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Reinforcing monetary union in Europe

An important ESG issue and a key consideration to ensure the eurozone’s recovery.

  • Political volatility and north vs. south disparity are risks for 2021/2022.

  • Making periphery economies more attractive through lower borrowing costs could be the key to lasting monetary union.

  • We believe a united eurozone will be more impactful in moving the ESG agenda forward.

  • As investors, we need to maintain pressure on policymakers to mitigate break-up risks, drive borrowing costs down and stimulate economic recovery.

ESG-oriented investors looking at eurozone sovereign bonds typically focus their attention on green bonds and mutualised EU debt issuance as an investment answer in the midst of the Covid-induced recession.

But there is an alternative option which many have not considered.

It could be argued that an ESG agenda can be more significantly achieved by looking at how monetary union in Europe can be strengthened by applying pressure to policymakers to reinforce this in order to mitigate future worries related to the break-up of the single currency.

This year bore witness to one of the biggest down-moves in global economies that any of us have experienced in our lifetimes.

Notwithstanding headlines around vaccines and what a recovery could look like, at some point it seems likely that attention will focus on political risk going into 2021 / 2022. Particularly as things start to improve and we see disparity in the performance of different countries.

Country disparity: North versus south

It’s likely that southern Europe will underperform its northern counterparts. The fact that German tourists haven't gone to Spain and Italy to spend their holiday money has actually been a net positive for the German economy, relatively speaking. Whereas those economies more reliant on tourism will continue to be badly hurt.

This disparity between north and south could in turn create divisions in monetary policy. We’ve started to see this within the European Central Bank (ECB), where certain policy hawks in northern Europe are already looking to take back some of the accommodation as those in southern Europe push for more.

There is also a lingering concern that although a lot has happened in the last few months to dampen down political volatility within Europe, there's plenty of scope for that to return.

And of course, when it comes to national politics, in countries like Italy, it will be interesting to see whether the recession that we're seeing on the back of Covid-19 and elevated levels of unemployment plays more into the hands of populists like Fratelli d’Italia.

As we move forward into 2021 / 2022, could we end up with politicians in power who are pushing an anti-EU agenda and thereby creating more stress within the eurozone?

An ESG lens on engagement

From an ESG point of view, it can be argued that our role as investors has less to do with how we approach buying EU bonds – which are AAA-rated assets. In a world where high-quality collateral is a rare breed, these assets will always find a buyer. Instead, it’s arguably important to make the periphery more attractive by constructively engaging with policymakers and applying pressure to make a lasting monetary union.

But why?

Take Italian bonds, for example. The reality is that Italy is a sovereign country, it's a wealthy country, it's a country with a high level of savings. There’s a high level of debt-to-GDP, but with a fairly long maturity and the interest burden that Italy is paying is relatively low.

Back in the days when you had a 60% target on debt-to-GDP in the Maastricht Treaty, everyone was assuming bond yields would be at 5% and therefore 60% debt-to-GDP meant you were spending 3% of your budget on interest payments. That was almost the maximum that was thought to be sustainable at the time.

However, if we're in a world of 1% or lower borrowing costs, clearly a much higher level of debt-to-GDP can be sustained without being a threat to fiscal sustainability.

When you look at the credit spread in Italy, it isn't really about pricing credit risk. For BTPs, it has always been about pricing in the probability of whether Italy is going to be part of the eurozone or not over the next 10 years.

That uncertainty, that ‘break-up premium’, effectively explains why spreads are higher in Italy than they otherwise would be. A consequence of that is Italian banks face high borrowing costs, which then get passed onto Italian businesses.

It also means that monetary policy is more restrictive in Italy than it is in Germany, even at a time when it would be preferable to see the reverse. In our view, more stimulative policy in Italy than in Germany would give some much needed support to the Italian economy.

In an ideal world, policymakers would continue to take steps to cement a monetary union to mitigate long-term break risks, drive borrowing costs down and in turn be in a situation to better stimulate the economic recovery.

So, frankly, EU bonds…who cares? It's good that there is EU issuance as it means less Italian BTP issuance. However, if you really care about helping the European economy recover from the Covid-19 crisis, you would want to see Italian borrowing costs driven down and spreads driven tighter.

Looking ahead

As investors in both Europe and the euro, we ultimately have a vested interest to make the region work. That’s not to say such lobbying and engagement efforts are being done in a Machiavellian sense, trying to purely make profits. It's ultimately done with a deep-seated desire to see positive policy outcomes.

An important part of this is maintaining a dialogue and applying pressure to European policymakers to ensure there is a continued move forward toward an ever-closer monetary union and not to allow complacency to creep in and outcomes to develop where ultimately you end up with renewed stress in the months ahead.

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