EU supras to play bigger part in funding bloc’s security and growth

Maria Demertzis, a professor of economic policy at the European University Institute in Florence, has been wrestling with a continent-sized problem. She thinks she has the diagnosis. “Europe is a big market. It has a lot of people, and it is a rich place, yet somehow it doesn’t seem to be doing as well as it ought to be doing,” she says. “The reason is that we haven’t managed to integrate to achieve scale.”

The problem is certainly not a new one — and perhaps neither is the diagnosis. But a cure seems to be a long time in coming. Speaking in 1991, Jacques Delors, architect of the modern EU, told its parliament that the completion of a borderless single market was “crucial to our prosperity and our role in the world”.

More than 30 years later, the EU, with its borderless single market, is struggling. It longs for further economic innovation to ensure global status, just at a time when it is perhaps becoming more vulnerable.

The euro area, for example, is comparable in size to the US but economically it has underperformed it drastically in recent times. Between 2010 and 2022 it grew about 50% slower than the US, according to the Centre for European Reform.

The EU may be a collection of only 27 states rather than 50, but they are of course far less homogeneous, not federalised and have hundreds of years of competition, conflict, independence and difference behind them. Meanwhile, Russia’s invasion of Ukraine has brought war to its doorstep and exposed its vulnerability to energy prices.

The latest effort to drive further EU integration to achieve benefits of scale came in the form of former ECB governor and Italian prime minister Mario Draghi’s September report, The Future of European Competitiveness. It again diagnoses the EU’s malady but makes policy recommendations to solve it, calling for €800bn of additional investment a year, or about 5% of the bloc’s GDP.

Few are better placed than Draghi to comment on EU rescue. Many consider him the saviour of the euro following his intervention in the sovereign debt crisis in 2012 while ECB president, when he famously said the institution would do “whatever it takes” to save the single currency.

He calls for a transition to a green, digital and more productive economy. But, for some, investment on this scale is hard to swallow. About 80% of investment in Europe has historically come from the private sector — but if it is to maintain that share in such a boost as Draghi prescribes, its cost of capital will need to plummet.

This means that public sector investment will probably need to do the heavy lifting. But simply dialling up the flow of government funding may not be possible.

“There are a lot of concerns for the future regarding public investment,” says Debora Revoltella, chief economist at the European Investment Bank (EIB). “The EU has fiscal rules in place and fiscal consolidation is expected in many countries. This usually comes with some deprioritisation of public investment. The concern is how to keep this level of public sector investment going, or even accelerate the pace.”

With some large member states fiscally constrained, the pressure is on the EIB, the European Stability Mechanism (ESM) and the EU itself to innovate and help deliver. That will not be without its challenges.

Perhaps one of the key levers for the EU to pull is the issuance of more common debt. Many see the EU accelerating its already rapid expansion into the capital markets as a necessary step to funding Europe’s future.

“My personal view is that we cannot do what we need to without more common debt,” Demertzis says. “We can dance around the issue all we like but we cannot do it.”

As an issuer, the EU is unrecognisable compared with its pre-pandemic form. Including the assistance lent to its member states, the EU has more than €500bn of outstanding debt and this will grow to almost €1tr, according to an official from the European Commission, which executes the EU’s capital markets borrowing. In 2020 it had about €50bn in debt.

“We have implemented all of what is needed in terms of funding strategy to be used as a new liquid safe asset,” the official says. “We have created a network of primary dealers, we have significantly increased our investor base and in parallel we have developed the ecosystem for EU bonds.”

The development of the €750bn NextGenerationEU (NGEU) programme, to fund the bloc’s economic recovery from the pandemic, is seen as a framework for the Commission to build off in the future.

Joint borrowing would help develop the long-awaited Capital Markets Union, coordinate policy among member states, and drive further EU integration.

However, increasing the debt pile alone will not be sufficient — or even possible — without political support. “Funding is not a purpose on its own, it always serves political objectives,” says the EC official. “It is powerful, but it requires political decision and political agreement.”

More frugal member states, such as Germany and Austria, have resisted further EU fiscal integration. Commenting on the Draghi report, Christian Lindner, Germany’s finance minister at the time of its publication, said that more joint borrowing by the EU “will not solve structural problems” and that “Germany will not agree to this”.

Apostolos Thomadakis, head of research for the European Capital Markets Institute (ECMI), thinks that without an urgent unifying cause, such as the pandemic, there will be no political appetite for more joint debt. Absent such urgency, “member states will likely continue prioritising and protecting the national turf, showing that unity in this area is still limited”, he says.

One such unifying cause might be defence, prompted by Russia’s invasion of Ukraine. EU member states are, according to the Financial Times, considering a €500bn fund for common defence projects. It would raise money in the bond markets, with treasury functions provided by the EIB.

The scheme may not be ready to be launched imminently. “We have not been seized of any such plans,” says an EIB spokesperson.

There are tough political conversations to be had about joint borrowing. One of them involves member states agreeing on how outstanding debt repayments will be made. Demertzis says that this is the “first thing” that needs to be done before further joint borrowing is discussed.

EU bonds are guaranteed by the EU budget, funded by the commitments of member states. About €350bn of the NGEU funds made available to member states, financed by those bonds, is in the form of grants rather than loans. The bonds mature from 2028 onwards. The Commission has not detailed where the funding for these payments will come from.

“The EU managed to issue common debt without committing to how it will be paid back,” Demertzis says. “In my view, this is very important. We need new own resources, and it is essential to communicate where this will come from as, ultimately, it will be the taxpayer that pays.”

The Commission has previously proposed avenues to source new own resources: contributions from the Emissions Trading Scheme (ETS), from the EU Carbon Border Adjustment Mechanism (CBAM) and from a share of the residual profits from large companies reallocated under an Organisation for Economic Co-operation and Development agreement. The concern is that member states will want to keep control of these resources. Meanwhile, new taxes have been proposed.

Commission president Ursula von der Leyen has recognised that new own resources will be needed to “ensure sufficient and sustainable financing for our common priorities”.

Research from Bruegel, a Brussels-based economic think tank, shows that, depending on which assumptions are used for the repayment profile, the interest and principal repayment costs for NGEU common debt could come to about €25bn in 2028.

“Without new revenue sources, this would put massive pressure on the relatively small EU budget and could lead to a bloodbath in the next multiannual financial framework,” says Conor McCaffrey, a research analyst at Bruegel, who co-authored the research.

“Bringing new revenue sources online would show that the EU has its act together and can service its debt without relying entirely on more contributions from national governments,” he adds. “It could help change attitudes and increase the political likelihood of more common debt.”

McCaffrey says that there is concern about the EU’s supply drying up if it only borrows to roll over debt after 2026, when the NGEU programme ends. Even if this were the case, the Commission spokesperson says, it would keep the EU in the range of being the fifth or sixth biggest issuer in the European bond market.

While Draghi advocates for more joint issuance, he recognises that it will be difficult to do. Many of his policy recommendations concentrate instead on improving efficiency.

“We don’t always need new regulations; rather, we need consistent application of the existing rules with clear oversight across markets,” Thomadakis says.

The EIB sends out an annual investment survey to help monitor companies’ behaviour. One question that the supranational asks is whether companies have problems exporting to other EU member states because of different standards or consumer protection rules. About 60% of respondents in this year’s report say they do.

Revoltella says that figure would be 0% if the single market were complete; Delors’ dream seems still to be a way off.

Complex regulations across the bloc make it less attractive for companies to invest and scale up in the EU. But that should not prevent the bloc’s big institutions from finding creative solutions. “I think that the role of supranationals is to think outside the box on how to crowd in more investment,” Revoltella says. “The EIB is really an institution that can play a big role in supporting the productivity and competitiveness in Europe.”

She stresses the point of creating financial innovations to shape incentives that bring in the private sector — de-risking instruments associated with renewable energy products exemplify this kind of innovation.

“The EIB has a lot to do,” she says. “We bring financial productivity, financial innovation and a wealth of knowledge to the market, and that is where we have a role to play.”

By the volume of its borrowing and lending, the EIB, based in the Kirchberg quarter of Luxembourg, can be described as the largest multilateral development bank in the world. It will be a vital tool in the EU’s efforts to achieve economic growth.

“The EIB is an important partner for us in implementing our policies,” says the European Commission spokesperson. “It is giving credit to the economy which is combined with other private money. What we are achieving here is a leveraging of public budget resources.”

By its nature, and to achieve the triple-A credit ratings that give it so much financial firepower, it is managed in a conservative fashion — it has never, for example, had a year in which it has made losses. This approach, according to Demertzis, has increased its capital buffers and has contributed to a decreasing leverage ratio. She suggests the EIB should increase the risk profile of its balance sheet.

“Because we don’t have the private money in Europe to take risks in the long term, somebody else has to do it,” she says. “The EIB has the capacity and the knowledge to take more risks.

“It could both do more and [be] more risky. With a change of leadership, I think that there is an occasion to do more.”

Spanish economist Nadia Calviño took over in January 2024 as the EIB’s president. Under her presidency the development bank has agreed to lift the statutory limit on its gearing ratio — the amount that the bank can lend in relation to its own resources — raising it from 250% to 290%.

“We are convinced on our side that the move will not change the perception the market has of the EIB or its triple-A rating,” Revoltella says. “We see it as a marginal move in terms of market effect.

“I think that there is more that we can do on the innovation side and scale-up side for firms, but we are already a very big player, so we have to search for ways to become more lean and efficient.”

Policymakers are having existential conversations about another piece of the European financial furniture.

The ESM, also headquartered in Luxembourg and with a €422bn lending capacity, has a mandate to ensure the financial stability of eurozone countries.

It was set up in 2012 during the sovereign debt crisis to provide access to funds for EU member states in distress. Some think that, with no country in the euro area in the same sort of distress as several were back then, the ESM can do more to help fund Europe’s borrowing needs.

“Since staff are being paid in Luxembourg at the ESM, why not repurpose it?” asks one public sector bond market participant. “This would be the whole idea behind a unified funding approach.”

In 2020 the lending institution created a credit line for euro area countries to help finance health-related costs incurred during the pandemic. It has not been used but it has sparked debate around further innovations the ESM could foster.

The possibility of installing a credit line for defence and security expenditures has gained the most traction. However, in a speech in July, ESM managing director Pierre Gramegna said that “there would need to be consensus among the 20 ESM member states that defence and security matters trigger financial stability risks” and perhaps a change to the treaty under which the organisation was created.

“Embracing new financing mechanisms at the EU level will help tackle significant challenges, ensuring a safer, more prosperous future for all,” he added. “But we must focus on the resources that are at hand first.”