French and German leaders agree to support €500bn EU aid package for worst-hit states

Deal still faces opposition from some northern European countries, who believe funding should be provided through loans rather than grants

German Chancellor Angela Merkel listens during a joint press conference with French President Emmanuel Macron, who attends via video link, at the Chancellery in Berlin, as the pair propose a €500bn aid package to help European Union states overcome the economic fallout from the Covid-19 pandemic. AFPShow less

German Chancellor Angela Merkel and French President Emmanuel Macron agreed to support a €500 billion (Dh2 trillion) aid package to help the European Union recover from the coronavirus pandemic in a major step towards tighter integration.

Following a videoconference between the two leaders, Ms Merkel said that Germany would accept a fund within the framework of the EU budget, financed by additional borrowing, that would make grants to member states that have been hardest hit by the virus. Crucially, she said the bonds issued by the European Commission would be repaid from the EU budget, the lion’s share of which is covered by Germany. Italian bonds jumped.

“The EU must act together, the nation state has no chance if it acts on its own,” the chancellor said in a joint online press conference with Mr Macron. “This is the biggest challenge in the history of the EU.”

The proposal marks a significant step in efforts to shore up the European project and a potential win for Mr Macron, who’s been calling for Germany and the richer northern states to do more to help those in the South who’ve suffered most. The sums involved would dwarf the commission’s existing debt issuance, a sign of Ms Merkel’s determination to keep the EU together.

Yet the plan is still only a foundation. A final deal will need the backing of all 27 members, and Austria signalled immediately that it remains opposed to direct handouts. A spokesman for Dutch Prime Minister Mark Rutte said the commission should come up with a proposal for members to discuss and that his team took note of the Franco-German outline.

If it goes through, the agreement could relieve some of the pressure on the European Central Bank, which has so far taken the lead in the EU-level response, pledging to buy more than €1tn of debt to stabilise markets while political leaders struggled to coordinate their own efforts.

Italian bonds jumped the most since March on Monday, with 10-year yields dropping as much as 20 basis points to 1.68 per cent. The risk premium over German bonds, which declined on the news, narrowed to 216 basis points, the lowest level this month. The euro climbed 0.6 per cent to $1.0887.

ECB President Christine Lagarde praised the proposal as “ambitious, targeted and, of course, welcome” in an interview with multiple newspapers published on the central bank’s website.

"This is the biggest challenge in the history of the EU,"

“They pave the way for the European Commission to borrow funds over the long term and, above all, they allow a substantial amount of direct support to be provided to the countries most affected by the crisis,” she said. “This is testament to the spirit of solidarity and responsibility.”

Ms Lagarde could still ramp up her bond purchasing programme when policy makers meet on June 4. Governing Council members have repeatedly said they’ll do what’s needed to guide the euro-zone economy through the crisis and, before this week, most economists predicted that would mean an extra €500bn of bond buying this year.

The ECB is concerned that if it doesn’t mop up the massive amount of debt needed to combat the fallout from the virus, financial markets will tighten and delay the recovery. In the worst case, the bloc could be tipped into another debt crisis.

Until now, the EU response has been delayed by a dispute over so-called eurobonds, with France and Italy leading calls for jointly issued debt to shield public finances in the worst-hit countries from the biggest decline in economic output since the Second World War. The commission projects that Italy’s public debt will be close to 160 per cent of its gross domestic product by the end of this year.

Spanish Prime Minister Pedro Sanchez indicated his support for the Franco-German proposal, saying on Twitter that “it is a step in the right direction, in line with our own demands".

The proposal Ms Merkel outlined on Monday marks a major shift toward bolstering the EU’s financial power while skirting Germany’s constitutional ban on debt mutualisation. While the plan would see member states share liability for the recovery fund, it wouldn’t breach the German constitution because the exposure is limited, according to an official for Ms Merkel’s Christian Democratic party.

German Chancellor Angela Merkel speaking with French President Emmanuel Macron, via video link, at the Chancellery in Berlin, Germany, on May 18, 2020. AFP

“As Germans, we are ready to make a significant contribution to the regions and industries that are particularly hard hit,” said Eckhardt Rehberg, the CDU’s budget spokesman in the German parliament. “European assistance is possible without coronabonds or Eurobonds – and thus without debt pooling.”

Ms Merkel said that EU treaties won’t be changed at this point but that might be possible in the future, opening the door to conversations about deeper fiscal integration.

A jointly-financed recovery fund would help to restore the level playing field within the EU single market, which has been distorted by deep-pocketed states like Germany showering their firms with subsidies while countries like Italy can’t match that spending power. The proposal also includes ambitious plans to overhaul the European economy, including stricter emissions targets for 2030, measures to punish imports from polluters outside the EU and looser state-aid rules to help the creation of larger and greener companies.

The agreement between France and Germany “acknowledges the scope and the size of the economic challenge that Europe faces”, Commission President Ursula von der Leyen said in a statement. The commission will unveil its proposal for the recovery fund on May 27.

But the key deliberations will be taking place in Austria, the Netherlands, Denmark and Sweden, which have so far proved to be the staunchest opponents of increasing aid to the areas worst hit by the virus. Austrian Chancellor Sebastian Kurz said on Twitter that the four nations’ position hadn’t changed and that a recovery effort should be made through loans. That’s in contrast to the German proposal, which would distribute money through grants.

But the initiative by Ms Merkel and Mr Macron could make it difficult for other member states to object.

“This Franco-German agreement means that the other ‘frugals’ cannot really oppose anymore the principle of European debt instruments,” said Daniel Gros, director of the Brussels-based CEPS think tank. “But they can still nibble at the edges, making eligibility more stringent.”