocks, a precarious move when volatility is rising and markets are over-bought.

Negative rates have also pressured Europe’s banks at a time when the goals of growth and economic recovery from Covid-19 would demand banks lend more.

EU leaders can’t even agree on the structure of the proposed Covid-19 recovery fund, Reuters reported this week. The proposed fund, a combination of grants and loans, is meant to finance the EU’s recovery and smooth over differences in regions where there have been varying national responses to the crisis and related economic fallout.

Hard-hit countries like Italy and Spain could do well with the support because they have less financial flexibility than their northern neighbors, but there are major differences among members about the best way to provide that support without burdening their own taxpayers with extra risk.

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