I’ve been trying to think of ways in which the European Council could surprise me tomorrow by coming up with an EU-level policy response that appreciably changes the asymmetry of risks regarding non-core Europe. 1/

Something really needs to happen. It’s not outlandish to assume a 10% drop in EZ GDP in 2020, and for Italy/ Spain to contract by more than this. Expectation for the 2020 Italian budget deficit may have to start at -10% of GDP and move wider. 2/

The ECB’s QE and PEPP will amount to ~7% of EZ GDP this yr. Given that these will be ultimately tied to the capital key, this will imply a similar proportionate purchase of Italian debt, which may result in ~6% of GDP worth of BTP purchases. 3/

That’s a notable (permanent!) absorption of duration from the mkt, but leaves a sizable funding gap or 2020 let alone 2021. The limitations of the ESM and ECB OMO as a way to bridge the residual are pretty well know, so I’ll focus on other options. 4/

There seems limited appetite for issuance of joint and several liability bonds at the EZ level which would provide an added funding source and represent a step change in progress towards a fiscal union, which would be relevant for risk premia. 5/

Hence, expectations are focused on the EU budget as a solution. What seems an immediate non-starter is an expansion of the EU budget sufficient to directly fund a proportional counter-cyclical fiscal easing and ease non-core funding issues. 6/

The existing budget is ~1% of GDP (~EUR160bn a yr). A proportional fiscal response would need a more than doubling of the budget which seems a stretch at a time of fiscal weakness and amid debate about replacing the UK’s contribution. 7/

A direct budget response would be sub-scale. It would also have allocation problems. Non EZ countries would be financing a problem caused in part by Italy not having its own central bank. (Italy requires looser conditions than the ECB is offering.) 8/

Would these non-EZ countries, and indeed other EZ countries, feel comfortable with the funds being allocated squarely to the countries where the need as greatest, or would they want a more balanced allocation? 9/

Any unlevered EU budgetary response would therefore likely be met with a resounding sense of disappointment. Which brings us to the levered options for the EU budget. 10/

Could the EU government’s allocate EU budgetary funds that could be levered via debt issuance, similar to the ESM, and ideally with some form of joint and several liability structure? 11/

This would markedly increase the resources available and, depending on the liability structure, could reduce risk premia by representing a large step to a fiscal union. It could provide a bumper headline number which may move markets. 12/

Even here, limitations grow apparent. If we assume that loss bearing capital in the EU budget is leveraged 10Xs, then the EUR1.5trn recovery package Spain is proposing could require a 0.9% of GDP of capital, a near doubling of the annual EU budget. 13/

A far smaller EUR40bn provision of capital from the EU budget, which would be “just” a 25% expansion of the existing budget, would create a EUR400bn recovery fund, which is useful but falls well short of shock and awe. 14/

You then have the same political problems. The EU level budget would require the financial contribution of non-EZ countries, whose commitment to large liabilities to fund a EZ problem would understandably be more luke-warm. 15/

You would also have the same political issue regarding the direction of those funds. Could they be allocated in a highly disproportionate manner towards the countries in greatest need? 16/

Could the funds be used for counter-cyclical reflation (infrastructure spending) rather than for direct CV-19 expenditures a la the planned ESM funding? (A quid pro quo for less conditionality seems to be a narrower and less effective use of ESM funds). 17/

There is also the timing. At earliest, it’s hard to see the funds being deployed before the start of next year when the new budgetary cycle begins, and would the full leveraged recovery fund be available on day 1 or be spread of the life of the EU budget? 18/

Similarly, could the desire for a shock and awe number (EUR2.2trn is currently mooted) see a smaller annual capital commitment but one paid over the life of the 7yr budget? Possibly, but the needs of the non-core are more immediate. 19/

You also have the broader policy framework to consider. Would any recovery fund be associated with a reversal of the current push for EZ fiscal austerity to begin in 2021? For the sake of internal consistency, one would hope so. 20/

This is a long-winded (boring) threat which leads me to a conclusion that I hope to be wrong about: it’s hard to expect a transformational policy response at the EU level tomorrow. For now, the ECB seems to remain the only real game in town. 21/