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Stabilising sovereign debt and deepening EMU after the pandemic - speech by Klaus Regling

Klaus Regling
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Klaus Regling, ESM Managing Director

Speech “Stabilising sovereign debt and deepening EMU after the pandemic”

Financial market conference of the CDU Economic Council

[Finanzmarktklausur des Wirtschaftsrats der CDU]

Online, 6 May 2021


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Ladies and Gentlemen,

The pandemic has changed Europe. Economically, politically and socially. I will focus on the economic aspects, which include the deepening of monetary union and the work of the ESM.

Europe is just emerging from the deepest economic crisis since the Second World War. All forecasts by international and European institutions as well as by market analysts predict strong growth from now onwards. Average annual growth will be four to five percent in this year and the next. On average, the euro area countries are expected to return to their pre-crisis economic performance of 2019 in the coming year.

However, the uneven impact of the symmetrical COVID shock on the different European countries is problematic for the European single market and the monetary union. This is mainly due to different economic structures. For example, Spain recorded a decline in GDP of 11% last year because of its strong tourism sector, while Germany had a decline of just 5%.

Both the economic downturn last year as well as this year’s recovery are unevenly distributed across countries and sectors, thereby further increasing the risk of growing economic disparities between countries. As this is harmful for all members of the EU and of the monetary union, it was important and right to undertake measures at EU level to prevent distortions in the single market and divergences in the monetary union. At the same time, the monetary policy measures of the European Central Bank stabilised financial markets.

The fact that the EU countries decided to grant the biggest share of the NextGenerationEU package, and especially of the Recovery Plan, to countries which were the hardest hit by the pandemic, is of crucial importance.

As a first step, three EU safety nets totalling €540 billion were put in place a year ago. First, the ESM pandemic credit line is available for countries to cover direct and indirect healthcare costs. Second, the European Commission is funding a safety net for workers, and third, the European Investment Bank's new guarantee fund is financing additional investments in businesses.

In addition, the €750 billion Recovery Plan, which consist of loans and grants, was decided upon in July. The aim of the Recovery Plan is to support promising investments and reforms in all EU countries to boost green, sustainable growth. In this context, it is crucial that countries particularly affected by the pandemic receive significantly more support. EU solidarity, which was always expressed through the EU budget, is thereby rightly brought to a new level.

The different countries are currently submitting their plans for the use of EU funds to the European Commission for assessment over the next two months. It is essential that all EU countries - especially those most affected by the crisis - make effective use of the recovery programmes to strengthen their resilience and competitiveness in the long term. If this is doable - which will not be easy - it will not only temporarily boost demand but may also lead to the desired increase in longer-term potential growth.

In addition to the measures taken at European level, the individual states responded to the pandemic with extensive national fiscal measures, guarantees, liquidity assistance and deferrals of taxes and social security contributions. In total, these measures amount to more than one third of GDP for the euro area and even exceed 40% in Germany.

As a result, average national budget deficits in the euro area have increased from 84% of GDP in 2019 to around 100% today. We also see a wide range here, from 18.5% in Estonia to 200% in Greece.

This fiscal policy response to the pandemic was entirely justified. Nevertheless, it raises the question of debt sustainability and to what extent high debt levels can jeopardise future growth.

As Managing Director of the ESM, I am of course very concerned about debt stabilisation. The ESM mainly focuses on debt sustainability, for which we consider factors such as interest rates compared to potential growth. At the moment, we still consider the sovereign debt in the euro area to be sustainable, even that of highly indebted countries such as Greece.

This is mainly due to the low interest environment. There are good economic reasons why interest rates have decreased substantially in Europe and in all major economies over the last decades. While rates will increase from their current very low levels, they will nevertheless remain lower in the future than they were 20 or 30 years ago. This means that a higher level of debt can be serviced in the medium term without placing an excessive burden on budgets.

However, the situation is very complex. On the one hand, government debt of 100% or maybe even more can be considered sustainable at such low interest rates. On the other hand, due to the ageing population, increased expenditures in the areas of healthcare and pensions will affect government budgets, thereby reducing potential growth.

At the same time, the current period of economic change makes growth forecasts difficult. While the crisis could weaken potential growth, the opposite could also be true, and growth could be strengthened thanks to a targeted and efficient use of the recovery fund.

Despite this uncertainty, we at the ESM currently remain confident that euro area countries will be able to service the debt they accumulated in the pandemic.

However, it will also be important to reform the fiscal surveillance framework of the monetary union in this context. EU rules on budget deficits, as laid out in the Stability and Growth Pact, rightly remain suspended until 2022. We should use this time to agree on an improved, simpler and more credible budgetary surveillance framework.

Nowadays, investors have little confidence in the current framework with its many exceptions. Simpler and more effective rules would help stabilise and guide policy decisions and market opinion.

There is another, methodological reason for reform: the output gap, one of the key variables for assessing fiscal policy, is not directly measurable but can instead only be estimated. We have been lacking consensus over how to perform this calculation since the financial crisis.

What is clear, however, is that the monetary union needs a set of rules to coordinate fiscal policy. In my opinion, the 3% deficit limit, which can be suspended in a real crisis, remains relevant. I could imagine taking a more flexible approach towards the current debt ceiling of 60%, since interest rates – as I already mentioned - will remain significantly lower in the foreseeable future than they were in the last decades. They will not remain as low as they are today, but they will still be lower than at the time of the negotiation of the Maastricht Treaty. An increase of the 60% limit therefore seems justifiable to me. At the same time, one should limit the growth of public expenditure and set the primary surplus in light of the debt level. This would make it possible to reduce excessive debt levels to an economically justifiable extent.

While the current crisis runs deep, it also has some positive aspects to it. It has the potential to accelerate structural, economic change as well as European integration. European integration also includes the further deepening of our monetary union. The EU is right to now focus on fighting the pandemic. Nevertheless, we should not lose sight of deepening Economic and Monetary Union because this will help us to be even better prepared for future crises.

The ESM reform will help further improve financial stability in the euro area. The backstop for the Single Resolution Fund is an important element of this reform.

While this backstop is an important step towards completing the banking union, some elements are still missing, in particular a European deposit guarantee. A hybrid model is currently under discussion, not least to accommodate Germany. This proposal provides for a national deposit guarantee as a first line of defence, making an EU fund no more than an additional liquidity safeguard.

By the way, the Greensill case clearly reminded us that Germany also has its weak points. It would therefore be a mistake to assume that an additional European protection would only benefit other states. A common deposit guarantee, together with the backstop of the ESM, some regulatory improvements - in particular to the crisis management framework - as well as stronger cross-border integration – I’m referring to the home/host problem here - would complete banking union.

In addition, we need to make progress on capital markets union. This would facilitate cross-border investments, strengthen the competitiveness of the euro area and open up new ways of financing companies. At the moment, this is particularly relevant as it would facilitate an economic rebound in the euro area once the pandemic has subsided. All this would improve the allocation of capital in the Economic and Monetary Union, increase the growth potential and make the euro more attractive to international investors.

In addition, I believe we need a central fiscal capacity for macroeconomic stabilisation in the euro area in the medium term. Although this is highly controversial among our member states, it is recommended by all European and international institutions. The countries in the monetary union have, after all, given up two important economic instruments, namely national monetary policy and exchange rates. The remaining macroeconomic instrument, fiscal policy, is thus gaining in importance. In a crisis, a central fiscal capacity would supplement the national fiscal buffers of the member states with a European fiscal buffer to cushion economic downturns. The ESM could take on this additional role.

We should therefore use the current crisis as an opportunity to address structural economic weaknesses, accelerate the digital and green transformation and to deepen Economic and Monetary Union. All this will help Europe to maintain its current position in the global economy and will strengthen European sovereignty between two global superpowers.

Thank you very much. I look forward to our discussion.