Euro Outlook: Spat over EU Recovery Fund has Substantial Implications for the Currency and Eurozone Growth in 2021 says ING

- EU leaders meet to try and rescue their Rescue Fund
- Spanish growth could be halved in 2021 and 2022 on failure
- EUR could unwind recent gains
- Dec. summit likely to be key moment

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The leaders of the European Union's 27 member states are not only meeting on Thursday to discuss the status of post-Brexit trade negotiations, but to also thrash out a potential solution to save the EU Recovery Fund agreed in mid-2020.

According to new analysis, the success or failure of leaders in rescuing the Rescue Fund will have substantial implications for economic growth for numerous EU economies, as well as the Euro.

"The EU's agreement on a Recovery and Resilience Fund (RFF) to fight the economic consequences of the Covid crisis can be seen as one of the most historic feats of the bloc in recent decades," says Bert Colijn, Senior Economist, Eurozone, at ING Bank N.V. "However, the implementation of the fund has turned out to be more difficult than many market participants thought when it was first agreed in July."

The recovery plan is due to be rolled out in 2021 but news this week that Hungary and Poland have blocked its progress draws questions on whether the plan will actually be passed. The two countries blocked approval of the EU's long-term budget on Monday, which includes the €750BN coronavirus recovery package, saying it would interfere in their domestic laws.

The reason for their rejection of the deal is because the budget comes with strings attached, which include a new condition designed to stop EU funds going to countries that violate certain rule-of-law standards set by the EU.

"Hungary and Poland made good on their threat and rejected the long-term EU budget in protest against the rule of law mechanism. This also blocks the recovery fund, which is supposed to benefit countries like Italy and Spain in particular. Now the heads of state and government must address the issue," says Christoph Weil, Senior Economist at Commerzbank.

EU leaders will meet over video on Thursday to see how the row can be defused, if at all.

Slovenia joined Poland and Hungary on Wednesday in backing criticisms of the plan. "The three countries are trying to block the currently negotiated rule of law mechanism, holding the entire package hostage and, with hindsight, illustrating that the decision to combine all three deals into one package may not have been the wisest one," says Colijn.

"It is a game of chicken as Poland and Hungary benefit significantly from the EU budget but they also know that other countries would benefit significantly from the Recovery Fund. Also, by blocking the package deal, net contributors will not get their recently negotiated “rebate” on contributions to the budget," adds the analyst.

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A fundamental pillar of support for the Euro exchange rate complex in 2020 has been an expectation for European Union member states to come together and agree a joined-up approach to funding the recovery from the covid-19 crisis in 2021.

The plan - agreed in July - entails the borrowing of funds by the European Commission to spend on those EU countries hardest hit by the crisis, thereby ensuring the debt is guaranteed by all nations. The success helped propel the Euro to multi-year highs against the Dollar in the summer.

But it is not just the resistance of these three countries to the conditions attached to the finance package that stands in the way of passing the Fund.

"European finance ministers have still not agreed on the technical details of the fund and are running out of time to get everything done before the end of the year. Secondly, the decision to combine the multi-annual budget framework with the rule of law mechanism and the Recovery Fund is a complication that is causing delay," says Colijn.

According to ING, the economic repercussions of a failure to reach a compromise that saves the Fund has significant implications for economic growth in the Eurozone's smaller and peripheral countries:

But bigger, more systemically important countries would see their growth potential severely restrained by a failure to pass the Fund.

ING says Spain would would see its GDP growth rate cut by more than half for 2021 and 2022 in the absence of the funds promised in the package, and this is said to be a conservative estimate.

ING analysis meanwhile shows Greek growth depends to a large extent on potential contributions from the Fund for the coming years as it stands to gain more than 3% per year.

For Italy, the research shows the impact as being somewhat smaller, owing to the larges size of the economy, but nevertheless still substantial.

The impact on financial markets and Euro exchange rates is meanwhile also seen as sizeable.

"Also, and maybe even more important, don’t underestimate the impact that the announcement of the Recovery Fund has had on financial markets. The eurozone received strong tailwinds, with the euro experiencing a rally over the summer and government bonds spreads narrowing. The message that the EU leaves no country behind in the Covid crisis is very important from a signalling perspective, which would be lost if no eleventh-hour solution is found," says Colijn.

Commerzbank's Weil says EU leaders will likely find a compromise agreement with Poland and Hungary over their concerns.

"The subject of the compromise is likely to be the application of the rule of law instrument. In this way, the EU could signal to both countries that it will forego harsh punishments in the ongoing proceedings for EU law violations," says Weil. "We assume that a breakthrough will be achieved at the regular EU summit on December 10-11 at the earliest."

However, Weil warns that a failure to reach a deal at the December EU Council summit will likely have serious consequences for the Eurozone and its single currency.

"If the adoption of the EU budget is delayed any longer, investors are likely to become more nervous," says Weil.