Covid-19: Darkest or brightest hour for the European Union?

The reports of the death of the European Union have been greatly exaggerated – to quote Mark Twain — a few times already in the bloc’s tumultuous life.

This time, however, the European Central Bank (ECB) cannot be the only one to do “whatever it takes” to save the eurozone – and implicitly the wider EU — from the economic consequences of the Covid-19 crisis.

A report on Monday, May 18 that Germany’s Chancellor Angela Merkel and France’s President Emmanuel Macron had reached agreement on creating a fund worth half a trillion euros to combat the effects of the coronavirus on the eurozone’s economies was hailed as a historical breakthrough.

Investors, but also ordinary people, praised this agreement as proof that the region’s politicians can raise above petty national considerations when the occasion demands it. The eurozone was saved, many of them thought.

If only it were that simple. The eurozone’s biggest economy may have finally agreed on some form of debt mutualisation – although Merkel did stress that the debt instruments needed to capitalise the fund would be issued by the European Commission, not the by the eurozone – but others are harder to convince.

The plan is for the Covid-19 recovery fund to get money from the sale of bonds issued by the European Commission, with which to finance grants to help the EU’s worst-hit regions. This would ensure that Italy, which was the first to be hit (and hit hard) by the new coronavirus, could avoid economic collapse.

However, Merkel did warn that agreement between her and Macron did not mean the matter was settled.

Will Covid-19 Break up the Eurozone?

Indeed, at least four EU members are not that keen on solidarity in times of crisis – despite the fact that they have been great beneficiaries of the many advantages of the EU, such as open borders and free trade.

Austria, Denmark, the Netherlands and Sweden joined forces to oppose the plan to distribute the funds as grants, insisting that they should be given out only as two-year loans.

But such a measure would risk a break-up of the eurozone for good. Its third-largest member, Italy, already had a huge debt before the crisis. It is set to increase even more, from 135% of gross domestic product to about 180% of GDP this year, according to predictions by London-based think tank Capital Economics.

Italy’s economy depends in a larger measure on tourism than that of other EU member states, and its growth was sluggish even before Covid-19 forced it to shut down one of its most lucrative sectors indefinitely.

These two headwinds have caught investors’ attention, and the cost of Italy’s debt, together with that of the other eurozone periphery countries — Greece, Spain and Portugal — jumped.

Eurozone countries 10-year bond yields

Yields on 10-year sovereign bonds. Source: Capital Economics, with data from Refinitiv


European rating agency Scope Ratings, whose top-notch analysis on the European Union’s economy and banks is a must-read, lowered its outlook on Italy’s sovereign debt, which it rates BBB+, to Negative on May 15.

Italy, Second-Weakest Growth After Japan?

Scope Ratings predicts that Italy’s debt will hit 155% of GDP by the end of this year – growing not as fast as forecast by Capital Economics, but still quite rapidly.

“This increase will likely result in a structural, that is, a material and lasting, rise in average annual gross government financing needs after the crisis, further limiting Italy’s fiscal space and adding pressure regarding the country’s medium-run debt sustainability,” the rating agency said in explanation of the outlook downgrade.

Italy’s nominal growth was 1.3% a year in average in the decade before 2019, whereas average real growth was a meagre 0.2%. Scope estimates the country’s real economic growth potential to be at around 0.7% in the medium term, the second-weakest in its rated sovereign universe after Japan’s potential.

The outlook downgrade partly reflects assumptions that the working-age population of Italy would decline by 0.4% a year and is influenced by the country’s track record of loosening fiscal policy during good times, high turnover in governments and lack of a consistent agenda to address debt reduction.

News about Italy is certainly grim. And yet, the eurozone – and the wider EU — cannot survive if Italy is to collapse under the weight of its debt. The Covid-19 crisis removes the public pressure on governments in the so-called “frugal” countries to impose drastic austerity on fellow Europeans.

Yes, Italy has to reform its economy and ensure that it engages on a sustainable path to reduce its debt mountain. But it cannot do this in the middle of a pandemic, weakened by the Covid-19 crisis and with the most efficient sectors of its economy virtually shut, and likely to be crippled for a long time.

Besides skill and hard work, luck plays an important role in succeeding, be it for individuals or for countries.

This could be the European Union’s darkest or brightest hour. Which one it will end up being depends entirely on its luckiest members.