German judges handed down an important verdict this week: EU treaties are no obstacle to shared debt in the union. The ruling comes shortly after the European Commission called for new joint injections into the economy. “As an investor I would carefully reconsider my bond portfolio,” one critic warns.
On Tuesday, the German constitutional court in Karlsruhe ruled that “exceptional” EU loans to overcome problems caused by the Covid-19 pandemic do not violate European treaties.
Earlier, the court paused the Covid aid packages because it would allow the European Commission to borrow money directly from the capital markets. That would violate European law, according to the complainants, including former German politician and professor of macroeconomics Bernd Lucke. However, the court ruled otherwise this week.
The ruling comes at an interesting time, only two days after European Commission President Ursula von der Leyen, speaking in Bruges, launched a new proposal for joint financing to counter US-China economic dominance and strengthen the European Union’s industrial base.
Foreign protectionism calls for more support
In particular, US President Joe Biden’s Inflation Reduction Act, passed in August, is perceived by many as a protectionist challenge to Europe and other parts of the world. “It should make us think about how to improve our state aid frameworks and adapt them to a new global environment,“ von der Leyen said. She called for “additional European funding” in the form of a “sovereign fund” in her speech in Bruges.
US protectionist subsidies and the “assertive industrial policies of Europe’s competitors”, von der Leyen said, require “common European financing”. The aim is to prevent companies in Europe from moving production to the US in response to the hefty subsidies, and other benefits, that Washington is willing to give these parties.
Although the court remains critical of shared debt through aid packages, the judges indirectly determined that EU treaties need not be an obstacle to future loans to promote European industry and energy supply.
The court takes no clear position
“It does not seem entirely impossible to base the funds on EU legislation,” the court stated in its ruling. In doing so, the court is essentially saying that current aid packages will not be blocked, but are highly problematic legally.
As far as the court is concerned, the budgetary powers of EU member states are indispensable elements of the constitutional principle of a democracy. However, the German judges argue that it is “not evident” that the aid packages create obligations for the German government that “impinge on the general budgetary responsibility of the Bundestag”, according to the ruling.
Should Germany eventually become responsible for the debt of other union member states, then the parliament must “take appropriate measures to protect Germany’s federal budget”, the ruling said.
‘Redistribution operation’
Sylvester Eijffinger, professor emeritus of monetary economics at Tilburg University, is surprised by the German Constitutional court’s ruling. Although the judges leave unanswered the question of whether the court will approve participation in further joint debt missions in the future, Eijffinger says EU aid packages are indeed made structural with this ruling.
“In the case of the emergency aid that followed the economic malaise of the Covid pandemic, one could still argue that there was an exceptional situation. That is much more difficult in the case of ‘industrial protection’,” said the professor emeritus. Exceptional, moreover, is the legal basis on which the loans are based, as the treaty explicitly prohibits the European Union from borrowing money - at least under normal circumstances.
“With the ruling, we are taking a big step towards the completion of the transfer union, where rich countries prop up the weaker ones,” Eijffinger argued. “France, Italy and other southern member states have long been on that track. With the riot with the US, von der Leyen wants new support packages. Member states have to guarantee that. So there is indeed a ‘redistribution operation’,” Eijffinger concluded.
British-like situations
Although bond markets hardly reacted to the news, it would have been better “for the long-term state of mind in financial markets” if the German court had made a different ruling, Eijffinger said. The problem, he said, lies mainly in the combination between the Commission’s expansionary fiscal policy and the ECB’s restrictive monetary policy, which actually needs to reduce its balance sheet.
Existing buyback programmes like the Asset Purchase Programme (APP) and the Pandemic Emergency Purchasing Programme (PEPP) are proving to be extremely effective in reducing bond spreads in the eurozone, academic research shows. But, as the ECB starts to slowly wind down those buying programmes, that effect will diminish. More eurobonds will only increase spreads further due to the credit rating differential with the periphery.
“As we have seen in the UK, central bank deleveraging, combined with extremely generous fiscal policy from the political side, is causing a lot of turmoil in financial markets. That combination is what worries me most. Investors should think carefully about what they do with government bonds in the portfolio,” Eijffinger said.
Market not pleased with legal controls
If the ECB decides to deleverage substantially in the coming years and market sentiment worsens, investors may become nervous about whether the ECB will activate the TPI (Transmission Protection Instrument) to accommodate southern countries, says Hendrik Tuch, head of fixed income at Aegon Asset Management. He is one of the investors unhappy with the court’s ruling.
Tuch argued that there is currently enough demand for sovereign debt from the periphery to keep spreads on domestic bonds contained. But, despite the judges’ finding that the support programmes do not violate the law, the German Constitutional court’s continued scrutiny drive is a thorn in the market’s side, Tuch said.
“It is worrying to see the German Constitutional court scrutinising every additional EU expenditure, or every new ECB monetary instrument, once again. Especially since the German government has previously approved these measures,” said Tuch.
“If the constant criticism from Karlsruhe continues, investors may well get nervous,” warned Tuch.“It seems that further financial integration of the European Union will require an amendment to the current EU treaty. Bringing that about is a political nightmare.”
This article originally appeared on InvestmentOfficer.nl.