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A euro area ‘rainy-day’ fund could support Europe’s institutional and economic resilience

A euro area rainy-day fund could support members in crisis and bolster the EU’s fiscal capacity, helping prevent or mitigate the fallout from economic shocks, but very significant challenges to its implementation remain, Scope Ratings says.

A recent International Monetary Fund publication emphasised a call for a rainy-day fund, suggesting that euro area countries could contribute 0.35% of GDP a year to a collective ‘pot’. Separately, European Central Bank President Mario Draghi last week stressed the need for a tool that facilitates investment in countries suffering the downside of economic cycles. Scope believes such a fund could support the EU’s resilience to shocks but notes that material challenges remain to progress in the fund’s evolution and design.

Scope Ratings analyst Dennis Shen addresses five questions on the ongoing deliberations.

Why does the EU need to develop this fiscal capacity in the context of monetary union?

The global financial crisis exposed the extent of imbalances between EU economies. A euro area cyclical stabilisation fund, or ‘fiscal capacity’, could help address the resolution of country-specific shocks before they spill over, and maybe even prevent some crises. An automatic financing tool via the fund could support investment in troubled economies that otherwise would have limited fiscal ‘wiggle room’.

How would such a rainy-day fund work?

Members would pool contributions to build assets in good times. They could draw on this pool in slowdowns or crises. It’s essentially a counter-cyclical fiscal insurance mechanism, helping smooth the business cycle. Funding could be set as automatic transfers contingent on a flat rate, or – in Scope’s view – preferably be partially variable, levying proportionately greater amounts from member states where growth is above trend or where macroeconomic imbalances are building. Counter-cyclical contributions ensure to an extent that countries with increasing risks would also contribute most to the fund during the boom, thereby effectively paying for their own disbursements once boom turns to bust.

Would the proposed fiscal capacity solve the euro area’s structural problems?

No, and it’s not supposed to. A solution to economic divergences in the euro area must go well past just counter-cyclical compensation to addressing the root causes of downturns and regional asymmetries. For a common monetary policy to be effective and support optimal efficiency and maximum employment in the euro area, there needs to be adequate convergence in real interest rates and economic cycles. One requirement is the completion of the single market for labour, goods and services. Completion of the banking and capital markets unions, tighter financial and macroeconomic supervision, and better coordination in economic policymaking also need to be addressed.

To what extent is there a danger of moral hazard?

Moral hazard is key to understanding the opposition of some countries that are keen to avoid the establishment of a system of automatic transfers that could allow debtor nations to drag their heels on reform and avoid consequences. These reservations are sensible. That’s why a combination of counter-cyclical fund contributions (to penalise countries that live beyond their means), and strict conditionality on disbursements (to facilitate economic reforms so crises don’t recur), is crucial to getting sceptical member states – particularly Germany – to support the idea.

Are there ratings implications of a rainy-day fund?

It’s too soon to say. Whether or not it will even materialise is itself still an open question (and if so, in what form). Scope highlighted in its 2018 Public Finance Outlook that meaningful reform of Europe’s institutional architecture is one of the main routes to potential rating upside for relevant countries. On this basis, we could view any progress on the rainy-day fund as credit positive in the long run, but this would be entirely contingent on its design.